Category: Market Action

Not much today, folks! In the spirit of the day, I had to spend some time slaying dragons and was unable to assemble my List of Interesting Things.

A return of good volume, the market was up and the index was down. What a great day!

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

Accrued Interest has reluctantly called a bottom in the credit markets:

But yeah, if you stick a gun to my head, I’d say we’ve seen the wides in credit spreads. Not because the economic problems are solved, but because liquidity has improved to the point that people are willing to be opportunistic. That will put a lid on how far investment-grade names will move before yield hungry investors come in. Issuers will be able to come to market with new issues, and the wheels of the credit market will continue to churn.

Meanwhile, today is the day that the CBOT officially attempts to find out why the basis on grain futures isn’t going to zero during the delivery period, as mentioned April 17. Naked Capitalism republishes a NYT article on the issue which suggests:

Mr. Grieder’s crop insurance premiums rise with the volatility. So does the cost of trading in options, which is the financial tool he has used to hedge against falling prices. Some grain elevators are coping with the volatility and hedging problems by refusing to buy crops in advance, foreclosing the most common way farmers lock in prices.
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Futures, for example, are less reliable. They work as a hedge only if they fall due at a price that roughly matches prices in the cash market, where the grain is actually sold. Increasingly — for disputed reasons — grain futures are expiring at prices well above the cash-market price.

When that happens, farmers or elevator owners wind up owing more on their futures hedge than the crops are worth in the cash market.
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John Fletcher, a grain elevator operator in Marshall, Mo., started pressing the C.B.O.T. to address the flaws of futures contracts almost two years ago — even before his futures hedge on a million bushels of soybeans failed to fully protect him last September, hitting him with a cash loss of $940,000.
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Frustrated over the flawed futures contract, Mr. Fletcher is voting with his feet. Last year, he entered into a contract with A.I.G. Financial Products, a leading sponsor of commodity index funds, which allows him and the index fund to hedge their risks without using the C.B.O.T.

Instead of using futures or options, A.I.G. simply buys the commodity directly from Mr. Fletcher, who stores it for a fee and buys it back six months later. His storage fee is lower than the one built into the C.B.O.T. contract, so A.I.G. pays less for its stake in the market. And he has a hedge he can rely on.

In a strong indication that Canadian banks are using their strong balance sheets to sniff around in the States, BMO has announced:

a definitive agreement today to acquire Chicago-based Griffin, Kubik, Stephens & Thompson Inc. (GKST). The acquisition will make BMO Capital Markets the sixth-largest bank qualified municipal bond dealer in the United States and the largest in Illinois, greatly accelerating BMO’s national presence in the municipal bond market.

Good for them! It would appear that the BNS / National City rumours discussed on April 11 have come to nothing:

Cleveland-based National City, Ohio’s biggest bank, agreed yesterday to sell a $7 billion stake to a group led by Corsair Capital LLC.
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National City agreed to sell the Corsair stake at a discount to market price, and increased the size of the offering after finding strong demand. The move, which may dilute existing shareholders by more than 50 percent, sent the stock plummeting almost 28 percent and drew complaints from investors who asked during a conference call whether there wasn’t “a more palatable alternative.”

The bank had to raise enough capital “to stabilize our debt ratings, beyond a shadow of a doubt,” National City Chief Executive Officer Peter Raskind responded, citing speculation about the bank’s condition. “We had counterparties who were uncomfortable interacting with us. That had to stop.”

Royal Bank of Scotland is also raising capital:

Royal Bank of Scotland Group Plc, the U.K. lender reeling from asset writedowns, will sell 12 billion pounds ($24 billion) of shares to investors in Europe’s largest rights offer and cut the dividend.
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RBS plans to raise its Tier 1 capital ratio, a measure of capital strength, to more than 8 percent from 7.3 percent and the core equity Tier 1 ratio to more than 6 percent from 4.5 percent by the end of the year, the bank said.

Good for them for doing it by a rights offering! It’s much fairer to existing investors, although I suppose it’s a little more expensive and slower.

Merrill has also joined the parade:

Merrill Lynch & Co., the third- biggest U.S. securities firm, plans to raise at least $7.3 billion by selling bonds and preferred shares after writing down the value of $6.5 billion of assets.

The firm today began offering $7 billion of senior unsecured notes in its biggest debt offering, luring investors with yields over Treasuries that would be as much as triple what it paid a year ago. Merrill is also selling at least $300 million of perpetual preferred shares that yield about 8.625 percent.

It should be noted, however, that the $7-billion headline number addresses liquidity issues, not equity; the preferred share issue is picayune.

I must say, it’s very pleasant for a fixed income guy to see the equity crowd get hit for a change. The last ten years have been all too often in the other direction.

There might be some adjustment to Regulation FD in the future – this is the source of National Policy 51-201, which states that Credit Rating Agencies may have access to material non-public information. Chairman Cox of the SEC said in testimony to the Senate Banking Committee:

To enhance transparency, the Commission may soon consider new rules that would require the disclosure of information about the assets underlying the mortgage-backed securities, CDOs, and other types of structured finance products they rate. This would allow market participants to better analyze the assets underlying structured securities, and reach their own conclusions about their creditworthiness. This data availability could particularly benefit subscriber-based NRSROs, who could use it to perform independent assessments of the validity of the ratings by their competitors who use the “issuer pays” model.

Further improvements in transparency could be considered in the form of enhanced disclosures about how NRSROs determine their ratings for structured products. This disclosure could include the manner of analysis of the mortgages’ conformance with underwriting standards, and the firms’ procedures for monitoring their current credit ratings.

