Category: Market Action

The Fed continued its process of reintermediation today – this time purchasing Agency direct and mortgage-backed debt:

Spreads of rates on GSE debt and on GSE-guaranteed mortgages have widened appreciably of late. This action is being taken to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved conditions in financial markets more generally.

Purchases of up to $100 billion in GSE direct obligations under the program will be conducted with the Federal Reserve’s primary dealers through a series of competitive auctions and will begin next week. Purchases of up to $500 billion in MBS will be conducted by asset managers selected via a competitive process with a goal of beginning these purchases before year-end. Purchases of both direct obligations and MBS are expected to take place over several quarters.

Assiduous readers will recall that on November 21 I reported a big move by the Chinese out of agencies and into Treasuries … now the Fed’s going to take the other side of that trade. Spreads narrowed considerably:

The yield premium, or spread, on the so-called current coupon 30-year fixed-rate mortgage securities guaranteed by Fannie Mae, over the benchmark U.S. 10-year note narrowed to 175 basis points, from 209 yesterday, data compiled by Bloomberg show.

That’s not all! The Fed will also be financing Asset Backed paper:

Under the TALF, the Federal Reserve Bank of New York (FRBNY) will lend up to $200 billion on a non-recourse basis to holders of certain AAA-rated ABS backed by newly and recently originated consumer and small business loans. The FRBNY will lend an amount equal to the market value of the ABS less a haircut and will be secured at all times by the ABS. The U.S. Treasury Department–under the Troubled Assets Relief Program (TARP) of the Emergency Economic Stabilization Act of 2008–will provide $20 billion of credit protection to the FRBNY in connection with the TALF. The attached terms and conditions document describes the basic terms and operational details of the facility. The terms and conditions are subject to change based on discussions with market participants in the coming weeks.

New issuance of ABS declined precipitously in September and came to a halt in October. At the same time, interest rate spreads on AAA-rated tranches of ABS soared to levels well outside the range of historical experience, reflecting unusually high risk premiums. The ABS markets historically have funded a substantial share of consumer credit and SBA-guaranteed small business loans. Continued disruption of these markets could significantly limit the availability of credit to households and small businesses and thereby contribute to further weakening of U.S. economic activity.

I have no idea of what the office politics behind these two moves might have been … but it is easy to speculate that one’s ideas are taken a lot more seriously when one is the Treasury Secretary Designate!

Sorry, folks! Not only is this late, but there’s only the index table done! I have rather a lot going on…

Treasury Bond trading may soon enter the 18th century – the Treasury Market Practices Group is recommending penalties for ignoring a contract:

The underlying problem is the Treasury market contracting convention that a seller can deliver securities after the originally scheduled settlement date at an unchanged invoice price, i.e., without incurring any penalty. Introduction of a dynamic fails penalty with a finite cap rate would remedy this problem. In particular, a dynamic fails penalty would provide an incentive for sellers to resolve fails promptly, and could lead to repo contracting conventions that would give beneficial owners of Treasury securities an opportunity to earn as much as the cap rate in securities loan fee income regardless of the level of nominal interest rates.

The TMPG recommends that market participants agree that the invoice price–that is, the cash amount that a buyer has agreed to pay against the delivery of securities–on any cash or financing transaction that fails to settle on the originally scheduled date be reduced at a
fails penalty rate equal to the greater of (a) 3 percent per annum minus the fed funds target rate at 5 p.m. EST on the business day prior to the originally scheduled settlement date, and (b) zero.
…
2. Margining of settlement fails: When sellers fail to deliver securities in settlement of agreed upon trades, counterparty risk exposures grow and can become acute as these fails age. To mitigate counterparty risk and to better incentivize delivery by increasing the cost of aged fails, the TMPG recommends that market participants take prompt steps to study the most efficient way to commence margining of fails in all cash and financing transactions in Treasury securities. The TMPG plans to convene a working group on this subject to make a recommendation by January 5, 2009.

Point two may be taken as criticism of the SEC for allowing counterparty risk to go unmargined. It is definitely criticism of bonehead risk control in the industry. Assiduous Readers will recall that on November 18 Scotia announced a big loss on trades – equities, admittedly – that were affected by that there counter-whatsit thingamajig.

