Category: Market Action

There’s a bit more colour on the Clear Channel deal today, which will of intense interest to those watching the BCE / Teachers deal:

Banks financing the $19.5 billion buyout of Clear Channel Communications Inc. stand to lose about $3 billion on the transaction because loan prices have tumbled since they promised to fund the deal.

Banks led by Citigroup Inc. and Deutsche Bank AG agreed in April to provide $22.1 billion for the purchase by private- equity firms Thomas H. Lee Partners LP and Bain Capital Partners LLC. Since then, losses on subprime-mortgage securities spread throughout credit markets and loan prices for similar LBOs fell to as low as 85 cents on the dollar
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“It doesn’t appear to be a gentleman’s market anymore,” said Neal Schweitzer, who analyzes the bank loan market as senior vice president at Moody’s Investors Service in New York. “The larger the transaction, the greater the potential for bigger discounts” when selling the debt.

The BCE buying group has repeated the same old party line.

Econbrowser‘s James Hamilton voices his support for Jeff Frankel’s explanation of high commodity prices mentioned here yesterday and follows up with a warning:

I have long argued that the broad increase in commodity prices over the last five years has primarily been driven by strong global demand. But I am equally persuaded that the phenomenal increase ([1], [2]) in the price of virtually every storable commodity in January and February cannot be due to those same forces.
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Nor do I agree with those who attribute the recent commodity price increases primarily to the falling value of the dollar.
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Instead I believe that Harvard Professor Jeff Frankel has the correct explanation– commodity prices at the moment are being driven by interest rates, with a strongly negative real interest rate increasing the incentives for speculation in any storable commodity.
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Swings in relative prices of this magnitude are destabilizing. The Fed would like to stimulate more, but it also has to be realistic about what it is capable of accomplishing through manipulation of the fed funds target. Bernanke also needs to be mindful that one of his most valuable assets, if he hopes to be able to accomplish anything through adjustments of the fed funds rate, is the confidence on the part of the public in the Fed’s long-run inflation-fighting resolve.

I agree. As written here on March 19:

I agree with him, as I agreed with his recently expressed view on limits to monetary policy. It seems to me that as far as the overall economy is concerned, the Fed should be waiting to see what its cuts – now 300bp cumulative since August – do to the economy. At the moment, the problem is land-mines of illiquidity blowing up unexpectedly, and the TSLF, together with the occasional spectacular display of force are the best defense against that.

I will also note that a linking of commodities with short-term rates seems in large part to be an attempt to treat them as money market substitutes … we’ve had far too much problems with money-market substitutes in the last year to start inventing more! Well … it’s not my money, and I suspect that the speculators will – eventually – pay through the nose for their presumption.
Accrued Interest mourns the lot of fixed income analysts in this environment:

In the case of mortgage-related credit risk, for instance the ABX index, prices should obviously be drastically lower. This is the kind of risk pricing that capital markets can handle. In fact, that kind of risk pricing is exactly why capital markets are an important part of our free-market system.
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But the second major theme is interfering with the market’s ability to properly price risks. Potential buyers of risk, from hedge funds to banks to broker/dealers, became overextended during the credit bull market and now need to repair their their own balance sheets. No matter how attractive various pricing levels are, these buyers are are not a position to take advantage. Some of those that became overextended have been forced to unwind some or all of their positions.
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As a result, classic investment analysis, pouring over 10K’s and analyzing cash flows, has not been a winning strategy. Until very recently, investors who dabbled in anything that looked fundamentally “cheap” got burned. Sector after sector suffered historic spread widening amidst persistent forced selling.

A major (major! major!) problem this time ’round is that we are currently experiencing the very first credit crisis in which it has been possible to short credit on a large scale – via Credit Default Swaps and Index shorts, for instance. In every other crisis to date, anybody who wanted to speculate against corporate credit had to arrange to borrow physical bonds, preferrably for a long term … at the very least, this added to frictional costs, even assuming a counterparty could be found.

No more. Just buy protection on a billion corporates and wait for the money to roll in.

The problem with this strategy is that shorting credit is ultimately a losing game. Issuers short their own credit because they can (or think they can) use the funds to invest in profitable ventures; ventures not available for the speculator, especially one who isn’t actually getting the funds but is just paying the spread. Shorting credit is a game for the short term only.

From a policy perspective, the ability to short credit is disturbing due to its procyclical nature – that is, speculation may be counted upon to exaggerate legitimate price swings.

Which is not to say I am in favour of banning the practice! However, I do think the margin requirements applicable to players in the core banking system and investment banking system should be reviewed to ensure that speculation is contained. This is similar to regulatory margin requirements on stocks: set partially in order to ensure that there are no destabilizing bankruptcies; and also to discourage ‘walk-away’ trades, in which a player just walks away from a losing bet. We’ve seen quite enough walk-away trades in the US housing market, thank you very much!

As an aside … I mentioned BMO’s new issue of sub-debt yesterday, as a note to the the 5.80% pref new issue announcement … that was a 10+5 year deal at 10s + 260. I have now been advised that TD is also issuing sub-debt, a 7+5 deal at 7s + 225.

In a speech that may be laying the groundwork for massive regulatory changes, Treasury Secretary Paulson has opined:

the Federal Reserve should broaden its oversight to include Wall Street investment firms that borrow from the central bank at the same interest rate as commercial lenders.
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“The Bear Stearns action was a sea change,” said Gilbert Schwartz, a former associate general counsel at the Fed, and now a partner at Schwartz & Ballen in Washington. “The Fed should be the umbrella agency for all these institutions. The SEC is not set up to handle this.”
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“We don’t think the SEC has the tenure and the expertise in a lot of these global capital adequacy, funding and derivative issues that the Fed would have,” said David Hendler, an analyst at CreditSights Inc. in New York. “If you’re going to extend the money you should have the right to look over the books.”
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“The Federal Reserve should have the information about these institutions it deems necessary for making informed lending decisions,” said Paulson, whose three decades on Wall Street culminated in seven years as chief executive officer of Goldman Sachs Group Inc. “Certainly, any regular access to the discount window should involve the same type of regulation and supervision.”

I’m not sure how much I agree with this. I am opposed to regulating investment banks on the same basis as regular banks, for reasons that I have stated until I have bored even myself: they represent part of the grey zone between banks – that should be ultra-regulated – and hedge funds – that should not be regulated at all. If the Fed extends only over-collateralized to brokerages, how necessary is it that they have supervisory responsibilities? Many countries – Canada included – separate central bank & bank supervision, a separation that I feel is sub-optimal, but not all that much sub-optimal.

Is there really anything wrong with the Fed simply seeking an opinion from the SEC regarding solvency of a brokerage prior to extending an over-collateralized loan in emergency circumstances? One thing’s for sure: we don’t want too many rules. Get good people at the Fed, pay them well and give them discretion; that’s the winning formula.

An increased field of operations for the Fed has been endorsed by Dallas Fed President Fisher.

Maybe they can lend money to the monolines next! FGIC dropped a bomb today:

Bond insurer FGIC Corp said on Wednesday that its exposure to mortgage losses exceeded legal risk limits and it may raise loss reserves due to litigation related to stricken German bank IKB.
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FGIC in a statement also said it has a substantially reduced capital and surplus position through December 31. As a result, insured exposures exceeded risk limits required by New York state insurance law, the New York-based company said.