The Commission may also consider rules requiring the disclosure of ratings information in a way that makes it possible for investors to readily distinguish among ratings for different types of securities, such as structured products, corporate securities, and municipal securities.

This is rather convoluted, frankly. The ratings agencies don’t release material non-public data because it’s non-public. The company or issuer makes the decision (subject to the SEC’s disclosure rules) regarding what’s public and what ain’t. All I can imagine is that the intended purpose of the rules the SEC is considering is to get disclosure by the back door … for one reason or another, the issuer can’t (or won’t) be forced by the SEC to disclose data, but the NRSRO’s will be … thus, if the information is to be kept out of the public domain, the company will have to forgo a NRSRO credit rating, which will (presumably) make the issue a much harder sell. If anybody has a better explanation, say so in the comments!

Following the BoC’s easing to 3.00% overnight rate, TD was the first major to cut Prime, although they were behind CCDQ. The second major was RY, followed by BMO, then BNS.

Another poor day for preferred shares, as PerpetualDiscounts are now yielding 5.73%, interest equivalent (at 1.4x) of 8.02%. Given that long corporates now yield about 6.1%, this represents spread maintenance against the competition.

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

Slowly, slowly, loans are coming off the banks’ books:

Carlyle Group, the world’s second largest private-equity firm, is raising a $500 million collateralized loan obligation to buy high-risk, high-yield debt being sold by banks at discounted prices, according to people with knowledge of the plan.

The CLO is being arranged by Deutsche Bank AG, said the people, who declined to be identified because the terms aren’t public. The fund follows a similar $450 million CLO that Carlyle and JPMorgan Chase & Co. closed this month.

Carlyle, the Washington-based buyout firm run by David Rubenstein, joins Blackstone Group LP and Apollo Management LP in purchasing loans from banks that have struggled to offload the debt after losses on securities tied to subprime mortgages caused investors to shun all except the safest of government bonds. Private-equity firms are emerging as buyers at a time when financial institutions from Goldman Sachs Group Inc. to Citigroup Inc. are willing to sell the loans for as little as 63 cents on the dollar.

Royal Bank of Scotland is doing the same:

Royal Bank of Scotland Group Plc, the U.K.’s second-biggest lender, plans to start a fund to transfer the risk of losses from 1.5 billion euros ($2.3 billion) of high-yield loans, according to three people with knowledge of the proposal.

The fund will earn a return for investors by selling contracts to RBS that protect the bank from losses on 15 loans in euros and pounds and a further six in dollars, said the people who declined to be identified because the discussions are private.

And hedge funds are still pulling in money! I’m certainly not about to declare the credit crunch over, but this is a good sign:

Some investors expect the current credit crisis will create opportunities for managers who trade distressed bonds and loans. Such funds attracted $8 billion in the quarter. Investors allocated $8.2 billion to equity hedge funds and $6.5 billion relative-value strategies, which try to profit from price discrepancies between securities.

The biggest outflows in the quarter were from funds that trade the securities of companies going through mergers, which lost a net $4 billion. Investors pulled $1 billion out of macro funds, which chase macroeconomic trends by trading stocks, bonds, currencies and commodities. The funds were the best performers in the first quarter, rising 4.7 percent.

In a further sign that the banks are serious about repairing their balance sheets, Citigroup is issuing $6-billion hybrids, although it’s not entirely clear to me whether these are prefs or Innovative Tier 1 Capital, as if there’s any difference anyway:

Citigroup Inc., the biggest U.S. bank by assets, plans to sell $6 billion of hybrid securities to bolster its balance sheet after reporting almost $16 billion in writedowns.

The perpetual, preferred shares may pay a fixed rate of 8.4 percent for 10 years, according to a person who declined to be named because terms aren’t set. If not called, the debt will then begin to float, the person said.

This follows hard on the heels of JPMorgan’s monster deal. How much is enough, already? The Reuters tally grows daily:

Financial companies around the globe have scrambled to raise capital to offset massive write-offs. Below are the 15 largest capital infusions announced by financial institutions since the credit crisis began, totaling more than $150 billion.

The Bank of England is going forward with the bond lending programme discussed briefly on April 17 … it is, in fact, a bond LENDING programme, with quite rational terms:

The measures, backed by Prime Minister Gordon Brown’s government, mimic a swap of $200 billion of securities by the U.S. Federal Reserve last month as central banks around the world struggle to prop up financial markets.
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Financial institutions will retain responsibility for losses from the assets they loan to the Bank of England. The swaps will be for a period of one year, renewable for up to three years. Only assets existing at the end of 2007 can be used in the swap.

The Bank of England won’t announce how much money has been tapped until the borrowing window closes in six months.
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Assistance will come at a price. Banks will have to pay a borrowing fee to participate in the plan and the value of the securities they receive will be less than that of the mortgage- backed bonds they hand over to the Bank of England.

“The Bank of England’s actions do seem to be quite punitive,” said James Nixon, a director of Societe Generale SA in London. “The sense yet again from the Bank of England is that it will provide an absolute backstop to the financial system, but won’t make any effort to ease the market’s liquidity.”

The market fell – probably in response to the RY new issue as the RY issues were conspicuous by the presence in the list of poor performers … several issues lost just less than the 1% loss qualifying for mention on the list. Volume was average, as far as recent history goes.

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

Willem Buiter writes a gloomy piece on financial activity, If it’s broke, fix it, but how?. Hat tip to Naked Capitalism, who commented on the piece … but quite frankly, NC’s commentary can’t be taken seriously:

3. Prohibit Level 3 assets; allow only Level 1 and strictly defined and audited Level 2 assets. This means regulators will not have anything overly arcane to assess; they ought to be able to get a clear picture of risks, processes, and exposures if they are dogged.