RBC has announced that 4Q08 will include some market-related write-downs … but not without some accounting gymnastics:

we reclassified most of our U.S. auction rate securities and U.S. agency and non-agency mortgage-backed securities from held-for-trading to available-for-sale. This reclassification is effective August 1, 2008. Accordingly, any unrealized changes in the fair value of these securities will not be reflected in our fourth quarter earnings

.

Realized pre-tax losses include

• $645-million loss on trading inventory
• $355-million loss on permanent impairment of available-for-sale securities
• $330-million gain on RBC’s liabilities designated as held-for-trading

RBC’s 2007 Annual Report notes that:

The decrease of $18 billion in financial assets classified as
held-for-trading and the increase of $8 billion in financial liabilities classified as held-for-trading in 2007 are primarily due to our equity and bond securities held related to our proprietary equity arbitrage and fixed income trading businesses, where we offset the risks from our securities holdings by short selling other securities that are of similar risks to those in our portfolios. The increase of $29 billion in derivative assets and of $30 billion in derivative liabilities in 2007,
primarily in foreign exchange and interest rate contracts, are largely due to increased volatility, strong shifts in exchange rates and interest rates, and higher client and trading activity, partially offset by the weakening of the U.S. dollar relative to the Canadian dollar. These
activities are consistent with our strategy for these businesses and the increases in 2007 are within the approved risk limits.

… and …

For the year ended October 31, 2007, we recognized a gain of $18 million in Trading revenue as a result of the net increase in fair values in various trading portfolios previously measured at amortized cost. This gain includes a $59 million gain on our deposit liabilities designated as held-for-trading resulting from the widening of our own
credit spread during the year.

… and …

liabilities designated as held-for-trading include (i) deposits and structured notes with embedded derivatives that are not closely related to the host contracts; (ii) assets sold under repurchase agreements that form part of our trading portfolio which is
managed and evaluated on a fair value basis; and (iii) certain deposits to offset the impact of related hedging derivatives measured at fair value. Fair value designation for these financial assets and financial liabilities significantly reduces the measurement inconsistencies.

Econbrowser‘s James Hamilton discusses the deflation problem in his latest post. Assiduous Readers will recall that I am completely unimpressed by the so-called evidence of deflation so far, but Dr. Hamilton takes the view that it doesn’t matter whether low yields on Treasuries are evidence of deflation or of flight to quality:

But a second and equally troubling suggestion of expected deflation is the extremely low yields on short-term Treasury bills. Again there may be those who interpret this not as a harbinger of deflation but instead as a reflection of the astonishing (and equally frightening) flight to quality that we have been witnessing.

Even if you don’t interpret the October CPI, TIPS yields, and nominal T-bill yields as warning flags of deflation, they nonetheless raise what is to me the core question: If the Fed wanted to use monetary policy to stimulate the economy at the moment, as I believe it should, what would it do?

TIPS yields are discussed in a John Dizard column in the Financial Times:

Yet, if you believe the yields on US Treasury inflation protected bonds, or Tips, we shall have a 2.2 per cent fall in prices in 2009, a 2.5 per cent decline in 2010 and only flat prices in 2011. If that turns out to be true, the real interest rate burden on even the highest-rated borrowers will be extremely hard to bear.

As a practical matter, long before we had significant “negative prints” of consumer prices, the Federal Reserve would just flat out buy Treasury bonds and monetise away with “quantitative easing”. Gold dealers would replace hedge fund managers at the art auctions, model agency parties and Congressional hearings.

What’s really going on is another effect of the disappearance of dealer and arbitrageur capital. The dealers can’t afford to make efficient markets, given their decapitalisation, downsizing, and outright disappearance. That means anomalies sit there for weeks and months, where they would have disappeared in minutes or seconds.

The arbs, well, they thought they had risk-free books with perfectly offsetting positions. These turned out to be long-term, illiquid investments that first bled out negative carry and then were sold off by merciless prime brokers.

Whatever the nature of the beast, Dr. Hamilton concurs with Mr. Dizard regarding the policy prescription:

So here’s my suggested Plan C. The goal of monetary policy should be to achieve a core inflation rate of 3.0% (at an annual rate) over the next 6 months. That’s something that can be accomplished without rate cuts or lending facilities, and here’s how.
…
Step 3 is to start creating money and use it to buy up assets until the [3% inflation] goal set out in Step 1 is achieved. What sort of assets?
…
What specifically would such assets be? I’d start with those clearly undervalued TIPS. Next I’d buy short-term securities in the currencies relative to which the dollar has been appreciating. Here again if the Fed has to sell these off in a sudden change in perceptions, the Fed will have both made a profit and, by selling, be a stabilizing force. If we’re still seeing no improvement, the Fed can start to buy longer-term Treasuries.

