Category: Market Action

The hills are alive with speculation that the Fed might buy mortgage paper:

The Federal Reserve is considering contingency plans for expanding its lending power in the event its recent steps to unfreeze credit markets fail.
…
The Fed, like any central bank, could print unlimited amounts of money, but that would push short-term interest rates lower than it believes would be wise. The contingency planning seeks ways to relieve strains in credit markets and restore liquidity without pushing down rates.

The Fed is reluctant to heed calls from some Wall Street participants and foreign officials for the Fed to directly purchase mortgage-backed securities to help a market that still is not functioning normally.

Such speculation has even reached Canada (hat tip: Assiduous Reader madequota):

Canadian Finance Minister Jim Flaherty said on Wednesday he expects Group of Seven finance ministers to adopt the Financial Stability Forum report with “perhaps some amendments.”
…
One of the many options is a plan to recapitalize banks and repurchase mortgages, with the possible use of taxpayer money.

… but US participation in such a plan seems a little dubious:

“The use of public balance sheets may be needed to help financial and housing markets,” Simon Johnson, the IMF’s chief economist, said at a news conference on the fund’s report today in Washington. Fund economists anticipate a 14 percent to 22 percent slide in U.S. house prices.

The Bush administration has opposed using government funds to purchase mortgages or mortgage-backed securities, as proposed by some U.S. lawmakers.

… although some big players favour the idea:

A March 13 proposal by Senator Christopher Dodd and Congressman Barney Frank that the Federal Housing Administration insure refinanced mortgages after lenders reduce the loan principal to make payments more affordable to homeowners “is the next step,” Senator Charles Schumer, a New York Democrat, said in a Bloomberg Television interview on March 19. It’s a “broader step, but not as broad as [Resolution Trust Corp. (RTC)],” he said.

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.

An RTC-like entity may not be “the best idea, but maybe it’s the idea that gets us through this,” said New York Life Investment Management’s Girard. “The likelihood of it happening has certainly increased.”

A certain amount of impetus for the idea comes, apparently, from the Bank of England. A recent speech by PMW Tucker of the BoE outlines the central banks’ conundrum:

The serious puzzle which that underlines is why there is a dearth of buyers for the supposedly undervalued paper. With the terms and availability of financing from banks and dealers having tightened, levered funds are hardly likely to be the US Cavalry. But it is interesting that there has not been more interest from investment institutions with ostensibly long holding periods, which are largely unlevered and are not exposed to liquidity risk from borrowing short and lending long. What we commonly hear from contacts is that investment managers do not want to be caught out if asset prices fall further before they recover. But no one can seriously believe that they can spot the bottom of the market, and short-term horizons should not weigh heavily in longer-term investment institutions. All of which suggests that there may be structural impediments. Those could include some combination of the reasonable difficulty that some asset managers experience in assessing the quality of securitised assets; and mandates and accounting policies that may have the effect of shortening asset managers’ time horizons.

… which, to a certain extent, underlines the difference between asset management and the selling of asset management capability that I whine about from time to time. According to Mr. Tucker, at any rate, there is undervalued paper out there that is known to be undervalued. Asset managers, however, are constrained from buying it because all their clients know that it’s all worthless garbage and will fire them if they do. Even if their clients – who are largely pension funds – are OK with the idea, the pension funds might expect difficulties from their clients, the beneficiaries, should this paper be bought and the prices move down a penny. So we have a coordination problem and overall conditions get worse.

Willem Buiter has no problems with the idea in principle:

If the central bank, or some other government agency, were to act as Market Maker of Last Resort and buy the impaired asset at a price no greater than its fair value but higher than what it would fetch in the free but unfair illiquid market, such a purchase would not be a bail-out. It would also be welfare-increasing.

The central bank is especially well placed to play this role because, as long as the distressed/impaired assets are denominated in domestic currency, the central bank will never become illiquid or insolvent by purchasing them.

Should, despite the fact that the impaired asset was purchased at a price below its fundamental value, the central bank eventually make a loss on the asset, recapitalisation of the central bank by the Treasury (that is, the tax payer) may well be necessary, or at least desirable, if the only alternative is self-recapitalisation by the central bank through monetary issuance.

This possibility of a capital loss and fiscalisation of this loss does not mean that the transaction ex-ante involved a subsidy by the central bank to the owner of the impaired asset, or a bail-out of the owner.

A subsidy is present only if the expected, risk-adjusted, rate of return for the central bank on the purchase of the impaired asset is less than the central bank’s opportunity cost of funds. There is no economic subsidy if the price paid to the seller exceeds what the seller would have received from a sale in the free but illiquid market, as long as the central bank expects to earn an appropriate risk-adjusted rate of return on the purchase.

… but he has not, as far as I know, actually advocated taking that step right now in this instance.