Moody’s downgraded FGIC in mid-February … there’s no word yet on the implications of the new revelations. They recently downgraded Security Capital Assurance when:

elected not to declare the semi-annual dividend payment on its Series A perpetual non-cumulative preference shares.

In other monoline news, Fitch has published a monograph on their ratings model, which takes note of the special characteristics of municipals.

Not a very good day for the markets, but no disaster and volume held steady. I regret I don’t have time for the indices tonight … I’ll try to get to them tomorrow.

There were nineteen other index-included $25-pv-equivalent issues trading over 10,000 shares today.
Update, 2008-3-27:

Naked Capitalism provides a very good round-up of the BSC/JPM deal commentary. I will quibble with the repeated suggestion that formal bankruptcy Monday morning was the only alternative to a deal. I agree that their options (speaking strictly in terms of their economic interests as shareholders, not as employees and creditors) were both limited and unpalatable – I pointed that out on March 14, but there is the question of the Japanese banks. Naked Capitalism – Why didn’t Bear use its credit lines? – couldn’t understand why they didn’t draw their lines; and the Japanese banks have previously advertised their willingness to lend to any player who is sufficiently desperate.

So – I think – Bear had a choice, albeit one with which Hobson would be familiar. Of particular interest in the post is the discussion of the alleged contract glitch that I briefly mentioned yesterday. Dealbreaker has posted twice on the issue, claiming that the conference call was crystal clear and then backing up his statement with the transcript. Upon thinking about it a little more myself – and reviewing the transcript – I’m inclined to believe that Dealbreaker is correct and the alleged glitch was in fact an explicitly desired thing.

Look: What’s the point of the guarantee in the first place? To ensure that Bear can operate until they’re formally taken over, right? If Bear had difficulties finding counterparties on the Friday, those difficulties were going to double on Monday (assuming that they did not file for bankruptcy at the crack of dawn). In order to serve its purpose, the guarantee had to be absolutely binding – who’s going to enter into a trading committment of a year, say (CDSs and Swaps will typically be 5 years) on the basis of a guarantee that might vanish in a month? JPM had to make the guarantee binding and lengthy, or there was no point going through the motions.

In familiarly cheery news, the US housing price drop is accellerating:

Home prices in 20 U.S. metropolitan areas fell in January by the most on record, a sign the housing recession is deepening, a private survey showed today.

The S&P/Case-Shiller home-price index dropped 10.7 percent from January 2007, after a 9 percent year-on-year decrease through December 2007. The gauge has fallen for 13 consecutive months.
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Lehman Brothers Holdings Inc. forecasts home prices as measured by Case-Shiller will decline another 10 percent by the end of 2009. It predicts new-home sales will bottom in the middle of this year and existing-home sales and housing starts will reach a trough in the third quarter.

“Prices have reached what might be called a fair value,” Dan North, chief U.S. economist at Euler Hermes ACI in Owings Mills, Maryland, said in a Bloomberg Television interview before the report. “However, prices have still got to go substantially past that” to trigger demand and a recovery.

A separate report from the Office of Federal Housing Enterprise today showed home values fell 3 percent in January from a year ago, and 1.1 percent from December.

The S&P/Case-Shiller index measures repeat home sales in 20 U.S. cities, regardless of mortgage size, while the Ofheo monthly index excludes sales of homes with mortgages higher than $417,000, the maximum allowed during that time for homes bought by government-chartered Fannie Mae and Freddie Mac.

There is further commentary on the WSJ Blog.

In other news of interest Jeffrey Frankel argues that commodity prices are rising due to low real interest rates rather than due to new demand from the BRIC bloc.

Assiduous Readers will be familiar with my view that banking regulation needs to be improved; primarily by drawing a brighter line between the core banking system and the shadow banking system (e.g., by increasing capital requirements for committed – or effectively committed, as is the case with bank-sponsored SIVs – credit lines) and reviewing capital requirements for non-core-but-still-bloody-important institutions like investment banks (such as margin requirements on derivatives, as mentioned yesterday). I’m not alone in this view: Mark Thoma of Economist’s View got some ink in the WSJ Blog by musing about the need for reform:

There is quite a bit of discretionary authority in the hands of regulators. As the philosophy of both parties has drifted toward a hands off approach over time, and as appointment after appointment to this or that agency has reflected that changing philosophy, the accompanying regulatory oversight has changed along with it. The changes have been more dramatic under Republican administrations, and the current administration strongly prefers a hands off approach on all matters involving economic policy (with the exception of tax cuts for the wealthy), so it’s no surprise that the same philosophy has, over the last several years, filtered into the offices charged with regulatory oversight more so than in the past (and appointments based upon how much someone contributed and the strength of their ideology rather than their competence hasn’t helped).

Very – very! – light on specifics, but it’s a start. I might as well stake out my position pretty clearly right now … I want a core banking system, an investment banking system and a shadow banking system, with exposure between the levels being determined by margin and capital requirements rather than flat prohibitions and directives. What’s more, I believe that the appropriate policy response can better be described as “tweaking” rather than “reform”. The pendulum never swings half-way however, so it will be a fight – and certainly the political response so far has been to erode capital at the GSEs and FHLBs to protect Americans’ God-given right to McMansions.

The Fed has announced that yesterday’s TAF auction ($50-billion, one month) came in at 2.615% for one month money – about 4bp less than current LIBOR. This continues to be a good sign – a rate significantly above LIBOR would imply that there were players shut out of the interbank market desperate for funds. For those having trouble with the plethora of new Fed acronyms, remember that the TAF is restricted to banks and is fully collateralized.

In news that will cause fear and trembling amongst BCE investors (the equity kind, anyway), the Clear Channel buy-out looks sick:

Clear Channel Communications Inc. dropped in extended trading after the Wall Street Journal reported its $19.5 billion private-equity buyout is close to falling apart.

The buyout group, led by Thomas H. Lee Partners LP and Bain Capital Partners LLC, hasn’t been able reach an agreement on terms with the banks financing the transaction, the newspaper said today, citing people familiar with the matter. The lenders include Citigroup Inc., Morgan Stanley, Deutsche Bank AG, Credit Suisse Group, Royal Bank of Scotland Group and Wachovia Corp.
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Clear Channel, the largest U.S. radio broadcaster, dropped 14 percent to $28 after closing at $32.56 in New York Stock Exchange composite trading. Since the buyout was announced in November 2006, the stock has traded below the $39.20-a-share offer price because of investor concerns that the deal won’t be completed. Credit-market turmoil has made it harder for buyout firms to obtain financing.
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Clear Channel’s 5.5 percent notes due in September 2014 rose 2.75 cents, or 4.4 percent, to 65 cents on the dollar to yield 13.9 percent, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

A day enlivened by the BMO new issue of 5.80% perps. Volume picked up nicely, but perpetualDiscounts got smacked as players adjusted their portfolios to account for … for … for … for what they think the new standard is. Or something.

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

Menzie Chinn of Econbrowser reviews the policy response to the credit crunch:

First, methinks the Administration protests too much, about “not bailing out” investors. If it were indeed the case that it was against further contingent liabilities being taken on by the Federal government, it would not have allowed the increase in the maximum size of conforming loans guaranteed by the Government Sponsored Enterprises, Fannie Mae and Freddie Mac. Nor would capital requirements have been reduced at exactly the time that a higher capital cushion would be in order, given the state of the economy. In addition, it would have taken some sort of action to limit the borrowing taking place through the Federal Home Loan Banks (see [5], [6] for discussion of recent actions, and implications).