TD Bank is diluting its common:

The Toronto-Dominion Bank (TD Bank Financial
Group or TDBFG) today announced it expects to further enhance its capital position by issuing common equity. TDBFG has entered into an agreement with a syndicate of underwriters led by TD Securities Inc. for an issue of 30.4 million common shares, at a price of $39.50 per common share, to raise gross proceeds of $1.2 billion.

The issue will qualify as Tier 1 capital for TDBFG and the expected closing date is December 5, 2008.

As announced last week, TDBFG’s Tier 1 capital ratio was 8.3% as of November 1, 2008. On a pro forma basis, adjusting for this $1.2 billion of common equity and the $220 million of Series AC preferred shares issued on November 5, 2008, TDBFG’s November 1st Tier 1 capital ratio would be approximately 9%.

Thanks, guys, for making the world a safer place for preferred share investors!

The preferred share world could use a little more safety, that’s for sure (provided one equates safety with price stability). Because it was yet another thoroughly appalling day. I don’t know where all the worry is coming from – how can people worry about preferred dividend cuts when the common dividend hasn’t even be touched yet? And not just not yet touched, but unlikely to be touched? I’m with Genuity Capital Markets analyst Mario Mendonca and an unnamed analyst quoted in the Globe today:

Mr. Mendonca said he does not expect any bank to cut dividends, and believes they would sooner turn to raising capital like CIBC did earlier this year when it tapped the market for a $2.9-billion equity injection.

“The odds are low, but not zero,” another analyst said of dividend cuts.

It could, just possibly, happen, to a limited extent (it’s more likely they do dilutive issues, like TD & CIBC this year, and keep the dividend steady for a long time). And I’m talking about the common dividends, people!

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

Across the Curve notes some dealer research that claims:

The NY Fed data released yesterday afternoon shows another huge reduction in Agency debt and MBS held for overseas investors. Of the $1.7tn in GSE debt and MBS held by overseas accounts, $885bn is held in these accounts. The decline in holdings for the week ending Nov 19th was $11.7bn, which is the 3rd largest drop on record, second only to Oct 15th (-18.6bn) and Oct 8th (-24.4bn).

I can’t find the NY Fed Release, but I do have a piece by Brad Setser:

At the end of July, China stopped buying Agencies and corporate bonds and started to pile into Treasuries. Over the last three months of data (i.e. the third quarter), the US data indicates that China has bought $81.1 billion in Treasuries ($45 billion short-term) and added $17.4 billion to its bank accounts — that is a flow of nearly $100 billion into the safest US assets China can find. Conversely, China sold $16 billion of Agencies, $1.8 billion of corporate bonds and a bit less than a billion of equity.

In the second quarter, by contrast, China bought only $13 billion of Treasuries and added only $2 billion to its US bank account while buying $17 billion of Agencies and $20 billion of corporate bonds.

That is a huge swing — and frankly a destabilizing swing. The notion that sovereign investors are always and at all times a stabilizing force in the market should be put to rest. China has clearly kept the RMB dollar stable — and been a big source of demand for Treasuries. But it has been a seller of other assets in a time of stress.

I noted in an update to the most recent post on Effective Fed Funds that the FDIC has finalized the new rule on debt guarantees – Accrued Interest predicts a flood of new US Bank paper – with Goldman Sachs first to go.

There’s a short piece in the WSJ Deal Blog regarding preferred share issuance by SEC regulated companies –

BDCs believe that there may be a substantial opportunity to issue preferred stock either in privately negotiated transactions or otherwise because preferred stock can be customized to some extent to the needs of potential investors. The 1940 act limits the ability of BDCs to issue senior securities, including preferred stock, by imposing a requirement that they maintain a ratio of assets to senior securities of 200%, or 2 to 1. Therefore, if a BDC, for example, has $10 in assets, it cannot have a total of borrowing or outstanding preferred stock of more than $5. If a BDC is already close to its asset coverage limit, it would be limited in its ability to issue preferred stock.

We finally get a decent inflation number and Bang! there are deflation fears. This is a completely crazy market.

Falling car prices and cheaper women’s clothing weighed on the consumer price index. Gasoline was still higher than a year ago, but was rising at a slower pace than in previous months, also bringing the annual inflation rate down, the agency said.