I don’t see a need, at this point, for the central banks to take that ultimate step. The success of regulation – yes, I used the word “success” and I have used it advisedly! – is shown by the fact that the system is still functioning at all. No major players have gone bankrupt (although some may wish to quibble about Bear Stearns) and capital ratios – while certainly lower than optimal and under strain – remain relatively strong.

At this moment, as I’ve said before, I think Bernanke’s got it right in acting as a lender of last resort. My only quibble is that I would like to see a penalty rate applied when lending to investment banks against mortgage collateral … say, maybe, discount rate + 25bp … or maybe a little bit more, just to ensure that the borrowers have a negative carry on the deal and feel some (well, OK, let’s make it “a lot of”) pain, without actually going bankrupt. Additionally, it should be made clear that the facility will be cancelled as soon as the situation has stabilized sufficiently that one or two of them can go bankrupt without causing systemic collapse.

Along these lines, there are reports that Citigroup is biting the bullet and selling $12-billion in loans at a big loss, just to get them off the books.

On a lighter note, the Fed has pointed out that a stunning proportion of the populace is financially illiterate. He feels that financial literacy should be a requirement for a high school diploma … well, first I want to know what will be thrown overboard to make room for such a thing. Make the information available and make it part of optional courses – sure, I have no problems with that.

The market moved up strongly today, with volume continuing fair.

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

Naked Capitalism points out that banks’ balance sheets tend to bloat in times of economic stress (this has been true for a long time – see Banks’ Advantage in Hedging Liquidity Risk) but manages to overstate his case:

A reader pointed us to this Bloomberg story, “Tribune, Dole May Need to Draw Down Bank Credit Lines,” which suggests that these two companies accessing committed credit lines is a harbinger of further demands on bank equity (note that a standby line does not result in a capital charge until the funds are drawn down).

Unfortunately, the helpful note is incorrect: a standby line does indeed result in a capital charge, equal to 50% of the charge that would be applied if the funds were actually drawn, provided this line is irrevokable:

Off-balance sheet items subject to a 50 percent conversion factor:
(1) Transaction-related contingencies, including performance standby letters of credit, shipside guarantees, bid bonds, performance bonds, and warranties.
(2) Unused portions of commitments with an original maturity exceeding one year, including underwriting commitments and commercial credit lines.
(3) Revolving underwriting facilities (RUFs), note issuance facilities (NIFs), and other similar arrangements, regardless of maturity.
…
Off-balance sheet items subject to a zero percent conversion factor:
(1) Unused portions of commitments with an original maturity of one year or less.
(2) Unused portions of commitments (regardless of maturity) which are unconditionally cancellable at any time, provided a separate credit decision is made before each drawing.

Assiduous Readers will remember that liquidity guarantees for ABCP are charged at a 10% conversion factor, subject to certain qualifying rules, and that there are rumblings (supported by me) that this might change.

For further confirmation of this fact, we can look at Citigroup’s Annual Report, page 75, “Components of Capital Under Regulatory Guidelines”, Note 7:

Risk-adjusted assets also include the effect of other off-balance-sheet exposures, such as unused loan commitments and letters of credit, and reflect deductions for certain intangible assets and any excess allowance for credit losses.

According to the most recent FDIC quarterly report:

Unused loan commitments – includes credit card lines, home equity lines, commitments to make loans for construction, loans secured by commercial real estate, and unused commitments to originate or purchase loans. (Excluded are commitments after June 2003 for originated mortgage loans held for sale, which are accounted for as derivatives on the balance sheet.)

This line item (see Table II-A) totalled USD 8.3-trillion in the fourth quarter of 2007, up 10% from 4Q06.

Accrued Interest looks at the US Jobs number as a predictor of stock prices:

Conclusion? During the last recession, unemployment predicted nothing useful to investors. Even had you been given a crystal ball and knew for a fact what future unemployment figures would be, it still wouldn’t have consistently indicated the right market trade. In fact it often would have given you the wrong indication.

True enough, but the last recession was a little funny … the market spent the first 2-3 years of this century unwinding the Tech Wreck … which is not to say that Accrued Interest is wrong, mind you, but rather to point out that there are a lot of factors in this chaotic world, and it is just as wrong to dismiss an indicator out of hand as it is to place blind faith in it. It’s all data.

Volume picked up today, although it can be called “good” only in contrast to recent depressed levels. Not too many price moves.

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

Not much interesting today!

There is some excitement over a recent accounting initiative – how’s that for an attention-grabbing lead-in – which Naked Capitalism believes to mean the end of SIVs.