4. Prohibit these regulated institutions from lending, providing other funding, or investing in concerns that have Level 3 assets

This is the sort of populist nonsense that betrays complete lack of understanding of the issue. In the first place bonds of virtually all kinds are Level 2 assets – even off-the-run government bonds are marked off half a dozen or so benchmarks. A liquid corporate issue might trade a few times a week – and every time (other than in the highly liquid distribution phase) it will be done at a ballpark guess of a spread to governments (by “ballpark guess”, I mean “what the trader thinks he can get away with”). Things like municipals in the States … well, have a gander at what Accrued Interest had to say on the issue.

Level 3 assets? Let’s talk about preferred shares, just for a moment, to lend some credence to the idea that this blog is about prefs. Say I have to value an issue that has something approximating a current coupon … maybe the new NA issue, for instance. If I price NA.PR.M based on the yield of the two other prefs from this issuer, then it’s a level 2 asset. However, this is a really bad mark – it makes no allowance for convexity. If, however, I adjust the “static”, level 2 price in any way to account for the “dynamic” effect of convexity, then my poor little NA.PR.M become level 3 assets … “convexity” is not an observable input.

One may well wish to impose a regime on regulated capital that allows the firm to assign a range to the unobservable inputs and have them use whichever end of the range is least favourable when valuing their securities for regulatory purposes. One may well wish to increase the capital requirements for level 2 and level 3 assets. But to speak of strict controls and prohibitions is simply a sign of hysteria.

Anyway, back to Prof. Buiter. He leads with an assertion that we have achieved the worst of two worlds:

I believe that the Western model of financial capitalism – a convex combination of relationships-based financial capitalism and transactions-based financial capitalism – has, in its most recent manifestations (those developed since the great liberalisations of the 1980s), managed to enhance the worst features of these two ideal-types and to suppress the best.

These worlds are defined as:

Transactions-based financial capitalism emphasizes arms-length relationships mediated through markets (preferably competitive ones), is strong on flexibility, encourages risk-trading, entry, exit and innovation. It is lousy at endogenous commitment: reputation and trust are not a natural by-product of arms-length relationships. Commitment requires external, third-party enforcement.

Relationships-based financial capitalism emphasizes long-term relationships and commitment. It has, however, compensating weaknesses. Investing time and other resources in building up relationships with customers creates an insider-outsider divide that is very difficult to overcome for new entrants. It also encourages, through the interlocking directorates of the CEOs and Chairmen (seldom women) of financial and non-financial corporations, a cosy coterie of old boys for whom competitive behaviour soon no longer comes naturally. At its worst, it becomes cronyism of the kind that was one of the key ingredients in the Asian crisis of 1997.

I think I will be referring to these definitions a lot in the future! Relationships-based financial capitalism describes the standard business model of a stockbroker or retail-level financial advisor. Transactions-based financial capitalism describes the standard business model of an asset manager. But remember – these are my characterizations, not Dr. Buiter’s.

Importantly, virtually everybody will claim that they want and need the latter, but most retail (and a hefty chunk of institutional) clients will go for the former when it comes time to sign a cheque.

So … now we’ve defined some terms, what’s the problem?

It is clear where the problems are. In the past 20 yearns, the financial sector has, starting as a useful provider of intermediation services, grown like topsy to become an uncontrolled, and at times out-of-control, effectively unregulated, hydra-headed owner of licenses to print money for a small number of beneficiaries. The sources of much of these profits turned out to be either a succession of bubbles or Ponzi schemes, or the pricing of assets based on the belief that risk disappeared by trading it. This belief that there is a black hole in the middle of the financial universe that will attract, absorb and annihilate risk if the risk it packaged sufficiently attractive and sold a sufficient number of times is closely related to the firm conviction of every trader I have ever met, that he or she can systematically beat the market. The fact that all traders together are the market did not constrain these beliefs.

This is a rather breathtaking condemnation and, quite frankly, I do not find much support for these assertions in the text. I can hypothesize, however, using the assumption that the explanation of the huge amount of CDO assets on the Merrill Lynch books (discussed on April 16) is correct (and making a few interpretations). In this case, we would say that the CDO-syndicator is using the worst of the transactions model: he didn’t care about the firm, as long as he could get the stuff off his books and onto the trader’s books. The trader, bullied into inventorying paper he didn’t think he could sell, agreed to the deal due to relationships model: he was making good money as a Merrill trader, and refusing the urgent request of the big powerful syndicator could jeopordize his position. If this is the case, it reflects a failure on the part of Merrill’s management to ensure that such asymmetric viewpoints are minimized.

Could it be true? Well, it’s plausible. And I like it a whole lot more than the everybody-is-stupid-except-me model.

Naturally, the first thing that comes to mind after Dr. Buiter’s assessment of the industry is MORE RULES!

It would be part of the solution if we could find and keep the right regulators and design and implement the right regulations.

… which immediately runs into the problem …

regulators involved in intrusive and hands-on regulation are virtually guaranteed to be captured by the industry they are meant to be regulating and supervising. This regulatory capture need not take the form of unethical, corrupt or venal behaviour by the regulators or members of the private financial sector. It could instead be an example of what I have called cognitive regulatory capture, where the regulator absorbs the culture, norms, hopes, fears and world-view of those whom he regulates.