Core inflation, which excludes the most volatile items such as energy and some food, was 1.7 per cent higher on the year – the same as in September, and close to analysts’ expectations. On a month-over-month seasonally adjusted basis, core inflation showed no growth.

I think Econbrowser‘s James Hamilton has the anti-deflation recipe about right:

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

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

The New York Times reports (to no-one’s great surprise) that Citibank is talking earnestly to Treasury & the Fed. A Sunday Night Special is widely anticipated.

Devastation. After another appalling day, PerpetualDiscounts now yield 8.22% pre-tax dividend, equivalent to 11.51% pre-tax interest at the standard equivalency factor of 1.4x. Long Corporates still yield 7.50% and are still up on the month … the pre-tax interest-equivalent spread is now 401bp.

There are complaints from retail that the preferred share market is way, way too exciting.

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

Lasse Heje Pedersen writes a good review piece on VoxEU, Liquidity risk and the current crisis:

the meaning of liquidity risk is clear.

• Market liquidity risk is the risk that the market liquidity worsens when you need to trade.
• Funding liquidity risk is the risk that a trader cannot fund his position and is forced to unwind.

For instance, a levered hedge fund may lose its access to borrowing from its bank and must sell its securities as a result. Or, from the bank’s perspective, depositors may withdraw their funds, the bank may lose its ability to borrow from other banks, or raise funds via debt issues.
…
If we have learned one thing from the current crisis, it is that trading through organised exchanges with centralised clearing is better than trading over-the-counter derivatives because trading derivatives increases co-dependence, complexity, counterparty risk, and reduces transparency. Said simply, when you buy a stock, your ownership does not depend on who you bought it from. If you buy a “synthetic stock” through a derivative, on the other hand, your ownership does depends on who you bought it from – and that dependence may prevail even after you sell the stock (if you sell through another bank). Hence, when people start losing confidence in the bank with which they trade, they may start to unwind their derivatives positions and this hurts the bank’s funding, and a liquidity spiral unfolds.
…
Banning short selling is a bad idea
…
Tobin taxes are a bad idea

TD Bank pre-announced some losses that will show up in the fourth quarter:

Credit trading losses of approximately $350 million (after-tax) for the quarter in Wholesale Banking, leading to a net loss of $228 million on an adjusted basis for that segment
…
The first significant item relates to the credit trading business in TDBFG’s Wholesale Banking segment. As previously disclosed, due to global liquidity issues, the widening in the pricing relationship between asset and credit protection markets (basis) has negatively impacted credit trading-related revenues for the first three quarters of 2008. The dramatic absence of liquidity in global credit markets in September and October has produced an unprecedented widening of the basis, causing larger losses in Wholesale Banking in the fourth quarter.

Hmmm … basis widening? It sounds like the Credit Default Swap Basis they’re talking about. So – I think – what happened is this:

• TD has a large corporate bond inventory (that they trade)
• The hedge it by buying protection (via Credit Default Swaps) … not necessarily on each individual name, it might be, f’rinstance IG 11)
• TD might even have deliberately put on a big negative basis trade
• Funding cash bonds has become a chancy thing. Liquidity is NIL (or close enough). The CDS basis becomes even more negative.
• On a mark-to-market basis, TD Bank loses money

Like I said, maybe. There’s not a lot of detail in the press release.

Teck Cominco eliminated its dividend. The market wasn’t very happy.

Preferred share investors shaken by the carnage can console themselves that they have a front-row seat on history while avoiding the brunt of the unwind. I will lift two quotes from the excellent Across the Curve today … Treasuries & Swaps:

The Long Bond is trading at a yield of 3.43 percent and the dollar price has exploded 9 points today. I have done this for nearly 30 years. I have never witnessed this before. Even more incredible is the 30 year swap spread and swap rate. The 30 year swap rate is 2.84. It has dropped about 80 basis points on the day and is about 60 basis points rich to the 30 year Treasury.I just spoke with an options trader about this historic move. He said that there structured product trades buried in trading books all over the world which are melting. There is a massive short in the 30 year sector (in Treasury paper and in the swap market) which resulted from sales of cheap volatility. Some of these positions have been on the books of various entities for years and it is only recently that the chickens have come home to roost. Each time the spread turns more negative, that movement forces some one to receive in swaps to hedge there position. There are short the long end trades in every permutation and combination along the curve. The receiving creates a self fulfilling prophecy which compels someone else to receive. He had no opinion on when this would end.