At issue is the ultimate effect of a FASB change in guidelines that will:

remove the Qualified Special Purpose Entity (QSPE) concept (used for some securitizations) from FAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities
…
The QSPE concept specified in FAS 140 had been criticized, particularly in light of recent market turmoil tied largely to origination (and related issues involving securitization) of subprime mortgages. To obtain ‘sale treatment’ or off-balance sheet treatment for assets transferred or sold to a QSPE, (and for asset transfers generally) the transferor (e.g. a bank or other originator of mortgages) must give up control over the assets, otherwise the assets would have to remain on the transferors balance sheet (and gain on sale would be limited). The QSPE concept as defined in FAS 140 provided a means to demonstrate control was given up by the transferor, however, the restrictions specified in FAS 140 prohibiting a QSPE from managing the underlying assets, unless pre-specified in the original documents of the securitization trust, or agreed to subsequently by a majority of the investors in the trust, was viewed by some as threatening the ability of lenders and servicers to modify the terms of mortgages to help borrowers avoid foreclosure in the recent credit crunch.
…
“For five years now we’ve struggled with application of [FAS] 140 [and] the fundamental question related to servicer discretion,” said board member Larry Smith. “We said, it’s almost impossible to structure a vehicle with the objectives the board had in mind when they created QSPEs: that is, an entity that has no decision making whatsoever relative to the run-out of these assets.”

He added, “I think the staff is appropriate in recommending that we do away with QSPE’s; there are no assets short of US treasury assets that somebody doesn’t make decisions over during the life of [those] assets.”

“We have a concept that really isn’t working, and we need to come up with some other way to help investors evaluate what these transactions are,” said Smith. “At the end of the day, I don’t think the current application of 140 is what the board that approved 140 had in mind, therefore I think we should just stop pretending, and eliminate QSPE’s from our literature, and rely on other aspects of the consolidation model to give [us an] answer that is appropriate.”

A major problem with the declaration that SIVs are dead is that SIVs are not equivalent to QSPEs:

QSPE (Qualified Special Purpose Entity)
A QPSE is described in FASB Statement of Standards No. 140 “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”, which includes conditions to limit the permissible activities of the QSPE, what the QSPE can hold, and when the QSPE can sell or dispose of non cash financial assets.

SIV (Structured Investment Vehicle)
SIV (Structured Investment Vehicle) are credit arbitrage vehicles. They issue debt in the U.S. and Euro medium-term note and commercial paper markets, and with the proceeds, purchase assets of varying maturities. These assets consist of traditional classes of debt and ABS. Derivatives transactions are used to eliminate both interest-rate and foreign-exchange risk. Since the SIVs are funding at the inexpensive AAA levels (commercial paper, junior notes and medium-term notes) but can purchase securities/assets at varying investment-grade rating levels, they can pick up credit spread over the life of that asset. Some SIVs are bank sponsored and some are privately sponsored. In either case, the SIV and its assets are usually off the balance sheet of the sponsor. For instance, on November 26, 2007, HSBC announced that it would place 2 of its SIVs back on its balance sheet and provide them with additional funding in the amount of $35 billion in order to restore investor confidence.

This could be important to Canadian investors, because there’s quite a bit of securitization done by Canadian banks via QSPEs – for instance, the Royal Bank 2007 Annual Report discloses $25-billion in securitized assets (page 82 of the PDF) which could, potentially, be affected by this change (they may reappear on the balance sheet, to be considered equivalent to covered bonds).

As far as I can make out, however, an independent SIV can still be an independent SIV … although these may find their liquidity guarantees to be more expensive in the future.

A slight upward move on the market today; volume increased a little, but not enough to take notice of.

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

There’s a wonderful article on risk models by Avinash Persaud at VoxEU:

Alan Greenspan and others have questioned why risk models, which are at the centre of financial supervision, failed to avoid or mitigate today’s financial turmoil. There are two answers to this, one technical and the other philosophical.
…
The technical explanation is that the market-sensitive risk models used by thousands of market participants work on the assumption that each user is the only person using them.
…
In today’s flat world, market participants from Argentina to New Zealand have the same data on the risk, returns and correlation of financial instruments, and use standard optimisation models, which throw up the same portfolios to be favoured and those not to be.
…
observation that market-sensitive risk models, increasingly integrated into financial supervision in a prescriptive manner, were going to send the herd off the cliff edge was made soon after the last round of crises.
…
If the purpose of regulation is to avoid market failures, we cannot use, as the instruments of financial regulation, risk-models that rely on market prices, or any other instrument derived from market prices such as mark-to-market accounting. Market prices cannot save us from market failures. Yet, this is the thrust of modern financial regulation, which calls for more transparency on prices, more price-sensitive risk models and more price-sensitive prudential controls. These tools are like seat belts that stop working whenever you press hard on the accelerator.

There are certainly a lot of advisors out there calling themselves quants without deserving the title! Pseudo-quants are entirely capable, I assure you, of producing a system that outputs a simple buy/sell signal, with no allowance for buy price and sell price.

“Cliff Risk” was referred to by BoC governor Carney in his speech to the Toronto Board of Trade that has been reviewed on PrefBlog. He was referring to credit ratings and changes thereof, but the principle is the same:

Finally, it appears possible that the incentives provided by a series of regulations may have encouraged crowded trades. The so-called “cliff risk” created by the mandated use of ratings is one example. A paradox of the current turbulence is that a desire to shelter in the perceived safety of AAA-rated assets led to a dangerous explosion in the supply of synthetically created AAA-rated assets. Since many of these assets were financed by excessive leverage and many participants were constrained by mandates to sell on downgrades, the rush to the exits has proven extremely destabilizing.