Second, whatever the reasons for the Administration’s actions, I think a very serious problem is that, by virtue of the Administration’s abdication of a substantive role (see Hubbard’s comment on this point), the Fed is lending to entitites it does not regulate. The Bear Stearns collapse might have been seen as a case where the Fed had to undertake unconventional actions, because of the rapidity of developments. But with the Administration providing an uncompromising stance, who will step in the next episode? If it’s the Fed again, then Blinder’s critique will take on heightened relevance.

I’ll agree with his first point – as I said most recently in the comments to March 20, a slight relaxation in the GSE capital requirements may be justifiable, but should be accompanied by a schedule whereby the capital standards would approach banks. Similarly, the FHLBs should be regulated like the banks they are.

Prof. Chinn’s second concern, the separation of regulatory and last-lender powers, does not seem quite so cut-and-dried to me. The issue was last discussed in PrefBlog in the post regarding Willem Buiter’s Prescription and on December 5 in response to a VoxEU article by Stephen Cecchetti. There are certainly good arguments to be made regarding combination of roles as far as the banks are concerned – and, by and large, I agree with these arguments – but the arguments for extending Fed oversight to the brokerages is a little less clear.

As I have stated so many times that Assiduous Readers are fed up to the back teeth with the incessant drone – we want a shadow banking system! We want to ensure that there are layers of regulation, with the banks at the inner core and a shock-absorber comprised of brokerages that will serve as a buffer between this core and a wild-and-wooly investment market. This will, from time to time, require (or, at least, encourage) the Fed to step in and take action, but the alternative is worse.

Which is not to say that regulation cannot be improved! Regulation can always be improved! Margining requirements for derivatives may have to be reviewed – interest rate swaps and credit default swaps particularly, without simply making the lawyers happy by getting them to invent a new instrument.

If I buy $1-million of a corporate bond from my broker, I have to put up 10% margin. Seems to me that if sell credit protection, I should have to put up 10% of notional. And if I buy credit protection, I should have to put up at least 10% of the present value of the contractual payments.

Similarly with an interest-rate swap: if I pay floating to receive fixed, that is functionally equivalent to going long a fixed-rate bond and short a floating-rate one. If I do this in the physical market, I will be allowed a consideration as far as offsetting credit risk is concerned, but I won’t get away scot-free! When done as a derivative, I should have to put up … 2%? … of notional.

And in both cases, positions should be marked to market at least monthly. As reported by the WSJ, Barney Frank, Chairman of the House Financial Services Committee, wants a review of margin requirements (among other things), but has no concrete proposals at this time:

Reassess our Capital, Margin and Leverage Requirements (and the nature of “capital” itself). This crisis has illustrated that seemingly well-capitalized institutions can be frozen when liquidity runs dry and particular assets lose favor.

The BSC/JPM deal was a big story again today, with the deal value quadrupling in exchange for a couple of things:

• JPM is getting a new issue of 39.5% of BSC as treasury stock
• A possibility that JPM will take $1-billion first-loss on the $30-billion Fed financing

Seems to me that this makes the deal a certainty, with the Fed managing to keep its self-respect by being able to point out that the billion dollars extra given to BSC shareholders has been met by a corresponding reduction in their loss-exposure on the financing. The certainty will be good news for JPM in terms of staff retention, as well as considerations that the guarantee of liabilities might have been poorly drafted, as reported upon by Naked Capitalism.

The WSJ has reported:

At the merger’s closing, the New York Fed will take control of about $30 billion of assets as collateral for $29 billion in financing from the New York Fed. The Fed will provide the funds at its primary credit rate, 2.5%, or a quarter percentage point above the benchmark federal funds rate. Under the new terms, J.P. Morgan would have to eat the first $1 billion in losses from those assets; the Fed would have rights to any gains.
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The New York Fed plans to provide additional details about the deal’s terms later Monday.

The New York Fed hired BlackRock Financial Management Inc. to manage the $30 billion portfolio “to minimize disruption to financial markets and maximize recovery value,” it said in a statement. Fed officials sought out BlackRock, seeing it as one of the few firms without conflicts of interest that could handle the task in the timeframe that was necessary. The Fed hasn’t provided details of the portfolio, whose assets were valued on March 14, but it’s believed to include hard-to-trade securities tied to riskier home mortgages.

Boy, that BlackRock’s got a good gig, eh? Paid to manage a portfolio that’s virtually untradeable and in run-off mode. A New York Fed press release confirms the terms.

In yet another indication that Regulation FD and its Canadian equivalent, National Policy 51-201, are in urgent need of amendment, the Fitch / MBIA battle has hotted up:

Fitch Ratings said it will still assess MBIA Inc.’s financial strength, snubbing a request by the bond insurer to withdraw the ratings.

Fitch will rate MBIA as long as it can maintain a “clear, well-supported” view without access to non-public information, the ratings firm said today in a statement.
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MBIA asked Fitch earlier this month to stop rating the company because of disagreements about modeling for losses. Fitch is the only credit rating company considering a downgrade of MBIA. Moody’s Investors Service and Standard & Poor’s both affirmed the company earlier this month after MBIA raised $3 billion in capital, eliminated its dividend and stopped issuing asset-backed insurance. Fitch will complete its review in “the next few weeks,” Joynt said.

Fitch probably won’t be able to continue rating the company for long, MBIA said today in a statement responding to the announcement.

“The non-public information currently in Fitch’s possession soon will become out of date, and public information alone will be insufficient to maintain the ratings,” MBIA said.

OK. So here we have MBIA saying that investors cannot possibly come to a well-supported conclusion about credit quality without access to material non-public information, which is available only to credit rating agencies that make their credit ratings public (the Lord alone knows what equity investors are supposed to conclude). How many times must this conclusion be repeated before the exemption is repealed and the required information is publicized?

Naked Capitalism has excerpted and colourized a post by Brad Setser regarding reliance of the US on foreign central banks:

So long as they are piling into safe US assets, central banks are contributing the “liquidity” to a market that doesn’t need any liquidity. They are helping to push Treasury rates down. And their activities, while rational from the point of view of conservative institutions seeking to avoid losses (beyond those associated with holding the dollar), also may be aggravating some of the difficulties in the credit markets. Private funds fleeing the risky US assets for the emerging world generally end up in central bank hands and currently seem to be recycled predominantly into safe US assets.
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In January, official investors – central banks and sovereign funds – provided the US with $75.5 billion in financing. Annualized, that is about $900b. That’s huge. It is also more than the US current account deficit. Central banks and sovereign funds are effectively financing the runoff of some private claims on the US. If the US were an emerging economy, that might be called “capital flight.”

$53.4b of the $75.5b in overall official inflows came from the purchase of long-term US debt and equities. $22.1b came from a rise in short-term claims (the $15.2b increase in short-term Chinese claims likely explains most of the overall rise in short-term claims).

That $53.4b in long-term inflow was concentrated at the two poles of the risk distribution: Official investors purchased $36.1b in Treasuries, next to no agencies (*), sold corporate debt and bought $13.9b in US equity. This is what an anonymous (but well informed) commentator here called a barbell portfolio. Buy safe stuff or buy risky stuff but don’t buy much in between.