… and CMBS:

Cash AAAs widened 325 basis points. The email author wanted to put the recent carnage into stark relief for the non aficionados in the room. He noted that GSMS 07-GG 10- A4 is a benchmark deal. Two weeks ago it traded at 83. Today it traded at 48.

CMBX AAAs wider by 130 basis points.

Look at the CMBS basis move! Cash moved 325bp … the CDS index moved by 130. The basis moved nearly 200bp! While I am not a specialist in the field, I would suggest that a move of 2 (two) basis points in the basis would be a pretty good day … in normal times.

The longer term moves? Bloomberg reports:

Yields on the safest category of AAA rated commercial- mortgage bonds rose 3.34 percentage points, the biggest gain ever, to a record 15.29 percentage points more than interest- rate swaps, according to Bank of America Corp. data.
…
The spread on the AAA commercial-mortgage securities, which entered this year at 0.82 percentage point, has climbed from 5.88 percentage points on Nov. 4.

The move in basis is indicative that even those who are willing to take some risk and lever up a position in CMBS … can’t get, or can’t trust, funding. So they have to take a synthetic position by selling protection. Lots of money to be made there, buying cash bonds and protecting them … if you can trust your financing … and your counterparties.

So, after a horrible day that was the fourth horrible day in a row (defining “horrible” as a loss of more than 1%), PerpetualDiscounts yield 7.95% as pre-tax dividends, equivalent to 11.13% pre-tax interest. Long Corporates are still at 7.50% so the Pre-Tax Interest-Equivalent Spread is … (drum-roll, please) … 363bp. Incredible.

Holy smokes. On a day like this, what would I do without Dealbreaker?

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

Accrued Interest leads off with some thoughts on the collapsing CMBS market. CMBS opened 40bp wider this morning – panic is the only appropriate word.

Meanwhile, US CPI is normalizing:

Consumer prices plunged 1 percent last month, more than forecast and the most since records began in 1947, after being unchanged the prior month, the Labor Department said in Washington. Excluding food and energy, so-called core prices unexpectedly fell for the first time since 1982.
…
Prices increased 3.7 percent in the 12 months to October, the smallest year-over-year gain since October 2007. They were forecast to climb 4 percent from a year earlier, according to the survey median.

The core rate increased 2.2 percent from October 2007, after a 2.5 percent year-over-year increase the prior month.

Citigroup is taking on a whack of SIV assets:

Citigroup Inc., the fourth-biggest U.S. bank by market value, agreed to acquire $17.4 billion of assets held by structured investment vehicles advised by the company.

Citigroup said today in a statement that the value fell from $21.5 billion as of Sept. 30, reflecting market declines of $1.1 billion and $3 billion in debt that matured or was sold.

This continues the re-intermediation process that has culminated in this cycle with the Fed grossing up its balance sheet and is also hitting the leveraged loans market:

The price of the average actively traded leveraged loan fell 2.6 cents to 71.2 cents on the dollar since Nov. 13, according to Standard & Poor’s LCD. Prices have slumped 4.4 cents since Nov. 4, reversing a rally of more than 8 cents on the dollar since the all-time low last month.

This is not a good sign for consumation of the BCE deal – even if the banks like the deal (even when properly risk-adjusted!) they might not have room for it.

There’s a report (h/t: Financial Webring Forum) from the Globe & Mail that the BCE buying consortium is issuing capital calls:

That means the two funds are asking institutional investors to pony up cash that was previously committed to each group, in order to pay for BCE.

These calls are routine in buyouts, and speak to the fact that the private equity funds are doing what’s needed to close the long-delayed transaction by Dec. 11. The move follows on BCE’s push last week to buy back some of its outstanding bonds.
…
Capital calls are to be expected at this stage in the BCE buyout. The issue is whether the limited partners -typically pension funds – will step up with cash. Under certain circumstances, backers can refuse to fund a deal that the private equity fund has agreed to.The penalty for pulling out is typically 8 per cent of the value of the contribution that was requested.

Well, maybe I’m a cynic, but I don’t see this as meaning anything one way or another. Of course everybody’s pretending the deal will go through and making sure they go through all the motions, carefully vetted by an expensive team of lawyers. The last thing you want is to be on the hook for the break-up fee! Any speculation as to whether the deal will actually close or not remains speculative.