Frankly, while I’m willing to believe Professor Persaud’s characterization of the modelling environment, I want to see more detail before I endorse his views unreservedly. If all preferred share market participants blindly followed HIMIPref™, for instance, then all issues would trade within a band, within which all participants would be indifferent to holding or not holding the issue. There would be some cliff risk upon changes in credit rating, but not really all that much.

My hypothesis until then is that models have acted far to quickly to promulgate contagion. KVM pricing models for bond defaults have made the corporate bond market far too sensitive to changes in common stock price (see references in the PrefBlog CDS Primer); while the common stock price has become hugely sensitive to the procyclical change engendered by mark-to-market accounting.

And it’s not at all clear that crowded trades can be blamed exclusively on quant models anyway … right on cue, Bloomberg reports that Buy Wal-Mart, Sell Goldman Becoming Easiest Trade … typical stockbroker tell-me-a-story pablum.

In the end, it doesn’t matter, does it? Andrew Willis of the Globe asserted yesterday that:

In 2007, the Teachers fund was up 4.5 per cent, compared with the composite benchmark’s 2.3-per-cent return.

In the past, critics have taken issue with the fact that Teachers executives earn the same pay as private sector peers, without having to actually go out and raise the money they invest.

I’d be a lot happier if there were names and references attached to the “critics”, but that is the mindset of the industry. What is paid for is the ability to bring in money. Performance is a flat fee, to be enjoyed by anybody who hangs up his shingle. How many of these so-called critics have a performance track record anywhere close to that enjoyed by Teachers’? And why doesn’t it matter?

Updating my posts on the David Berry situation brought to mind one of the allegations against him:

Market participants had no knowledge of Berry and McQuillen selling shares in the new issue to clients once the shares opened for trading. They only saw Berry and McQuillen buying the shares, which is consistent with an accumulation strategy. This had the potential to mislead other market participants as to the true nature of the demand for the stock, and affect their subsequent investment decisions.

In other words, RS sees as one of its purposes the encouragement of cliff trades. Scotia’s accumulating? Holy smokes, we’d better jump right in! Fundamentals be damned, cries RS!

Naked Capitalism republishes an article on foreclosure rates … the foreclosure process is now a bottleneck:

The number of borrowers at least 90 days late on their home loans rose to 3.6 percent at the end of December, the highest in at least five years, according to the Mortgage Bankers Association in Washington. That figure, for the first time, is almost double the 2 percent who have been foreclosed on.

Lenders who allow owners to stay in their homes are distorting the record foreclosure rate and delaying the worst of the housing decline, said Mark Zandi, chief economist at Moody’s Economy.com, a unit of New York-based Moody’s Corp. These borrowers will eventually push the number of delinquencies even higher and send more homes onto an already glutted market.

“We don’t have a sense of the magnitude of what’s really going on because the whole process is being delayed,” Zandi said in an interview. “Looking at the data, we see the problems, but they are probably measurably greater than we think.”

Lenders took an average of 61 days to foreclose on a property last year, up from 37 days in the year earlier, according to RealtyTrac Inc., a foreclosure database in Irvine, California. Sales of foreclosed homes rose 4.4 percent last year at the same time the supply of such homes more than doubled, according to LoanPerformance First American CoreLogic Inc., a real estate data company based in San Francisco.

The US Jobs number came out today and the bad news was good for bonds, albeit with something of a lag. Econbrowser‘s Menzie Chinn was more interested in the revisions.

Remember SIVs? There was some news about the Sigma SIV today:

Gordian Knot Ltd.’s $40 billion Sigma Finance Corp. had its Aaa credit rating cut five levels by Moody’s Investors Service as the value of its assets fell, increasing the risk the credit fund may have to be wound down.

Moody’s downgraded Sigma’s long-term debt to A2, the ratings company said in a statement today. The investment company’s short-term debt rating was lowered to Prime-2 from Prime-1. The downgrades affect $23 billion of debt.
…
Sigma must refinance $20 billion of debt by September, Moody’s said. The company has been funding itself by borrowing through repurchase agreements, selling holdings and swapping assets with bond investors, Moody’s said.

The credit fund has $14 billion of repurchase agreements, contracts that allow it to raise cash by pledging collateral it agrees to buy back at a later date. Sigma has exchanged $4 billion of assets with investors in so-called ratio trades and sold $9.5 billion of its holdings into the market, Moody’s said.

Something of a sleepy day for the preferred market – little volume and little movement, although there was the usual quota of outliers to keep things interesting.