Sure. Especially with revolving-door regulation being such a popular model. There is another problem:

regulators will serve their own parochial, personal and sectional interests as much as or even instead of the public good they are meant to serve. No bank regulator wants a bank to fail on his or her watch. As a result, either excessively conservative behaviour will be imposed by the regulator on the regulated bank or other financial intermediary (ofi), that is, we will have if-it-moves-stop-it-regulation, or the regulator will mount an unjustified bail out when, despite the regulator’s best efforts at preventing any kind of risk from being taken on by the regulated entity, insolvency threatens.

This is especially the case if, for instance, one takes the editorial stance of the Globe and Mail seriously. They decided that Canadian ABCP was a problem indicative of a failure of regulation, then decided that since OSFI is a regulator, they are at fault. This started with misrepresentation of a speech and continues with wild charges of loopholes, as mentioned on April 11. Despite the fact that you don’t really need more than a handful of functional brain cells to dismiss the charges as nonsense, these gross distortions can’t be a lot of fun for a regulator to endure, and will lead Our Beloved Government to impose MORE RULES!

Anyway, Prof. Buiter has the intellectual honesty to admit:

I don’t know the solution to this conundrum.

I suggest, as I have suggested before, that regulations need tweaking. So the off-balance-sheet vehicles weren’t as off-balance-sheet as they might have been? Make the sponsors consolidate them for regulatory capital purposes if they are intimately involved in the vehicle – e.g., by being the selling agents of the SIV’s paper, or having their name on the fund, or by getting miscellaneous fees from the SIV. Allow a reduced hit due to first loss protection. Lots of details will emerge through discussion. If they’re sponsoring a money market fund (same thing, opposite direction), they should take a charge. It would seem that rules on the assets to capital multiple need to be reviewed, since a lot of the problem was the zero risk weight assigned to synthetic-AAAs by the regulatory authorities.

And for heaven’s sake, let’s approach regulation with the idea that the objective is to mitigate and contain harm, not to eliminate it. How many times must I repeat? Risk is Risky!

When will people learn? You can’t regulate fear and greed. Ask a Chinese or Russian pensioner how well that idea works out! As long as we have fear and greed, we will have booms and busts. And as long as we have stupidity, we will have people being hurt – sometimes badly – through over-exposure to a single class of risk.

From the oh-hell-I’ve-run-out-of-time-here’s-some-links Department comes a speech by David Einhorn of GreenLight Capital, referenced by another blog. Einhorn is always thoughtful and entertaining, although it must be remembered that at all times he is talking his book. The problem with the current speech is that there is not enough detail – for instance, he equates Carlyle’s leverage of 30:1 which was based on GSE paper held naked with brokerages leverage, which is (er, I meant to say “should be”, of course!) hedged – to a greater or lesser degree, depending upon the institution’s committment to moderately sane risk management. But there are some interesting nuggets in the speech that offer food for thought.

Accrued Interest speculates that European credit strains make short-dollar a risky trade:

So rising Libor may say more about tight liquidity in Europe than in the U.S. A combination of tough liquidity in Europe and among smaller banks would explain the divergence between CDS spreads and Libor spreads.

To me, this sends two cautions. First, it should remind anyone who thinks the liquidity crunch is over, that it ain’t. Liquidity does seem to be improving in the U.S. bond market, which is a very positive sign. So maybe the worst case scenario has been taken out. But this will be a long process.

Second, it should caution those who are short the dollar. If the next phase of the credit crunch hits Europe as hard as it hits the U.S., then we may see the Bank of England and the European Central Bank get more aggressive with rate cuts.

Barclays PLC disagrees. Takes two to make a market!

No real direction in the preferred share market today – and not much individual issue price volatility either. Volume returned to levels that are normal for now, but would have been labelled light last year.

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

This is about as far as one can get from preferred shares … but it’s interesting! There has been a lot of kerfuffle lately about the seeming randomness of the commodity futures basis in the States. Econbrowser has a guest-poster, Professor Scott Irwin, who explains what this means and why it’s important.

My suspicion is that it will have something to do with unsettled credit conditions. If you’re going to buy spot grain and sell a futures contract about it, you have a storage and financing problem that needs to be solved. First you need storage, then you need a price on your storage, then you need financing, then you need a price on your financing. It’s not just the spot and future price! I suspect that the financing requirements are injecting a little randomness into the process … I was once speaking to a bank rep, who very seriously intoned “The Bank [the capital “B” was audible] does not finance arbitrage.” Now, he was a very junior bank employee, but those were good times! I’m no expert, but I’ll bet on the financing aspect.

Prof. Irwin points out that there is an official hearing April 22 … we’ll see what comes of that. The post has some good comments.

Calculated Risk references a Times article that indicates:

It is understood that the Treasury about to finalise a scheme under which the Bank would allow lenders to swap their mortgage-backed assets for government bonds rather than cash. Lenders would be able to use the gilts as collateral for loans from other banks. It is hoped that the move will ease the seizure in the credit markets and lead to a drop in mortgage rates for homeowners.

It is not clear to me whether the word “swap” means “collateralize a loan with”, as in the Fed’s TSLF, or “trade”, as in Willem Buiter’s idea mentioned yesterday. I think the former is a great idea, provided that the loan is at a penalty rate; I have yet to be convinced that desperate measures such as the latter are necessary.

However, there is no doubt that excesses in the UK were just as spectacular as those in the US:

Richard Lee spent 5.3 million pounds ($10 million) buying 20 rental homes across the U.K. with just 150,000 pounds of his own money. Today, the properties are worth about 60 percent less and owned by the banks that financed the purchases.