Assiduous Reader MP – who, I think, makes something of a hobby of SEDAR’s New Prospectus Page – alerts me to some massive, massive shelf prospectuses, including $4.5-billion in debt and preferreds from National Bank. There’s also some very hopeful filings for proposed Brompton Group Split Share corporations … whethere anything comes of them is another matter!

Triple A CMBS widened another 100bp today. US Corporates have reached an all-time wide, with continued term inversion for credit product.

What can I say? It was a lousy day. It was a sloppy day. Long Corporates in Canada have come back in to 7.50%; PerpetualDiscounts now yield 7.56% pre-tax dividend, equivalent to 10.58% pre-tax interest … which means spreads have rocketted out to 308bp. All in the blink of an eye.

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

Remember the BMO Natural Gas fiasco that cost them so much money in the third quarter of 2007? The Fed has announced:

the issuance of a Consent Order of Prohibition against David Lee, former managing director of the Commodities Trading Group and institution-affiliated party of the Chicago, Illinois, branch of the Bank of Montreal (“BMO”).

Mr. Lee, without admitting to any allegations, consented to the issuance of the Order based on his alleged participation in unsafe and unsound banking practices, breaches of fiduciary duty and violations of law, in connection with his natural gas options trading activity at BMO. The Order asserts that Mr. Lee allegedly compromised the independent price verification process BMO relied on to ascertain the true value of his trading book, and also executed and then misvalued exchange of options for options trades in order to conceal the true value of his book, which led to after-tax losses to the bank of at least C$327,000,000.

In addition, the United States Attorney for the Southern District of New York and the District Attorney for New York County announced today that Mr. Lee has agreed to plead guilty to criminal charges relating to this matter. The Commodity Futures Trading Commission and Securities and Exchange Commission also separately announced the filing of civil lawsuits in related matters.

Accrued Interest reviews the function of leverage in the bond market of a deleveraging world and concludes:spreads on credit are permanently higher – not due to credit concerns, but because of financing concerns by leveraged players.

Credit markets got whacked today:

a weakening economy exacerbated concern that the government may not be doing enough to stem the financial crisis.

Top-rated securities backed by subprime or commercial mortgages fell to record lows and the cost of protecting against defaults on leveraged loans and investment-grade company bonds climbed, according to banks and benchmark credit-default swap indexes. Yields on Fannie Mae and Freddie Mac debt over benchmarks also approached records, according to data compiled by Bloomberg.
…
Weakening across debt markets accelerated after commercial- mortgage securities began plunging, following reports that two borrowers with $334 million of loans bundled into bonds were about to default. Yields on top-rated bonds backed by commercial mortgages soared 225 basis points to a record 1,125 basis points more than benchmark interest rates as of 1:26 p.m. in New York, according to a Goldman Sachs Group Inc. note to clients. A basis point is 0.01 percentage point.

The ABX-HE-PENAAA 07-2 index tied to subprime bonds rated AAA when created in the first half of 2007 fell about 5.5 percent to a mid-price of 34.25, according to a note to clients today from JPMorgan Chase & Co.

The index is down almost 29 percent this month and indicates the bonds might fetch about 34 cents for each dollar of unpaid balances.

The PENAAA index has been discussed previously.

Scotia has announced:

that its results for the fourth quarter ended October 31, 2008 will include charges of approximately $595 million after tax ($890 million before tax) relating to certain trading activities and valuation adjustments.

The pre-tax charges are comprised of:

• $170-million on the Lehman bankruptcy – not an investment loss, but a failed settlement and trade unwinding. I’m really happy about this one – bankers have been dragging their feet on T+1 settlement for too long and it’s nice to see them get hurt due to their own laziness.
• $560-million on valuation adjustments
  • $150-million on trading inventory
  • $410-million on mark-to-market on CDOs
    • $245-million on CDOs purchased from their US ABCP operation.
    • Other CDOs, $165-million
• $160-million on “derivatives used for
  asset/liability management purposes that do not qualify for hedge accounting.”

To continue today’s tale of woe, the US Commercial Mortgage-Backed Securities market collapsed:

That is the word that one market participant used to describe the action in the CMBS market today. I am sorry to be writing this so late but I just found it as I checked emails and thought it worth posting.

CMBX AAAs widened by 130 basis points. AJ tranches widened 250 basis points to 350 basis points. ( I am lacking expertise in this area but believe an AJ is sort of a junior AAA piece.) And tranches below AAA widened 150 basis points to 350 basis points.