Well – that’s what happens when you run a fiscal deficit for so long … the country’s financial markets become the plaything of foreignors.

Volume picked up a little in the preferred share market today, but was nothing special – no major price trends either.

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

Another implosion in the US today, as CIT Group drew on bank credit to pay short-term debt:

“Protracted disruption” in capital markets and downgrades of its credit ratings prompted the company to borrow from backup lines, Chief Executive Officer Jeffrey Peek said in a statement today. Proceeds will be used to repay debt maturing this year, including commercial paper, New York-based CIT said.

Moody’s Investors Service and Standard & Poor’s cut the company’s credit ratings this week, restricting its ability to finance itself in the commercial paper market, where it has $2.8 billion in debt outstanding, John Guarnera, an analyst at Bank of America Corp., said. CIT, which leases airplanes and trains and provides financing to companies, follows Countrywide Financial Corp. in seeking bank financing after struggling to access traditional means of funding.

Quite frankly, I don’t understand this at all. I’ve been looking at CIT, and agree – they have problems! But their book value of $34 looks entirely reasonable, financing requirements don’t (didn’t!) seem to be horribly lumpy, lots of cash on the balance sheet. The worry is their 10:1 debt:equity ratio … but it’s a leasing company! That’s what they do! It seemed to me that while the common share holders were probably not going to be happy campers for the duration of crunch (higher financing costs grinding away at profit) and sometime thereafter (while the financing runs off the books), it seems to me the credit was fine. And now…

Credit-default swaps tied to CIT’s bonds traded at 27 percent upfront and 5 percent a year today, according to broker Phoenix Partners Group in New York, meaning it cost $2.7 million initially and $500,000 a year to protect the company’s bonds from default for five years. That’s up from 23 percent upfront and 5 percent a year yesterday.

Wow. At any rate, I suspect CIT is ripe for a take-over … market cap of $1.4-billion makes it a nice little tuck-in for a bank that wants a leasing business. But we shall see! My macro-calls are no better than any other idiot’s. One thing that may be affecting matters is extraordinary volatility in the stock markets:

The U.S. stock market is the most volatile in 70 years, according to a Standard & Poor’s study of daily price swings in the S&P 500.

The benchmark for American equities has advanced or declined 1 percent or more on 28 days this year. That’s 52 percent of the trading sessions so far, which is the highest proportion since 1938, said Howard Silverblatt, S&P’s senior index analyst. The S&P 500 lost 12 percent in 2008 through yesterday following $195 billion in bank losses related to subprime mortgages.

Increased stock volatility can lead to increased CDS spreads via variants of the Merton structural model.

And according to Citigroup’s analysis:

While Citigroup apparently does not invoke the underlying theory, they see a massive deleveraging in process and tell investors to get out of the way. Via Marketwatch:

The Great Unwind has begun, Citigroup Inc. strategists warned on Wednesday.

As markets and economies de-leverage across the globe, investors should avoid companies and countries that have grown to rely too much on borrowed money, they said.

That means favoring public-equity markets over hedge funds, private-equity and real estate, while leaning toward emerging market countries and away from developed nations like the U.S., the bank’s global equity strategy team advised.

Within equity markets, the financial-services should be avoided because it’s still over-leveraged, while other companies have stronger balance sheets, the strategists said….

For example, there are reports and speculation that Bear Stearns’ problems are feeding into commodities:

When confidence in the brokerage firm was waning last week, many hedge fund clients working with the firm’s prime brokerage division pulled back and tried to quickly move accounts to rival brokers, according to hedge fund investors, prime brokers and other experts in the business.

One executive at a smaller prime brokerage firm said he was bombarded by calls on Friday from hedge funds wanting to move from Bear. His firm has gained about 10 new clients from Bear during the past 10 days, he added. Another executive at one of the largest prime brokers said his firm has also been picking up new clients as a result of Bear’s problems. They both spoke on condition of anonymity.
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“Leverage is being closely watched,” said Josh Galper, managing principal of Vodia Group, which advises hedge funds on borrowing strategies. “That does not mean that hedge funds from Bear are being told specifically that they may not put on as much leverage as Bear had let them, but rather that the amount of leverage being utilized is being reviewed much more carefully than it has been in the past, for obvious reasons.”
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The price of commodities including energy, metals and grains slumped for a second day on Thursday amid speculation that some hedge funds are selling leveraged positions to either meet margin calls or lock in profits and shift to other assets.

Two articles today brought into sharp relief the issue of individuals’ compensation within the financial services industry. Naked Capitalism republishes an article from the Financial Times which brings up the old chestnut about an investment strategy that returns 10% in nine of ten years and -100% one time in ten:

We can identify two huge problems to be solved. First, many investment strategies have the characteristics of a “Taleb distribution”, after Nicholas Taleb, author of Fooled by Randomness. At its simplest, a Taleb distribution has a high probability of a modest gain and a low probability of huge losses in any period.

Second, the systems of reward fail to align the interests of managers with those of investors. As a result, the former have an incentive to exploit such distributions for their own benefit.

Further, it is claimed that:

Professors Foster and Young argue that it is extremely hard to resolve these difficulties. It is particularly difficult to know whether a manager is skilful rather than lucky.

Well, says I, no more difficult than with anything else. You have to actually look at an investment; looking at returns – whether actual or backtested – is only half the story. If we look, for instance, at the just-reported blow-up of Endeavor Capital, we see:

Endeavour Capital LLP, the London- based hedge-fund firm founded by former Salomon Smith Barney Inc. traders, has fallen about 28 percent this month because of “extreme volatility and vast moves” in Japanese bonds, according to two investors.

The $2.88 billion Endeavour Fund sold “substantially all” of its Japanese government debt this week, Chief Executive Officer Paul Matthews said today in an interview. He declined to comment on the March decline.

Endeavour seeks to profit from discrepancies in the prices of various fixed-income securities and currencies, a strategy known as relative-value trading. The fund lost money as the spread, or difference, between yields on Japanese 7- and 20-year bonds widened to 1.44 percentage points on March 17, the most in almost nine years. Investors bought shorter-term debt as the benchmark Nikkei 225 stock index fell 13 percent in March.

Let’s think about this. They lost money because the spread between 7s and 20s widened … so presumably they were long 20s and short 7s. Since they are calling themselves “relative value” investors, we will assume (assume!) that the position was duration neutral and in that case their position was most likely long cash, short 7s, long 20s in such a way that parallel shifts in the yield curve would not – to a first approximation anyway, for smaller small parallel moves – harm them. Note that the assumptions leading to this conclusion are entirely reasonable, but are still assumptions. Anybody who knows better – feel free to tell me. Anyway .. long cash / short 7s / long 20s is a coherent strategy, at the very least.

But “relative value”? Well – I don’t know what the proponents themselves called it when pitching clients for money. And, at a stretch, “relative value” can cover a lot of ground … if you feel that the value on stocks is cheap relative to cash, you can justify levering 20:1 on a stock portfolio and call it a “relative value” play.