The idea of outright government purchases of debt is hardly unique to the UK. There are plans afoot to have the US purchase student loans:

The U.S. House of Representatives, trying to avert a looming shortage in available student loans, approved allowing the Department of Education to buy federally guaranteed loans that lenders are unable to sell to private investors.
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The global credit crunch has raised student-loan makers’ financing costs, and they’re unable to raise the rates they charge for federally guaranteed loans because the rates are locked in by the government.

SLM Corp., known as Sallie Mae, has stopped offering consolidation loans, which allow borrowers to combine several loans into a single one charging a lower rate. The company said today that new student loans are being made only at a loss.

Agencies in several states including Massachusetts, Michigan and Pennsylvania have announced plans to stop providing federally guaranteed student loans.
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The legislation passed by the House today would let lenders sell their debt to the Department of Education at a premium. The move is designed to give investors more confidence in securities backed by the loans.
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A similar bill has been introduced in the Senate. A Bush administration statement yesterday backed most provisions of the House measure while recommending some changes to ensure that the secretary of education has “the necessary authority and flexibility needed to respond to the unfolding situation.” The legislation is H.R. 5715

What tangled webs are a surprise, when first we seek to subsidize!

Volume dropped off to light levels, but the market edged up with low price volatility.

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

The latest report of nefarious skullduggery involves the possibility that banks have under-reported the yields paid on interbank borrowing to avoid looking desperate, resulting in a quote for LIBOR that understates the true rate. Naked Capitalism republishes an extract from the WSJ article; the British Bankers’ Association has threatened to ban any bank caught misquoting rates.

Speaking of the BBA, they have recently released a response to proposals for increased/changed regulation … most of it is UK-specific, but they have strong views on the funding of a central deposit insurer:

We are strongly of the view that a pre-funded deposit protection scheme is inappropriate for UK market. We believe that there should be greater appreciation of the limited ability of deposit protection schemes to save a troubled bank and the impracticality of devising a scheme large enough to cope with the failure of a large UK institution.

We have significant concerns over the competitiveness impacts on the UK financial sector of moving to a pre-funded deposit protection scheme. The costs of moving to a pre-funded scheme would be significant and would have a harmful effect on banks’ competitiveness and their ability to lend to business and individuals alike. The industry has already sustained a significant cost increase from the removal of coinsurance and, subject to further consideration of the issues involved, would be prepared to take on the additional costs of a move to gross payments.

…

We note that in the US scheme, operated by the FDIC, the pre-fund was created for the purposes of closure and/or failure of a large number of small entities operating in that market. It is not set up to resolve problems in a bank the size of Northern Rock nor does the US system necessarily need a pre-fund to operate. Consumer confidence is driven by expectations that money can be retrieved in a crisis. We believe it would be impractical to build up a UK fund of sufficient size to deliver his. The United States ex-ante scheme of $49bn, built up over many years and in relation to circa $4 trillion insured deposits, is approximately equivalent to Northern Rock’s retail deposit base prior to the run. So unless it is a small institution that is in distress there would not be enough in the fund to head off a run.Whilst a pre-funded scheme would provide a ready pool of liquidity in the event of a bank default there are other more efficient means of delivering liquidity for prompt payout.

FDIC insurance is backed by the “full faith and credit of the United States Government”. We believe that a similar arrangement whereby the UK government provides support for an FSCS deposit scheme which borrows funds only when required provides the most effective balance for achieving a credible scheme in the eyes of the consumer whilst minimising costs to the industry.

In an update to my post Is Crony Capitalism Really Returning to America, I confessed to some confusion regarding the rationale for brokerages having such enormous chunks of sub-prime on their books:

Taking the last point a little further, I will highlight my confusion as to why the brokerages are taking such enormous write-downs on sub-prime product. This has never made a lot of sense to me

. The WSJ (via Naked Capitalism) has provided a much more venal rationale than the one I suggested at the time:

In August 2006, one Merrill trader fought back when managers pushed to have the firm retain $975 million of a new $1.5 billion CDO named Octans….

The result was a heated phone conversation with Merrill’s CDO co-chief, Harin De Silva, who was out of the office. Mr. De Silva urged the trader to accept the securities….The alternative was to let the deal fall apart, which would leave Merrill holding the risk of all the securities that would have backed the CDO.

In the end, Mr. Roy’s group took the $975 million of securities on the firm’s books….a step that helped the firm hold its top rank in CDO underwriting and led to an estimated $15 million in fee revenue…

Pressures rose in early 2007 as the housing bubble lost air. Merrill set out to reduce its exposure, in an effort referred to innocuously as “de-risking.”

It could have sold off billions of dollars’ worth of mortgage-backed bonds that it had stockpiled with the intention of packaging them into more CDOs. But with the market for such bonds slipping, Merrill would have had to record losses of $1.5 billion to $3 billion on the bonds, says a person familiar with the matter.

Instead, Merrill tried a different strategy: quickly turn the bonds into more CDOs.

Doing so was no longer a profitable enterprise….Still, executives believed that so long as all they retained on their books were super-senior tranches, they would be shielded from falls in the prices of mortgage securities….

In the first seven months of 2007, Merrill created more than $30 billion in mortgage CDOs, according to Dealogic, keeping Merrill No. 1 in Wall Street underwriting for this type of security.

The call for comments, Financial stability and depositor protection: strengthening the framework. At issue are the following notes regarding UK deposit insurance:

1.48 On 1 October 2007, the FSA changed the FSCS compensation limit applying to deposits so that 100 per cent of an eligible depositor’s losses up to £35,000 are covered. The FSA proposes that this limit will continue to be applied per person per bank, and without any co-insurance below the limit. The FSA intends to consult on a review of the FSCS limits in all sectors and other changes to the compensation scheme. The Authorities will also work with the financial sector to explore alternative ways for individuals to cover amounts above the threshold, as the Treasury Select Committee has recommended.