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

Accrued Interest notes that he’s hearing some chatter about credit markets finally troughing, and urges caution:

Anyway, as much as I’d like to believe in a bottom in credits, we need to get through mid April with some strength. April is going to be a key month for bank/finance earnings (translation, writedowns) Here are some earnings dates to mark on your calendar.

I’ll add my caution to his. Remember, it is in the interest of the sell-side to convince clients that a turning point has been reached and therefore that a rejigging of portfolios is in order. It is in the interest of the press to convince readers that right now this minute is quite possibly the most exciting time in the history of markets.

Be skeptical and remember Rule #1: Things are always less exciting than they seem. And if you take the view that things are getting worse, you can find big name support for that idea.

Felix Salmon reviewed the CDS market after an article in the NYT. Reasonable enough reviews; the NYT article made the point I’ve been making about the credit crunch:

But many speculators, particularly hedge funds, have flocked to these instruments to bet on a company failure easily. Before the insurance was developed, such a bet would require selling short a corporation’s bond and going into the market to borrow it to supply to the buyer.

The market’s popularity raises the possibility that undercapitalized participants could have trouble paying their obligations.

“The theme had been that derivatives are an instrument that helps diversify risk and stabilize risk-taking,” said Henry Kaufman, the economist at Henry Kaufman & Company in New York and an authority on the ways of Wall Street. “My own view of that has always been highly questionable — those instruments also encourage significant risk-taking and looking at risk modestly rather than incisively.”

I will not attempt to quantify the effect of the ability to short corporate debt easily has had in intensifying the damage of the credit crunch. But it’s there! This is not necessarily a bad thing, though; one of the great attributes of financial markets in general is that they tend to anticipate and intensify pain, thereby getting it over with more quickly so we can go back to work.

Stephen Cecchetti’s idea of forcing CDS trading onto exchanges (noted on PrefBlog on November 19 has found support from George Soros:

There is an esoteric financial instrument called credit default swaps. The notional amount of CDS contracts outstanding is roughly $45,000bn. To put it into perspective, that is about equal to half the total US household wealth and about five times the national debt. The market is totally unregulated and those who hold the contracts do not know whether their counterparties have adequately protected themselves. If and when defaults occur, some of the counterparties are likely to prove unable to fulfil their obligations. This prospect hangs over the financial markets like a sword of Damocles that is bound to fall, but only after some defaults have occurred. That must have played a role in the Fed’s decision not to allow Bear Stearns to fail. One possible solution is to establish a clearing house or exchange with a sound capital structure and strict margin requirements to which all existing and future contracts would have to be submitted. That would do more good in clearing the air than a grand regulatory reorganisation.

Sounds nice, but I’m not certain that there’s enough volume in the off-the-run CDSs to justify an exchange. And I’d really like to know who’s going to pay for it! I will admit that the notion of controlling counterparty risk by such a mechanism does have its attractions … but I suspect that most of the trouble in this department is coming from the esoteric swaps on sub-prime paper, of which maybe one or two will exist world-wide for any given tranche.

Several exchanges were reported in 2006 to be gearing up to trade CDSs:

Morgan Stanley, Deutsche Bank AG and Goldman Sachs Group Inc. risk losing their hammerlock on the most lucrative financial market when exchanges begin offering credit derivatives next year.

Paris-based Euronext NV, which is being bought by NYSE Group Inc., plans to create contracts based on credit-default swaps, making them cheaper to trade and easier to understand than the derivatives sold by banks. Credit-default swaps, used to speculate on credit quality, also top the product list for Chicago Mercantile Exchange Holdings Inc., the largest U.S. futures market, the Chicago Board Options Exchange and Frankfurt- based Eurex AG.

I don’t know why this initiative foundered – it may be fear of trying something new during a crunch, of course – but the NYSE is now promoting a service to report prices of such illiquid securities, presumably in competition with Markit.

There were further indications of skullduggery in the BSC implosion today:

The SEC opened probes last month into whether hedge funds and other investors spread false rumors in seeking to profit from declines in stocks of companies including Bear Stearns and Lehman Brothers Holdings Inc., people familiar with the inquiries said at the time.

“It looked like more than just fear, it looked like people wanted to induce a panic,” Bear Stearns Chief Executive Officer Alan Schwartz told the Senate panel today. “The minute we got a fact out, more rumors started or there was a different set of rumors.”
…
The SEC can’t yet say whether market manipulation was responsible for the run, Cox told the Senate committee. During the week it occurred, the Fed passed along “extremely helpful information” on rumors from a “variety of market sources,” he noted.

New York Fed President Timothy Geithner testified regarding the BSC / JPM deal today to the Senate Banking Committee today. Of most interest was the information regarding the BSC collateral:

The New York Fed presented a one-page description of the portfolio. The assets include investment-grade securities and residential and commercial mortgage loans, all of which were current on principal and interest as of March 14.