I certainly wouldn’t call it a “relative value” play. The position I’ve described – long cash, short 7s, long 20s – is a “flattener”. It will make all kinds of money if the overall yield curve flattens, and lose all kinds of money if the overall yield curve steepens … and it appears that the Japanese government curve has just done that latter. It’s not a “relative value” play at all – it’s a macro-market call, subject to all the chaos and market risk of any other macro market call.

If they want to go long 5s, short 7s, long 10s … then maybe they can talk to me a little bit more about their “relative value” plays. Maybe. But that’s the outside limit, and too much leverage takes it out of consideration.

In a similar vein, Guido Tabellini of Bocconi University asks in VoxEU Why did bank supervision fail?:

On the other hand, there were systematic incentive distortions. First, the “originate and distribute” model entails obvious moral hazard problems. Second, credit rating agencies face a conflict of interest. Third, management compensation schemes reward myopic risk taking behaviour; it is rational for me to under-insure against the occurrence of rare disruptive events, if my bonus only depends on short-term performance indicators.

These are bare assertions – Prof. Tabellini may well have good reason to believe they are true, but they are incidental to the main point of his article, which I will not discuss.

What I find interesting is the renewed focus on short-term compensation; it’s reminiscent of the handwringing of the 1980’s – remember? When the ceaseless pressure on American corporations to post quarterly returns was blamed for all that was wrong with the world and predictions that the long-term oriented Japanese would end up owning the world? This was before the Japanese property bubble collapsed and sent them into a 15-year recession, of course.

I’ve said it before, but I never get tired of seeing my own words on screen: there are problems, sure, but most of these will be self-correcting. It’s going to be awfully difficult to sell originate-and-distribute product any more without better disclosure and accountability … the pendulum has, if anything, swung over too far on that one, at least for now. And bank supervision – via the Basel accords – needs to provide a brighter line between the (protected and regulated) banking system and the (unprotected and unregulated) shadow-banking system.

Compensation structures for individuals can always be improved – but there is always a lot competition for talent:

As more than 14,000 Bear Stearns Cos. employees watch the value of their stock sink and brace for firings, some of the company’s 550 brokers who handle individual investors’ accounts are receiving job offers from competitors promising windfalls of $2 million or more.

Merrill Lynch & Co., Morgan Stanley, UBS AG and Citigroup Inc.’s Smith Barney unit are offering Bear Stearns brokers packages that include signing bonuses of two times the revenue they bring in annually, said Mindy Diamond, president of Diamond Consultants LLC, a Chester, New Jersey-based executive search company. Someone generating $1 million in commissions and fees could receive $1.5 million up front and the rest over three years, she said.

Note that in highlighting this example, I am using the word “talent” to denote “ability to bring money in the door”.

Back to economics, Econbrowser‘s James Hamilton opines on yesterdays massive Fed easing:

suppose you believe that oil over $100 a barrel is a destabilizing influence– and I do— and that the Fed’s recent decisions on the fed funds rate are the primary reason that oil is over $100– and I do— and that further reductions in the Tbill rate have limited capacity to stimulate demand– and I do. Suppose you also saw a risk that the inflation, financial uncertainty, and slide of the dollar could precipitate a run from the dollar, introducing an international currency crisis dimension to our current headaches.
…
I think the Fed missed an opportunity here. A 25 or a 50 basis point cut would have sent commodity prices crashing. Even the mildly hawkish surprise of “only” a 75 basis point cut may have some effects in that direction. If the Fed did convince the commodity speculators that their path leads only to ruin– and I believe the Fed could easily have done just that– that would leave Bernanke with a lot more maneuvering room to cope with what comes next.

I agree with him, as I agreed with his recently expressed view on limits to monetary policy. It seems to me that as far as the overall economy is concerned, the Fed should be waiting to see what its cuts – now 300bp cumulative since August – do to the economy. At the moment, the problem is land-mines of illiquidity blowing up unexpectedly, and the TSLF, together with the occasional spectacular display of force are the best defense against that.

In other words, I’m worried about the collateral damage from such an unfocused tool as the Fed Funds rate. I will note that Accrued Interest is of the view that the (assumed) objective of deleveraging is being (somewhat) achieved by the spanking given to Bear Stearns:

Deleveraging continues. All the big brokers know that the surest way to avoid a Bear Stearns problem is to make sure they aren’t over exposed to hedge funds. Supposedly there have been several commodities-oriented funds which are selling today. Gold getting crushed. Haven’t heard anything about equity-oriented funds but that might be part of what’s going on today as well.

Speaking of Bear Stearns, the SEC has released some FAQs, one of which supports Bear Stearns’ story of sudden and unforseeable liquidity collapse:

Why was Bear Stearns’ loss of credit so critical to its ongoing viability?

In accordance with customary industry practice, Bear Stearns relied day-to-day on its ability to obtain short-term financing through borrowing on a secured basis. Although Bear Stearns continued to have high quality collateral to provide as security for borrowings, as concerns grew late in the week, market counterparties became less willing to enter into collateralized funding arrangements with Bear Stearns.

Late Monday, March 10, rumors spread about liquidity problems at Bear Stearns, which eroded investor confidence in the firm. Bear Stearns’ counterparties became concerned, and a crisis of confidence occurred late in the week. In particular, counterparties to Bear Stearns were unwilling to make secured funding available to Bear Stearns on customary terms.

This unwillingness to fund on a secured basis placed stress on the liquidity of the firm. On Tuesday, March 11, the holding company liquidity pool declined from $18.1 billion to $11.5 billion. On Wednesday, March 12, Bear Stearns’ liquidity pool actually increased by $900 million to a total of $12.4 billion. On Thursday, March 13, however, Bear Stearns’ liquidity pool fell sharply, and continued to fall on Friday.

Joe Lewis is opposing the JPM / BSC deal:

Lewis, a former currencies trader born in an apartment above a pub in London’s East End, will take “whatever action” he deems necessary to protect his $1.26 billion investment in New York-based Bear Stearns, he said in a filing today with the U.S. Securities and Exchange Commission. He said he may “encourage” the firm and “third parties to consider other strategic transactions.
…
“If he gets others to vote with him he may be able to get some token increase in the price,” said John Coffee, a securities law professor at Columbia University in New York, referring to Lewis. “He’s not going to get a significantly higher bid because no one else can get the Fed’s support and the Fed’s financing.”

Lewis paid an average of $103.89 apiece for his 12.14 million Bear Stearns shares, according to today’s filing. He started accumulating most of his shares last July and has lost about $1.19 billion on the investment, or almost half his wealth, which Forbes magazine estimated at $2.5 billion in its 2007 survey.
…
The SEC filing today showed that Lewis purchased 1.04 million Bear Stearns shares during February and March, raising his total stake 8.35 percent of common shares outstanding. His price per share ranged from $55.13 to $86.31. He said he may dispose of his holdings entirely or bet that the stock will drop further.

Naked Capitalism highlights some rumours about European banks, which brings to mind Accrued Interest‘s prescient emphasis on the effect of rumours in a bear (Bear?) market reported here March 12. 

And in the regular trickle of news about LBOs in general and how the market is affecting the chances for Teachers / BCE, there is a snippet about current conditions on Bloomberg:

U.S. banks have whittled their holdings of leveraged buyout loans to $129 billion from $163 billion at the beginning of the year by offering the debt at discounts, according to Bank of America Corp. analysts led by Jeffrey Rosenberg.
…
Goldman reduced its backlog of loans by $20 billion in the past quarter from $43 billion, chief financial officer David Viniar said on an investor call yesterday. The New York-based firm, which booked a loss of $1 billion on the loans, also added $4 billion of new commitments during the period.