4.42 The Authorities have considered the possibility of making depositors a preferential class of creditor, (i.e. to introduce depositor preference), but the likely adverse consequences of this for other creditors in insolvency proceedings and for banks generally, in terms of increased costs of credit, shorter loan periods and increased demand for collateral, appear to make this undesirable in the UK context. It is therefore proposed that the claims of the FSCS and depositors (whose claims are not settled by the FSCS) will continue to rank alongside the claims of other ordinary unsecured creditors. While a bank liquidator will have a duty to assist the FSCS to effect a repaid payout (i.e. to process depositor information at an early stage), the funding for any payout to depositors would be provided by the FSCS.

5.53 The Treasury Select Committee has identified two disadvantages of a ‘pay as you go’ approach to financing the FSCS:

There are reports that Citigroup’s sale of LBO debt is not going as planned, with investors picking off debt from the deals they know best, rather than buying the complete package holus-bolus.

And the SIV-unwinding proceeds apace. Bloomberg reports that State Street bought $850-million in assets from its sponsored conduits; Assiduous Readers will remember that PrefBlog reported on August 28 that State Street had the highest exposure to conduits of its American and European peers. However, they’ve experienced a strong first quarter:

“During the first quarter, we strengthened our regulatory capital position with strong net income of more than $500 million and the issuance of $500 million of tier-1 qualified regulatory capital.”

Their 8-K filed today discloses (page 32 of the PDF) that their Tier 1 Capital Ratio of 12.35% would decline to 10.15% if all their ABCP conduits were to be consolidated. They have a considerable investment portfolio devoted to AAA tranches of sub-prime – fortunately, mostly well seasoned, with a high degree of credit enhancement.

Credit enhancement is a good thing, with bank repossessions of houses doubling over 2007 levels! Meanwhile, Naked Capitalism highlights a story about increased corporate bankruptcies … some firms were dancing pretty close to the edge even in those halcyon days of easy money and have now been pushed off, as I suggested September 20.

Derivative indices have come in for some heavy criticism:

“The indices are just trading on their own account with no relationship whatsoever to an underlying cash market that’s ceased to exist,” Jacques Aigrain, chief executive officer of Zurich-based Swiss Reinsurance Co., said at a March 18 insurance conference in Dubai.
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“The last thing the securitization market needs is another no-cash-upfront instrument that people can use to knock the markets about with,” said Andrew Dennis, the London-based head of the asset-backed debt syndication group for UBS AG of Zurich.
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The latest version for AAA rated subprime mortgage bonds slumped by 43 percent since it began trading in August, according to Markit, as rising U.S. home loan delinquencies triggered a surge in the cost of credit-default swaps. That implies a 53 percent loss on the underlying mortgages, according to Schultz, almost four times the 13.75 percent rate predicted by Wachovia.

The cost to protect $10 million of AAA commercial mortgage securities jumped 10-fold during one six-month period to $100,000 a year, based on the first CMBX index from Markit. That implies about 13 percent losses on the underlying loans, more than four times the 2.8 percent forecast in the event of a recession by JPMorgan Chase & Co. analyst Alan Todd in New York.

“ABX, CMBX, any kind of X you like, are totally uncorrelated to any kind of underlying market,” Swiss Re’s Aigrain said at the Dubai conference.

Indices without an option of forcing delivery (of something! anything!) are evil. Assiduous Readers will remember that I pointed out the discrepency between the cash market and the index-marked market in my review of the IMF report as well as the earlier Goldman Sachs paper.

There was finally a day of decent volume for preferreds, but price moves were pretty insignificant.

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

On March 31 I indicated my approval of the idea that the Fed should have discretion over the conduct of monetary policy; in Econbrowser, Prof. James Hamilton has pointed out that discretion should have boundaries:

And this is where I feel that Robert Reich raises an excellent point:

the Fed can expose taxpayers to hundreds of billions of dollars of potential losses without a single appropriation hearing, as it did recently when it allowed Wall Street’s major investment banks to exchange tainted mortgage-backed securities for nice clean loans from the Treasury. And the Fed can do amazing things– like decide one big bank, JP Morgan, is going to take over another, Bear Stearns, backed by $29 billion of taxpayer money.

Reich is exactly correct– the Fed’s recent behavior does expose U.S. taxpayers to a risk of default on these assets. While some may argue that the Treasury is exposed to risks in the current situation no matter what the Fed does, it seems to me that this decision is ultimately a matter for fiscal policy. And just as I don’t want Congress deciding how much money to print, I don’t want the Fed deciding how much taxpayer money is appropriate to pledge for purposes of promoting financial stability.
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I agree very much that Congress has a quite proper role in determining the magnitude of the fiscal risk that the Fed opts to assume. Congress’s statutory limit on the quantity of debt that the Treasury can issue is something I have previously derided as political circus. But a statutory limit on the non-Treasury assets that the Fed is allowed to hold might make sense. Perhaps the outcome of a public debate on this issue would be a decision that the Fed needs the power to lend to private borrowers even more than the $800 billion or so limit that it would run into from completely swapping out its entire portfolio. Indeed, Greg Ip speculates on the possibility that the Fed could “ask Treasury to issue more debt than it needs to fund government operations.” Surely that would be something that should require congressional approval. Or perhaps after deliberations, Congress would decide that the business of swapping Treasury debt for private sector loans is one that is better run by the Treasury rather than the Federal Reserve.