Cash CMBS underperformed the index and some AAA bonds with 30 percent protection widened 200 basis points. These are AAA bonds (allegedly) trading swaps plus 1050 basis points. That is alot of yield and alot of fear.

These incredible spreads might explain today’s weakness in BAM and related issues. US corporates gapped wider:

The corporate bond market as measured by the IG 11 has begun to crumble. The index is currently quoted 226/228 which is about 19 basis points wider on the day.Why the sharp spike out in that spread today? I think it is partly a result of the significant widening in other spreads.

Canadian Preferred shares … were not immune.

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

There’s a naked short tempest in the loans market:

At least two fund managers complained verbally to officials of the Loan Syndications and Trading Association, saying they believe Goldman helped drive down prices by using the technique, according to people with knowledge of the objections. New York- based Goldman is acting against its clients by trying to profit at their expense, the investors said.

Well, boo-hoo-hoo. The so-called fund managers are upset because they bought things that went down, and are distressed to hear that their counterparty was Goldman.

They aren’t fund managers. They aren’t investors. They’re mewling little weenies is what they are; they should apologize to their clients, hand in their licenses, get out of the business and go home and play with their dollies.

There is a novel form of reintermediation going on in the States:

American International Group Inc. and GMAC LLC are among money-losing companies whose banking units are paying higher rates than larger rivals to lure depositors, pressuring bank profits needed to offset rising loan losses.

AIG, the insurer bailed out by the U.S. government, and GMAC, the biggest lender to General Motors Corp. car dealers, are offering yields of more than 4 percent for one-year certificates of deposit. Bank of America, the largest U.S. bank by deposits, is paying 2.75 percent, according to its Web site.
…
The fight for the $7.4 trillion in U.S. deposits is intensifying as companies gain retail-bank status and unprofitable firms seek a lifeline during a worldwide credit crunch. American Express Co., Goldman Sachs Group Inc. and Morgan Stanley, which have received Federal Reserve approval to become bank-holding companies, may drive the market even higher by paying more to depositors, said David Hendler, a credit analyst at CreditSights Inc. in New York.

So they can’t sell Commercial Paper, therefore they open a bank and take deposits with a FDIC guarantee!

Shell-shocked Assiduous Reader pugwash asked in an unrelated thread:

What happened today – No news and prefs got nailed – is this forced selling by hedge funds etc?

You got me! Long corporates are actually up on the month. I’d be very surprised if it was hedge funds – preferred shares aren’t really their style (I’m still trying to get mine off the ground!). As far as the States is concerned:

Participants in the corporate bond market describe a deadly, dull depressing day. The level of activity from clients was quite subdued.The IG 11 is currently 208/210. It had opened 8 wider this morning on a wide 210214 quote.

Preferreds? Lots of activity, broadly based … I’d say that, for today, preferreds just aren’t fashionable.

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

Julia Dickson, OFSI Superintendent, has released a speech made to Langdon Hall Life Insurance Forum:

It is best to see the current cycle through before making major changes to Minimum Continuing Capital and Surplus Requirements (MCCSR);
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Pillar 3 is all about disclosure and transparency. Shedding additional light on these issues will encourage better risk management. Sunlight is a great disinfectant and I think it encourages good risk management.
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The changes OSFI made to the seg fund guarantee capital requirements reflected the same thinking – the need for something that stands up to evaluation and is reasonable.

The trouble is, of course, is that

• A massive change has been made to the MCCSR rules
• OSFI itself is a secretive organization that seldom, if ever, justifies or explains its decisions
• The reasoning behind the seg fund guarantee requirements has not even been exposed for evaluation, much less stood up to it.

There has been an inverted credit curve on some financial issues for quite some time, but FT Alphaville has pointed out this is now more common than not:

FT Alphaville claims this is due to front-end-loaded default fears, but Across the Curve says there’s another factor in play:

Time Warner offering of 5 year and 10 year bonds. The 10 year priced at T+525 and recently someone quoted the issue 510/490.

That two tranche offering yesterday pricedwith an inverted credit curve. As I mentioned the 10 year was T+525 but the 5 year issue required a wider spread to Treasury paper and that paper priced at T+590. This phenomenon is not confined to Time Warner but manifests itself in quite a few other names.