Lehman, the fourth-biggest U.S. securities firm, booked losses of $500 million on leveraged loans last quarter, CFO Erin Callan said on a conference call with investors yesterday.

Morgan Stanley, the second-biggest U.S. securities firm, reduced its leveraged finance pipeline to $16 billion from $20 billion during the first quarter, CFO Colm Kelleher said in an interview today after the company reported first-quarter profit fell 42 percent.

Make of it what you will!

In other jolly news, DBRS has announced that it:

has today withdrawn the ratings of the below-listed Affected Trusts under the Montréal Accord. This action has been taken at the request of the Affected Trusts.

Well, I guess the court appointed monitor didn’t want to pay rating bills for trusts that were under CCCA protection anyway! Speaking of ratings, by the way, I am participating in an exchange with Naked Capitalism in the comments to an almost unrelated post.

The pref market eased downward today on modest volume, enlivened by some sharp declines among financial-based splitShare corporations.

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

Price & Value! They’re not always the same thing – which is wonderful for those of us who achieve outperformance by exploiting the difference – but sometimes they get so far out of whack that real pain is experienced. We’re going to be hearing a lot about the two over the next few years, as the regulators wrestle with what they can do to avoid future procyclical margin calls on banks.

AIG, for instance, took an $11.1-billion hit in its fourth quarter, compared to its internal “worst case” stress test of $0.9-billion because its CDS positions (short) were marked-to-disfunctional-market. Bear Stearns investors are looking at book value $84, accepted bid $2. And, of course, it has become fashionable to make fun of mark to make believe accounting, enjoyment being inversely proportional to understanding.

Brace yourselves! There’s going to be a lot of discussion over the next year! Nouriel Roubini claims that the Bear Stearns price is, in and of itself, clear proof of insolvency:

As JPMorgan paid only about $200 million for Bear Stearns – and only after the Fed promised a $30 billlion loan – this was a clear case where this non bank financial institution was insolvent.

I think Prof. Roubini goes too far in his statements:

The Fed has no idea of which other primary dealers may be insolvent as it does not supervise and regulate those primary dealers that are not banks. But it is treating this crisis – the most severe financial crisis in the US since the Great Depression – as if it was purely a liquidity crisis.

While it is indeed true that the Fed does not regulate the brokers, the SEC does, and had examiners on the scene at Bear as the crisis evolved:

Cox said on March 11 the SEC was monitoring firms’ capital levels on a “constant” basis and sometimes daily in response to the subprime-loan meltdown that triggered the crisis.

Now, I will agree that it is better, in general, for the Lender of Last Resort to also wear the Regulators’ hat … this has been discussed before on PrefBlog, but now I find that the damn “search” function isn’t working and I can’t find it … but if the functions are separate (as they are in Canada and the UK, to name but two) it’s not the end of the world. Any bureaucracy is much more dependent upon esteem, morale and independence from politicians than it is on formal structure. If Bernanke calls Cox and asks (in J. P. Morgan’s famous 1907 phrase) “Are they solvent?” I’m sure he gets the best answer available.

Back to Roubini:

Here you have highly leveraged non bank financial institutions that made reckless investments and lending, had extremely poor risk management and altogether disregarded liquidity risks; some may be insolvent but now the Fed is providing them with a blank check for unlimited amounts.

All I can say is … it’s easy to second-guess. BSC management has come a cropper and it’s easy to say ‘I told you so’ … especially when, as in Prof. Roubini’s case, he DID say ‘I told you so’! And share-holders are looking at a wipe-out scenario as a result. The Fed moves involve a risk of moral hazard, but somehow I feel a little doubtful that BSC executives are currently exchanging high-fives at being bailed out so generously; if moral hazard exists in this matter, it is with respect to the bond-holders who, it would seem, have a good expectation of seeing their credit quality improve with a takeover.

The most familiar example of moral hazard is in banking; I have previously discussed the state of deposit insurance in Europe … it’s really lousy because they are absolutely terrified of moral hazard. It may be necessary to regulate brokerages more strictly and come up with some refinement of the rules to ensure that liquidity is always abounding … but I’m not sure if, ultimately, such an effort will be worth-while. How often does a market turn from go-go-go! to zero inside of six months, as has happened with sub-prime? How often does an eighty-five year old securities firm with $11-billion book value and profitable operations find itself with dusty telephones?

I’ll listen to suggestions, but I suggest that this is probably one to be permanently filed in the “Why Regulators Need Discretion” category. A much greater source of moral hazard is deliberate moral hazard, as is now being encouraged by Congress:

At the beginning of this decade, derivative risk management geeks, interest rate swaps traders and central bank econometricians filled up entire server farms with what-ifs on the balance-sheet hedging activities of the GSEs. The essential problem was that the GSEs were balancing ever-larger portfolios of fixed-rate mortgages on tiny equity bases. Fortunately, as we all knew, the credit risks of those portfolios were limited because homeowners rarely default on their mortgages. But that still left very large interest rate risks.

The core problem for the housing GSEs is, and has been, the prepayment option embedded in US fixed-rate mortgages. That has meant that the term of the GSE assets extends or contracts depending on whether homeowners can refinance at an advantageous rate. However, most of the long-term debt on the liability side of the GSE balance sheets has a fixed term. So the GSEs must more or less continually offset this imbalance between the average maturity of their assets and liabilities through the derivatives market, specifically the interest rate swap market. Otherwise the mark-to-market losses would overwhelm their small equity bases.

I have said before: the terms on a perfectly normal, standard US mortgage are ridiculous:

Americans should also be taking a hard look at the ultimate consumer friendliness of their financial expectations. They take as a matter of course mortgages that are:

• 30 years in term
• refinancable at little or no charge (usually; this may apply only to GSE mortgages; I don’t know all the rules)
• non-recourse to borrower (there may be exceptions in some states)
• guaranteed by institutions that simply could not operate as a private enterprise without considerably more financing
• Added 2008-3-8: How could I forget? Tax Deductible 

First, the GSEs need to be regulated as the banks they are; second, implementation of this discipline must be allowed to make the terms of US mortgages less procyclical. 

Back to Bear Stearns for a moment, with a hat-tip to Financial Webring Forum. There are some very interesting theories regarding why BSC stock is going up:

what could account for the rise in shares? One of the most intriguing theories, as expressed by observers like ThePanelist.com’s David Neubert, Portfolio’s Felix Salmon and Fortune’s Roddy Boyd, is that bondholders are buying up Bear Stearns shares. Bankruptcy would almost surely have been Bear Stearns’ fate if it had not secured an 11th-hour deal, which would have defenestrated shareholders and thrust bondholders into a potentially bruising battle with other, more senior creditors.

But the JPMorgan deal offers bondholders a potential payout: Upon completion, Bear Stearns bonds currently trading at steep discounts would be made whole by the banking giant. Buying shares in Bear Stearns would help ensure that the deal goes through, and so it’s possible that bondholders are buying up the still-cheap shares in hopes of guiding the JPMorgan takeover to completion.

Buying shares in Bear Stearns could also be a hedge, Mr. Neubert and Mr. Salmon add. If the deal falls through, the bonds will fall in value, but the stock could rise.