Another bank, Wachovia, is cutting its dividend and raising capital, while Deutsche is flogging its LBO debt in an effort to delever … in competition with Citigroup’s efforts, mentioned April 11 to unload $12-billion worth.

A very quiet day for preferreds.

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

The most interesting news today was a report that Scotiabank is interested in National City. National City has had some problems lately:

Our mortgage business came under considerable pressure starting in late July and early August 2007 with the near-total stoppage in the mortgage capital markets. While we ceased broker production of new national home equity originations immediately, we had a warehouse of loans held for sale for which there were no buyers, as well as a pipeline of approved applications awaiting funding. The retention of these loans increased the size of our balance sheet above where we had planned it to be, and also drove losses in the third and fourth quarters as we marked loans down to their current value. Other than conforming, agency-eligible mortgages, the market for virtually all other types of mortgage loans continues to be illiquid to non-existent. Therefore, we have further downsized and restructured our mortgage business, exiting all wholesale production channels and narrowing our mortgage product set to agency-eligible mortgages and a small amount of high-quality “jumbo” mortgages.
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The combination of a larger balance sheet, further disruption in the capital markets, mortgage-driven losses, and other developments in the last two months of the year has taken the company’s year-end capital position below its target range. For that reason, we announced in early January plans to raise non-dilutive Tier 1 capital, as well as our Board’s decision to reduce the dividend by 49 percent. We did add $650 million of Tier 1 capital in January, exceeding our objective for that transaction. I can assure you that the decision to reduce the dividend was not taken lightly. However, it was and is an important step, in conjunction with the aforementioned capital issuance, to increase capital to the higher end of our announced target ranges: 5 to 6 percent for tangible common equity and 7 to 8 percent for Tier 1 risk-based capital. We have also embarked on an aggressive program to manage the size of the balance sheet to further accelerate the increase of these ratios to desired levels. A strong balance sheet is the foundation which will see us through difficult times.

National City’s year end ratios were appalling … Tangible common equity / Tangible assets of 5.28% (down from 7.77% at year end 2006); Tier 1 Capital of 6.53% (from 8.93%); Total Capital of 10.27% (from 12.16%). We shall see! I’ve been wondering for a long time when one or more of the Canadian banks would use its strong balance sheet to make a play in the States … but I think it was Ed Clark of TD Bank who said the problem with the idea was that after you bought it, you then had to recapitalize it.

On similar lines, Accrued Interest has a thoughtful piece on what appears to be a change in the Private Equity business model:

Private equity is one area where there is clearly plenty of capital. Its not just the WaMu transaction. Citi is apparently going to sell $12 billion in loans to private equity. Private equity is creating “PennyMac” to buy distressed mortgage loans. Etc. Etc.

So here is the question. Is private equity adroitly putting their excess capital to work in these distressed assets? Is this a case where PE is the only player with adequate capital to take on these risks, and therefore set to reap big profits?

Or is it a case where they have too much cash and not enough good ideas? Two years ago, PE was all about using their business acumen to acquire whole companies, usually by using huge leverage. Now, as Deal Journal’s Dennis Berman wrote, it isn’t PE’s smarts but their capital that’s in demand.

Time will tell. It would be my view that there are very good values in corporate loans. Some good values in residential mortgages, especially if there is some kind of government bailout. But for WaMu, I’m very skeptical. If I were a betting man, I’d bet on Washington Mutual eventually accepting a buyout offer from another bank, probably Wells Fargo or J.P. Morgan. Given that J.P. Morgan supposedly offered $8/share, TPG may wind up disappointed in their results.

I’ll suggest that what’s happening to Private Equity is the same thing that happened to Hedge Funds about ten years ago … time was, they were called “Hedge” funds because they … er … hedged. Market neutrality was the name of the game.

Then the market started getting a little more crowded and the salesmen needed a new gimmick. ‘A hedge’, they remembered, ‘is a position that wipes out the value of your good idea’. So the typical hedge fund model moved from “market neutral” to “highly levered”.

The private equity model is getting similarly crowded. There have been lots of complaints over the past couple of years that deals are getting harder to come by, it’s hard to find those 20% p.a. returns any more. So private equity is morphing too … the name is just a label. You can’t be sure it means anything until you look under the hood.

ABCP? I’m sorry … I just can’t seem to get interested in the whimpering over this fiasco, despite the discussion in the comments to April 9. Flaherty is claiming a federal regulator would have made everything better, but doesn’t say how. The Globe & Mail, of course, is doing its best to whip up hysteria, talking of “loopholes” and such. I’m sorry. It’s all meaningless and boring.

Very quiet day for preferreds today, but the market was up smartly, led by CM.

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

Not much today!

Prof. Stephen Cecchetti (regularly quoted on PrefBlog) has written a review of the Fed’s actions in fighting the credit crunch, in both full and ultra-condensed versions. It’s nice to have all the actions and numbers in one place, but there’s nothing particularly new or startling in the piece. He concludes:

In the heat of a financial crisis, the central bank is the only official body that can act quickly enough to make a difference. Politicians are not well-equipped to take actions literally from one day to the next. So, while we might want to reassess the role of the central bank once the crisis is over, for now it is difficult to fault the Federal Reserve’s creative responses to the crisis that began in August 2007. Let’s just hope that they work.

A complicating factor is that only five of the seven governor’s seats are filled; all in all, the crunch will be fodder for learned papers and theses for many, many years to come.