The portfolio also holds collateralized mortgage obligations, most of which are bonds of government-sponsored enterprises such as Freddie Mac and Fannie Mae. The holdings include asset-backed securities, adjustable-rate mortgages, commercial mortgage-backed securities and collateralized mortgage obligations issued by companies other than government-chartered companies.

The (rather general) statement of collateral and the full testimony is available from the NY Fed. His main point is that action was necessary to break the cycle:

What we were observing in U.S. and global financial markets was similar to the classic pattern in financial crises. Asset price declines—triggered by concern about the outlook for economic performance—led to a reduction in the willingness to bear risk and to margin calls. Borrowers needed to sell assets to meet the calls; some highly leveraged firms were unable to meet their obligations and their counterparties responded by liquidating the collateral they held. This put downward pressure on asset prices and increased price volatility. Dealers raised margins further to compensate for heightened volatility and reduced liquidity. This, in turn, put more pressure on other leveraged investors. A self-reinforcing downward spiral of higher haircuts forced sales, lower prices, higher volatility and still lower prices.

Pity the Fed! It’s a thankless task at the best of times, second-guessed by every granny who buys a short-term bond, but the worst part must be having to tolerate grandstanding politicians.

Lehman doesn’t want to follow the path of the Bear! They’ve raised $8-billion in two weeks, helped by securitizing a package of LBO debt.

Volume was light today, but prices were up nicely. Interestingly, the S&P/TSX Preferred Share index (and the NAV of CPD) was down, as closing bids (used by the HIMIPref™ indices) and closing prices (used by a few small outfits) moved in opposite directions.

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

Sorry folks! Today’s commentary is greatly abridged … but I did post some commentary on Financial Stability and MAPF Portfolio Composition.

Not much price movement in the preferred share market today, and volume eased off.

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

No commentary today, I’m afraid! Duty called, with a shrill, unpleasant voice!

The post on the travails of XCM.PR.A has been updated.

Not much price movement in the preferred share market today, but volume spike dramatically – portfolio managers placing their bets for the second quarter?

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

A good article on VoxEU today by Xavier Vives of the CEPR. He looks at policy responses to the credit crunch:

An old-fashioned bank run happened if enough people tried to withdraw their funds from a bank; even if the bank was solvent, it might not be able to meet all the withdrawals and thus the fear of bank failure could become a self-fulfilling prophecy. In the current crisis, participants in the interbank market take the place of long queues of withdrawers. They have stopped extending credit to other banks that they suspect to have been contaminated by the subprime loans and which therefore may face solvency problems. The commercial bond market and structured investment vehicles are facing similar trouble.

Both the old and new forms of crisis have at their heart a coordination problem. In the current one, participants in the interbank market and in the commercial bond market do not renew their credit because of fear others will not either.
…
Bagehot advocated in 1873 that a Lender of Last Resort in a crisis should lend at a penalty rate to solvent but illiquid banks that have adequate collateral.
…
Central banks, because of information limitations, are bound to make mistakes, losing face and money in the process. This doesn’t mean they should not try.

The collateral should be valued under “normal circumstances”, that is, in a situation where the coordination failure of investors does not occur. This involves a judgment call in which the central bank values the illiquid assets. A central bank that only takes high quality collateral will be safe, but will have to inject much more liquidity and/or set lower interest rates to stabilise the market. This may fuel future speculative behavior.
…
The problem is that central banks are extending the lender of last resort facility outside the realm of traditional banks to entities, like Bear Stearns, that they do not supervise and, therefore, over which they do not have first hand information. How does the Fed know whether Bear Stearns or other similar institutions are solvent? It seems that the Fed is not following Bagehot’s doctrine here.

Finally, if banks and investors are bailed out now, why should they be careful next time? This is the moral hazard problem: help to the market that is optimal once the crisis starts has perverse effects in the incentives of market players at the investment stage. The issue is that only when the moral hazard problem is moderate does it pay to eliminate completely the coordination failure of investors with central bank help. When the moral hazard problem is severe, a certain degree of coordination failure of investors – that is, allowing some crises – is optimal to maintain discipline when investing and, amending Bagehot, some barely solvent institutions should not be helped.

I will take a certain amount of issue with the idea that there is a major problem with central banks lending to institutions they don’t supervise … most central banks, including the Canadian and UK institutions, have no supervisory powers. While I feel it is preferrable for them to supervise the banks, I am not prepared to agree that this is a necessary condition for lending.

The Fed / JPM / BSC situation is clearly a special case, with Bernanke using his discretion to address a problem that he felt had the potential for contagion – with the agreement of the other Fed governors. That’s fine with me. Why hire a smart guy and pay him well if you’re not going to allow him to exercise discretion? As far as solvency goes … JPM is prepared to take on risk and he’s got (surely!) reports from the SEC on BSC’s capital adequacy, as well as some collateral. The internuts are screaming that the collateral is all worthless, but I continue to believe that regulation – via the SEC – is good enough that prices have been marked down to some plausible estimate based on ultimate recovery and influenced by market value.