Mr. Roddy also points out that hedge funds who sell credit default swaps, financial instruments that protect buyers against the default of a given company, have an incentive to see the deal go through as well. As Bear Stearns’ financial health improves by forging closer ties to the bigger, steadier JPMorgan, the cost of insuring the company through these swaps goes down.

I’ve mentioned the decoupling of de facto & de jure economic interest before, in the context of Credit Default Swaps. Now maybe the swaps boys are at it again! Fascinating. Incidentally, another story making the rounds is that JPM wanted to bid more, but the Fed insisted that management not only be wiped out, but publicly humiliated to boot. Makes sense, but I will not venture an opinion on its accuracy!

Update:In the absence of an endgame, it makes more sense for the bond shorts (that is, those who have bought CDS Protection) to buy shares, since there’s a bigger payoff if they get their way, forcing bankruptcy and then forcing a fire-sale. There is the danger, however, that the company would walk into bankruptcy court with a ready-made plan signed by the Fed giving full recovery to bondholders. The game-players would then lose on both sides of their hedge. Those long bonds have the Promised Land at their feet as soon as the merger succeeds.

Econbrowser‘s James Hamilton approves of the Fed action:

Bear is not going to be last, but it is the model I think for what we’d want to see– owners of the companies absorb as much of the loss as possible, while the Fed does its best to minimize collateral damage.

And I’d say he’s right.

A good strong day in the preferred market, with volume picking up substantially.

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

The big news today is the JPMorgan takeover of Bear Stearns, which has been the subject of so much commentary I’ll keep mine to a minimum. The interesting part is that the Fed is taking a first-loss position on the mortgage paper:

The steps were announced at the same time the Fed agreed to lend $30 billion to J.P. Morgan Chase & Co. to complete its acquisition of Bear Stearns & Co. The loans will be secured solely by difficult-to-value assets inherited from Bear Stearns. If the assets decline in value, the Fed — and thus, the U.S. taxpayer — will bear the cost.

The fact that this financing is non-recourse to JPM is confirmed by their investor presentation:

Special Fed lending facility in place; non-recourse facility to manage up to $30B +/- of illiquid assets, largely mortgage-related

The investor presentation is also remarkable for the coy nature of its disclosure of deal terms:

No material adverse change clause. JPM has customary protections

Huh? That’s it? One possibility that the deal is a stalking horse: JPM is backstopping an auction with a reserve price of $2 per share. In exchange, they’re getting a nice break fee and BSC is getting a “go shop” clause. But … Assiduous Readers who have heeded my advice that the first thing to examine in any commentary is what isn’t being said will note that no probability is assigned to this possibility!

The non-recourse provision is extraordinary and reinforces the arguments of the TSLF’s nay-sayers – such as interfluidity:

If you think, as I do, that the Fed would not force repayment as long as doing so would create hardship for important borrowers, then perhaps these “term loans” are best viewed not as debt, but as very cheap preferred equity.
…
The Federal Reserve is injecting equity into failing banks while calling it debt. Citibank is paying 11% to Abu Dhabi for ADIA’s small preferred equity stake, while the US Fed gets under 3% now for the “collateralized 28-day loans” it makes to Citi. Pace Accrued Interest (whom I much admire), I still think this all amounts to a gigantic bail-out. And that it is a brilliantly bad idea from which financial capitalism may have a hard time recovering. Like a well-meaning surgeon slicing up arteries to salvage the appendix, the Federal Reserve is only trying to help.

In an admirable discussion of the further implications of the TSLF, Econbrowser‘s James Hamilton pointed out:

One measure economists sometimes use for the liquidity of an asset is the bid-ask spread. By that definition, one might be justified in referring to the present problems as a problem of liquidity– the gap between the price at which owners would like to sell these assets and the price that counterparties are willing to pay is so big that the assets don’t move. That illiquidity itself has proven to be a paralyzing force on the financial system. By creating a value for these assets– the ability to pledge them as collateral for purposes of temporarily acquiring good funds– the Fed is creating a market where none existed, thereby tackling the problem of liquidity head on.

OK, but if we agree to use that framework to describe the current difficulties as a liquidity (as opposed to a solvency) problem, which is closer to the “true” valuation, the bid or the ask price?
…
Even in the worst possible outcome, the ultimate increase in outstanding Treasury debt would be substantially less than $400 billion, because the collateral is far from worthless. And I would trust the Fed to be taking a smaller risk on behalf of the Treasury than I would expect to be associated, for example, with congressionally mandated expansion of FHA insurance, or the unclear implicit Treasury liability that results from increasing the assets and guarantees from Fannie or Freddie. Nevertheless, the doubters seem to me to be correct that the risks currently being absorbed by the Federal Reserve are substantially greater than zero.

You don’t get something for nothing.

Accrued Interest provides an entertaining analysis of the knock-on effects of the BSC/JPM deal:

Nothing, nothing, would surprise me today. Down 500? Up 200? Who knows? What we have is a tug of war. Traders betting on things getting worse. The Fed and Treasury are trying to draw a line in the sand, telling the market they won’t let either banks nor primary dealers fail as long as they still have decent assets to pledge as collateral.
…
I will say that I wouldn’t be a buyer of protection against any of the big banks or brokerages here. The Fed just delivered a big middle finger to people who bet against Bear Stearns. If you want to bet against brokerages, the stock is a much smarter bet. The Fed doesn’t give a fuck if a stock falls 50%. They have basically unlimited power to prevent a bankruptcy.
…
The problems brokerages are facing today have nothing to do with the normal financial ratio-type analysis that the ratings agencies do. In fact, for a guy like me who likes to pour over financial statements when making an investment decision, analyzing credits now is next to impossible.
…
Lehman and Goldman’s earnings reports tomorrow are probably the most important earnings reports for the broad economy of my career.

Naked Capitalism points out that we are currently engaged in a monstrous game of prisoner’s dilemma:

[Eugene Linden observes] The problem facing the credit markets right now is yet another iteration of the “prisoner’s dilemma” from game theory, at least in the sense that participants know that if everybody takes the stance of “every man for himself” the markets will crater, but they also know that if they rush for the exits there’s a chance that they will get out the door relatively unscathed. Studies of the problem suggest that the more anonymous the context, the more likely that players will adopt “every man for himself,” and, of course there’s nothing more anonymous than markets.
…
[Naked Capitalism reader Lune argues] We’ve already seen the law of unintended consequences so far:

1) Congress raises conforming limits on Fannie/Freddie to help unfreeze the mortgage market. Result: agency spreads skyrocket, bringing down Bear and a host of hedge funds. Mortgage markets still remain frozen.

2) Fed opens TSLF to unfreeze mortgage market. Result: Carlyle goes bankrupt as people rapidly arbitrage the difference between holding MBS in firms that can and can’t access the new credit facility. Mortgage markets remain frozen.

Now we have 3) Fed opens TSLF to broker-dealers.
…
[Also “Lune”] I’m wondering: if the demise of Carlyle and BSC was hastened because they were firms that couldn’t access Fed money and thus were foreclosed by firms that could, what will happen Monday? I’m thinking hedge funds, unable to access the Fed directly, will be eaten alive by the IBs.