California was able to refinance some auction debt:

California is offering general obligation bonds to institutions such as mutual funds and insurers today after collecting $898 million of orders from individuals, according to Tom Dresslar, spokesman for state Treasurer Bill Lockyer. Denver International Airport also plans to refinance auction-rate securities by selling $445 million of fixed-rate bonds.
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Long-term municipal bonds have risen four of the past five days as investors buy tax-exempt securities whose yields have exceeded those on benchmark Treasuries.
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The gains drove yields on top-rated, 30-year municipal debt to 4.80 percent, the lowest in six weeks, according to Municipal Market Advisors. That still exceeds the 4.35 yield on the 30- year U.S. Treasury bond.
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Municipal bonds dropped in late February after hedge funds liquidated some of their holdings in the tax-exempt market, as asset values fell and funding costs rose.
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Such leveraged investors typically buy fixed bonds, fund their purchases by issuing lower-yielding variable-rate notes to money-market mutual funds, and then hedge their investments with interest-rate contracts.

Such a strategy by hedge funds will involve basis risk – if they buy a long-term bond and sell an interest-rate swap against it, they will be receiving LIBOR plus a spread. If this spread exceeds the spread they’re being paid on their own commercial paper, they’re happy … otherwise, not so much. It’s all part of the arbitrage that exists because borrowers want long-term funding and lenders want short term risk … and it works … usually.

Bernanke gave a speech today reviewing the situation. There will be more rules!

the Federal Reserve has used its authority under the Home Ownership and Equity Protection Act to propose and seek comment on new rules that, for higher-cost loans, would strengthen consumer protections. The rules would restrict the use of prepayment penalties and low-documentation lending, require the use of escrow accounts for property taxes and homeowner’s insurance, and ensure that lenders give sufficient consideration to borrowers’ ability to repay. In addition, for all mortgage loans, we have proposed rules regarding broker compensation methods and the ability of appraisers to provide judgments free of undue influence, as well as rules regarding the accuracy of advertisements and solicitations for mortgage loans and the timeliness of required disclosures. We also plan to propose a revised set of required mortgage disclosures based on the results of a program of consumer testing already under way.

… and pension boards might have to do something at their meetings …

Some investors, such as public pension funds, are subject to government oversight, and in these instances, the PWG will look to their government overseers to reinforce implementation of stronger due diligence practices. When investors employ advisers, the mandates and incentives given to these advisers should be structured so as to induce a more careful and nuanced evaluation of the risks and returns of alternative products.

Another “key priority” is:

analytical weaknesses and inadequate data underlay many of the problems in the ratings of structured finance products. Beyond improving their methods, however, the credit rating agencies would serve investors better by providing greater transparency. Credit rating agencies should, for example, publish sufficient information about the assumptions underlying their rating methodologies and models so that users can understand how a particular rating was determined. It is also important for the credit rating agencies to clarify that a given rating applied to a structured credit product may have a different meaning than the same rating applied to a corporate bond or a municipal security.

Different rating scales is a cosmetic change … but publishing assumptions is a little fishy. What if the assumptions relate to regulation FD? The only real problem with the credit rating agencies is that investors cannot reproduce their work without access to the material non-public information to which the agencies have access.

With respect to bank supervision:

Prudential supervisors in the affected financial markets began joint work late last summer to identify common deficiencies on which they and the firms should focus. The supervisors concluded that the firms that suffered the most significant losses tended to exhibit common problems, including insufficiently close monitoring of off-balance-sheet exposures, inadequate attention to the implications for the firm as a whole of risks taken in individual business lines, dependence on a narrow range of risk measures, deficiencies in liquidity planning, and inadequate attention to valuation issues.
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The PWG also will be asking U.S. regulators, working together and through international groups such as the Basel Committee on Banking Supervision, to enhance their guidance in a variety of areas in which weaknesses were identified. I expect, for example, to see work forthcoming on liquidity risk management, concentration risk management, stress testing, governance of the risk-control framework, and management information systems.

It will be most interesting to see what they come up with respect to liquidity risk management. The banks don’t like the idea … liquidity is a chancy thing!

On the regulatory front RS has a contested hearing about some allegations that are remarkable for their triviality. I truly hope that there’s a lot of back-story to the case that isn’t specified … the potential fine of $3-million seems far out of proportion to the wrongdoing. For heaven’s sake, shouldn’t these trade cancellations have resulted in an automatic penalty of $1,000, end of story? The stenographer at the hearing will cost more than the clients were harmed – even if you agree that the clients were harmed.

A quiet day today. A number of issues traded over 100,000 shares, but volume was highly, highly concentrated in these issues.

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

Update: Late update here from the PrefBlog Looking Gift Horses in the Mouth Department. Remember PIMCO’s Bill Gross’ comment yesterday?:

For Pimco’s Gross that’s not enough. “If Washington gets off its high `moral hazard’ horse and moves to support housing prices, investors will return in a rush,” he wrote in a note to investors published Feb. 26. Gross, who runs the $122 billion Total Return Fund from Newport Beach, California, didn’t return calls seeking additional comment.

Apparently, Pimco’s Gross Holds Most Mortgage Debt Since 2000:

Pacific Investment Management Co.’s Bill Gross lifted holdings of mortgage debt in the world’s largest bond fund to the highest since 2000, while putting on the biggest bet against government debt since at least the same year.

The $125.1 billion Pimco Total Return Fund had 59 percent of assets in mortgage debt in March, up from 52 percent the prior month and 23 percent in March 2007, according to data on the Newport Beach, California-based firm’s Web site. The fund’s cash position dropped to 32 percent, the lowest since July 2006, from 34 percent in February.