Traditionally, that would indicate that investors see a greater a chance for default sooner rather than later and require a wider spread to protect portfolios from that risk.

Conversations with market participants, though, lead to a different conclusion. The credit spread inversion is a function of demand for duration. There is much more demand for 10 year assets from insurance companies and pension funds and that demand is evident in the number of credits which experience the inversion.

Like everything else in the investment world, I’ll suggest that there’s a bit of truth to every half-way reasonable explanation. Here in the preferred share world, I’ve been puzzled for some time as to why BAM Perps yield less than BAM retractibles (discussed on August 22) … the duration hypothesis from Assiduous Reader prefwatcher didn’t convince me at the time and doesn’t convince me now … but who knows?

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

Assiduous Reader MP alerts me to the fact that both POW and PWF have filed shelf prospectuses for new series of prefs. We shall see!

Accrued Interest notes that the long Treasury auction today was terrible:

Across the Curve estimates that the sloppy auction cost US taxpayers $175-million.

In sympathy, Canadas got whacked for about 7bp across the curve today.

TD Bank talked a good game about BCE debt (if there should happen to be any):

Toronto-Dominion Bank, one of the lenders financing the C$51.7 billion ($42.6 billion) takeover of BCE Inc., may have to keep the loans on its balance sheet because selling new debt will be difficult amid the credit crisis, the bank’s top executive said.

Toronto equities were heading for a new low but then recovered. Preferreds did much the same, but didn’t recover completely.

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

The Fed and other US regulators have released a motherhood statement on banking practices:

• DO lend to your regular customers
• DON’T pay excessive dividends
• DON’T be unnecessarily mean to delinquent mortgagees
• DON’T pay dumb bonuses to management

A nod’s as good as a wink to a blind man, eh?

On September 25 I predicted that TARP would fail for the same reason MLEC failed: disagreement over valuation of assets. So I pleased to see that Paulson has abandoned the asset-buying idea:

U.S. Secretary Henry Paulson plans to use the second half of the $700 billion financial rescue program to help relieve pressures on consumer credit, scrapping an effort to buy devalued mortgage assets.
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Paulson’s remarks are an acknowledgement that the centerpiece of the $700 billion bailout request to lawmakers was ill-conceived. Neel Kashkari, the Treasury official who heads the rescue program, told legislators last month that officials shifted to buying stakes in banks because it was a faster way revive capital markets and the economy.

“I will never apologize for changing a strategy or an approach if the facts change,” Paulson said.

The nice part about being part of a lame-duck administration – or working out your notice at McDonalds, or whatever – is the joyous feeling of being able to tell the truth and behave intelligently! Accrued Interest mourns the plan’s failure.

Spend-every-Penny has announced a $50-billion mortgage swap with Canadian Banks:

The Honourable Jim Flaherty, Minister of Finance, today announced the Government will purchase up to an additional $50 billion of insured mortgage pools by the end of the fiscal year as part of its ongoing efforts to maintain the availability of longer-term credit in Canada.

This action will increase to $75 billion the maximum value of securities purchased through Canada Mortgage and Housing Corporation (CMHC) under this program.

Also announced was:

• The rate on the Canadian Lenders’ Assurance Facility will be decreased by 25bp and insurance costs of 25bp waived
• OSFI has debased bank capital quality (at least we now know where the instruction came from – I thought it was National Bank, who have basically maxed out their issuance capacity under the old rules)
• The Bank of Canada has the spigots wide open

Jon Danielsson reviews the Icelandic situation on VoxEU:

A third of the population is considering emigration.

Does anybody remember Richard Rohmer’s book, Exodus UK?

The first main cause of the crisis was the use of inflation targeting. Throughout the period of inflation targeting, inflation was generally above its target rate. In response, the central bank keep rates high, exceeding 15% at times.

In a small economy like Iceland, high interest rates encourage domestic firms and households to borrow in foreign currency; it also attracts carry traders speculating against ‘uncovered interest parity’. The result was a large foreign-currency inflow. This lead to a sharp exchange rate appreciation that gave Icelanders an illusion of wealth and doubly rewarding the carry traders. The currency inflows also encouraged economic growth and inflation; outcomes that induced the Central Bank to raise interest rates further.

The end result was a bubble caused by the interaction of high domestic interest rates, currency appreciation, and capital inflows. While the stylized facts about currency inflows suggest that they should lead to lower domestic prices, in Iceland the impact was opposite.

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