There is a danger in throwing out the baby with the bathwater here. I believe that Investment Banks should be regulated, but not in the same way and not by the same people as regular banks.

Of most interest, however, is Dr. Vive’s assertion that targetting the “bad collateral” that is the source of the problem, the Fed is acting to minimize the amount of more general liquidity injection that will be necessary to surmount the crunch. That seems eminently sensible to me.

There was some more capital-raising today, with a National Bank preferred issue and a Lehman preferred issue in the States. The reporting of the latter is illuminating:

Lehman Brothers Holdings Inc., which has dropped 42 percent this year in New York trading, is selling at least $3 billion of new shares to U.S. institutions to reassure investors it has ample access to capital.
…
“We still maintain that we don’t need capital, but we’ve realized that perception is the dominant issue in today’s markets,” Chief Financial Officer Erin Callan said in an interview. “This is an endorsement of our balance sheet by investors.”
…
Merrill Lynch raised $6.6 billion in January by selling preferred shares to a group including the Kuwaiti Investment Authority and Japan’s Mizuho Financial Group Inc.

Today’s motto is “Strong Balance Sheets Are Good”. I’ve just read a history of the Overend & Gurney collapse which drives this home – I’ll be reviewing the book here shortly, to add to the PrefBlog Museum of Catastrophe.

It looks like CPD managed to arrest its fall and remain very slightly above its historical low point (in terms of total return) to close the month. This won’t be much consolation for holders, though, as their total return will have been minimal over the past four months since November 30. It’s close enough to the trough that I will not speculate on whether the BMOCM-50 was also able to eke out a gain. MAPF did not do well on the month, ending its streak of three superb months with a rather poor one – but will have outperformed CPD handsomely on the quarter.

Perpetuals got smacked today by the new National Bank issue; volume was good.

There were nineteen other index-included $25-pv-equivalent issues trading over 10,000 shares today.
Update, 2008-4-1:

No commentary today, I’m afraid! Month-end calls, with a shrill, unpleasant, voice!

Besides, I’m sulking. All those comments for March 27 and nobody explained to me why, given prices for all the other instruments, CIT CDSs have to be so expensive. Feh.

Apolcalyptionists will be thrilled to learn that we are within a whisker of deepening the peak-to-trough poor performance that I noted had set a record, March-November 2007. From November 30 to February 29, CPD returned +3.33% … month to date it has returned -2.96%. Mind you, the peak-to-trough referred to the BMOCM-50 Index, which is not the same as the S&P/TSX index referenced by CPD … but a bad day on Monday could make the Official Pain a year-long event.

Overall, a down day on the market, but with lots of outliers. Volume was low.

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

In a post remarkable for its vitriol, Naked Capitalism has attacked a rather innocuous article by Robert Shiller that mounted a defense of financial innovation. So today I’ll comment on the commentary and try to get past the slogans du jour.

Shiller: The entire sub-prime market is largely a decade-old innovation – the word “sub-prime” did not exist in any language before 1994 – built on such things as option adjustable-rate mortgages (option-ARM’s), new kinds of collateralized debt obligations, and structured investment vehicles. Previously, private investors in the US simply did not lend to mortgage seekers whose credit history was below prime.
Naked CapitalismFirst, option ARMs are not a subprime product; they were targeted to prime borrowers (see here and here from the esteemed Tanta). This is a striking error from a supposed expert on housing markets. Second, financial innovation does not equal “securitization of subprimes” which is what his second paragraph implies. CDOs frequently contain heterogeneous assets; many CDOs contain only corporate bond exposures.

Naked Capitalism is factually correct – option-ARMS (these are adjustable rate mortgages in which the borrower has an option regarding how much principal to repay … this can be a negative amount, giving rise to negative amortization) are not a sub-prime product.

As Table 9 in Ashcraft’s paper (reviewed on PrefBlog) shows, Option-ARMs have next-to-no representation in subprime MBS pools. However, the proportion of option-ARMs in Alt-A pools increased rapidly in recent times: from 1.7% in 2003 to 42.3% in 2006. Given that the second Calculated Risk post referenced by Naked Capitalism notes a 15% delinquency rate in Yuba City (north of Sacremento) I don’t quite see that this slight inaccuracy detracts from the credibility of the piece as a whole.

I am completely mystified regarding NC‘s second point: Shiller does not mention “securitization of subprimes” at all, despite NC‘s quotation marks. And while tranching and CDOs have been seen before, the widespread adoption of tranching in creating AAA securities from junk via subordination, which has confused so many commentators, is indeed a new thing.

Naked Capitalism then goes into a long rant, taking issue with Shiller’s statement that:

A study published in 2005 by economists Geert Bekaert, Campbell Harvey, and Christian Lundblad found that when countries liberalize their stock markets, allowing them to operate freely without government intervention, economic growth rises by an average of one percentage point annually.

NC claims a strong belief that this is in reference to a paper titled Growth Volatility and Financial Liberalization, going in to great detail to show why the paper does not show this. Unfortunately, a thirty second search of the SSRN site turns up a paper by the same three authors titled Does Financial Liberalization Spur Growth?, with the abstract:

We show that equity market liberalizations, on average, lead to a one percent increase in annual real economic growth. The effect is robust to alternative definitions of liberalization and does not reflect variation in the world business cycle. The effect also remains intact when an exogenous measure of growth opportunities is included in the regression. We find that capital account liberalization also plays a role in future economic growth, but, importantly, it does not subsume the contribution of equity market liberalizations. Other simultaneous reforms only partially account for the equity market liberalization effect. Finally, the largest growth response occurs in countries with high quality institutions.

It would seem that NC is very eager to confound financial liberalization with depredations of investors! There are other problems with his post; mainly attempts to portray innovation as the antithesis of regulation, but I’ll leave those as an exercise for the student.

Fascinating disclosure about Bear Stearns’ ownership today:

Bear Stearns Cos. Chairman James “Jimmy” Cayne sold his shares in the firm prior to a shareholder vote on the company’s pending takeover by JPMorgan Chase & Co.

Cayne sold 5.6 million shares at $10.84 a piece on March 25 on the New York Stock Exchange, according to a regulatory filing today. Bear Stearns spokesman Russell Sherman had no comment on why or to whom Cayne sold his shares.

I think I’ve mentioned my interest in CIT Group before; a number of interesting things have happened recently. They announced they were tapping their bank lines to build up cash and pay off their un-rollable commercial paper; short interest skyrocketted; Option volatility went way up; the price of CDSs soared (it’s a member of the investment grade high volatility index); and bonds tanked.

So … I’m trying to figure out investment strategies that would relate all thes data (bonds / CDSs is too easy. No marks for that one). I do recognize that all this could be happening completely independently … but I have real trouble believing that CDSs at +1300 is a rational response … even at +1000, that was being quoted at 25 points up front and 5 points a year. That’s not default risk – that’s “how much recovery will there be from the carcass?” What I’m saying is, I suspect that there’s some kind of amplification/transmission mechanism that’s operative and I’m trying to figure out how such a thing might work.

I’m not expecting to find a perfect arbitrage, I’m just trying to find a transmission mechanism. How about … short the stock at $10. Buy a call option with a $15 strike to cover. Sell 5-year Credit protection at 1000bp (net. get some points up front!). Do all this for $10-million notional on each position.

Scenario #1: CIT taken over. Stock goes way up, option exercised, loss $6-million. CDS comes in 700bp, gain about $3.5-million. Net -$2.5-million. Hmmm … maybe the hedge ratio on that one needs to be changed…

Scenario #2: CIT goes bust. Stock goes to zero, option expires worthless. Gain $9-million. CDS settles at 40% recovery. Loss $6-million. Net +$3-million Hedge ratio again … but this is beginning to look interesting.

Scenario #3: Nothing happens. Replace option, cost … Oh, call it $4 annually, or $4-million annually on the position. Receive credit protection payment of $1-million. Net loss $3-million annually

Scenario #4: Nothing happens, but you got 25 points up front. Wait one year, buy back the stock at $10, stop replacing options. Cost of options $4-million. Receive CDS payments of $2.5-million up front + $0.5-million for the year. Net loss $1-million; left with written CDS of 4-years at 500bp

So it doesn’t quite work (with these prices, which probably aren’t 100% executable), but I think there’s something there. And it’s the CDS prices I think are abnormal anyway, so that strategy’s in the wrong direction. How about … buy $10-million stock, buy $25-million notional credit protection?

Scenario 1: Company goes bust in one year. Lose $10-million on stock. Pay $6.25-million up front on CDS, pay $1.25-million annual charge. Make 60% (assumed) on notional CDS = $15-million. Net loss $2.5-million … $2.50/share

Scenario 2: Company taken over at $20. Make $10-million on stock. Pay $6.25-million up front on CDS, pay $6.25-million (total over 5 years) for four year’s credit protection on acquirer. Net = four year, $25-million CDS on acquirer for total cost $2.5-million = 25bp That’s very very cheap, could be sold for … um … 150bp? Then $25-million x 4 years x 125bp = $1.25-million profit. So the break-even takeover price is about $18.75, with full exposure up or down. You’re paying $8.75 for the chance at the other two scenarios.

Scenario 3: Nothing happens. Sell stock, no loss or gain. Have very expensive credit protection on CIT.

… Hmmmmm … still doesn’t quite work.

Any ideas for transmission between asset classes will be appreciated! I do appreciate that a drop in stock price accompanied by a rise in volatility will lead to a higher CDS price according to some models – I’ve mentioned the BoC study – but … but … I want something more direct.

Volume was light on the preferred market today, but there were some violent price moves amid a sharp decline. BCE issues did very well, but quite a few PerpetualDiscounts got hammered.

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