Meanwhile, in a Financial Times piece dissed by Naked Capitalism as self-serving, Greenspan has pointed out the vulnerabilities of quantitative models:

The most credible explanation of why risk management based on state-of-the-art statistical models can perform so poorly is that the underlying data used to estimate a model’s structure are drawn generally from both periods of euphoria and periods of fear, that is, from regimes with importantly different dynamics.

The contraction phase of credit and business cycles, driven by fear, have historically been far shorter and far more abrupt than the expansion phase, which is driven by a slow but cumulative build-up of euphoria. Over the past half-century, the American economy was in contraction only one-seventh of the time. But it is the onset of that one-seventh for which risk management must be most prepared. Negative correlations among asset classes, so evident during an expansion, can collapse as all asset prices fall together, undermining the strategy of improving risk/reward trade-offs through diversification.

If we could adequately model each phase of the cycle separately and divine the signals that tell us when the shift in regimes is about to occur, risk management systems would be improved significantly. One difficult problem is that much of the dubious financial-market behaviour that chronically emerges during the expansion phase is the result not of ignorance of badly underpriced risk, but of the concern that unless firms participate in a current euphoria, they will irretrievably lose market share.

Paradigm-shift is indeed a problem in quantitative modeling – such models, including all the ones I’ve ever worked on, tend to perform poorly during trend changes, and not at their best when a definite trend exists. All you can do is manage diversification – ‘I can compare equities, and I can compare bonds, but I can’t compare bonds to equities’.

The key phrase in these remarks is: If we could … divine the signals that tell us when the shift in regimes is about to occur, risk management systems would be improved significantly. Can’t be done! The world is chaotic and every bad result has its own unique set of circumstances. So diversify! I am in complete agreement with Mr. Greenspan’s conclusion:

In the current crisis, as in past crises, we can learn much, and policy in the future will be informed by these lessons. But we cannot hope to anticipate the specifics of future crises with any degree of confidence. Thus it is important, indeed crucial, that any reforms in, and adjustments to, the structure of markets and regulation not inhibit our most reliable and effective safeguards against cumulative economic failure: market flexibility and open competition.

A horrible, horrible day for the preferred share market, particularly the PerpetualDiscounts, on light volume. The guy who sold a whack of RY.PR.F at 20.45 last week is starting to look a lot smarter!

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

Bear Stearns! Bear Stearns! Bear Stearns!

What can I say? Their options are limited:

• Find a parter – e.g., sell out to JPMorgan at a price of about maybe $27 – this is about $60 less than book.
• Hold a fire sale of assets. Then watch the business die.
• Go broke.

Whatever they choose, common shareholders are dead. The only question is whether the franchise will survive. I suspect that it will … there’s a gun to the directors’ heads, because trying to tough it out will just destroy their business before the month is out. There’s a lot of franchise value in Bear Stearns … so they have to go cap in hand to every major investment bank in the world, and desperately hope that at least two of them show an interest. As clearing bank, JPMorgan is most familiar with the assets – if they want it.

Another day of light action in the preferred market, with PerpetualDiscounts down again. CIBC was busy!

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

There was a very gratifying article about the lopsided (disfunctional?) CDS Market today in the Financial Times reprinted by Naked Capitalism:

“The credit default swap market has become lopsided,” says Peter Fisher, co-head of fixed income at BlackRock Financial Management in New York. “It’s not deep and liquid the way we normally think of that — it’s more like an insurance market in which few want to write insurance and many want to buy.”
…
In a normal world or in a world where the derivative is closely tied to the underlying cash security, if the price of the derivative became utterly divorced, market operators would step in to trade away the difference, Mr Fisher adds.

But volumes in the credit derivatives market exploded precisely because most of the bonds hardly trade at all. At Goldman Sachs, for example, for every three dollars of trading in bonds, the firm trades $97 in credit default swaps.

As I mused on February 21:

Despite my interest in the asset class, I’m not convinced that the CDS market is ready for prime time. If their main attraction is the ability to lever up a portfolio significantly, then a huge degree of uncertainty is introduced into pricing, in addition to the uncertainty introduced by debt decoupling. I continue to wrestle with the idea, but these twin, undiversifiable uncertainties probably introduce a required risk premium that makes inclusion of these instruments, long or short, in a fixed income portfolio uneconomic.

Treasury Secretary Paulson has announced an initiative to make everybody feel good:

The group also will propose directing credit-rating firms and regulators to differentiate between ratings on complex structured products and conventional bonds. In addition, it wants rating firms to disclose conflicts of interest and details of their reviews and to heighten scrutiny of outfits that originate loans that are enveloped by various securities.
…
Mr. Paulson also is planning to encourage the development of a domestic market for “covered bonds,” bonds issued by banks that are secured by mortgages. Popular in Europe, these could be an alternative to securitization. When mortgages are securitized, they generally leave bank balance sheets and banks don’t hold capital against them; covered bonds remain on bank books, and banks must set aside capital to back them.

Covered bonds will be familiar to PrefBlog’s Assiduous Readers. The separate credit rating scale for structured securities is cosmetic nonsense and simply represents more political interference with credit ratings. “Don’t downgrade XYZ, it’s a big employer in my district!”.

In yet another disturbing development, it is felt that indices might attract shorts, therefore don’t have indices:

Markit Group Ltd. shelved plans to create an index that would have allowed investors to bet on the $200 billion market for securities backed by auto loans.

Markit Director Ben Logan confirmed the index was put on hold because of a lack of support from dealers.

The decision follows criticism from analysts at Merrill Lynch & Co. and Wachovia Corp., who said the index would drive down prices of the underlying bonds. Markit had been in talks with firms including Lehman Brothers Holdings Inc., Morgan Stanley, and Bear Stearns Cos. to create and index allowing investors to speculate on auto-loan securities from issuers such as Detroit-based GMAC LLC and Ford Motor Credit Co.

In happier news, S&P opines that the worst of the write-downs is over:

Standard & Poor’s said the end is in sight for subprime-mortgage writedowns by the world’s financial institutions.

Writedowns from subprime securities will probably rise to $285 billion, New York-based S&P said today in a report. The ratings company previously estimated losses of $265 billion in January. S&P raised its estimate because of increased loss assumptions for collateralized debt obligations.

“The positive news is that, in our opinion, the global financial sector appears to have already disclosed the majority of valuation writedowns” on subprime debt, S&P credit analyst Scott Bugie said in an accompanying statement. Losses on other debt such as leveraged loans are still likely to increase, the report said.

The actual report is available from S&P – thanks to Accrued Interest, who found the link and commented on the implications:

Anyway, so people love to talk about what inning we’re in when it comes to the subprime crisis. But let’s be more positive about it, shall we? We’re in the first inning of the healing process. The subprime contagion has decimated broker/dealer capital. That phase is probably wrapping up.

Bank of Canada Governor Mark Carney gave a speech today that was also soothing in its message:

some of the world’s largest financial institutions have recorded substantial losses, the cost of borrowing has increased, and the availability of credit has decreased. More than seven months on, the end is not yet in sight, although it is safe to say that we have reached the end of the beginning of this turmoil. This is not because the dislocations in markets have eased; in fact, strains in financial markets have intensified recently, but rather because we are entering a new phase where policy-makers and market participants have a better understanding of both the shortcomings in the current financial system and what needs to be done – by both groups – to address them.

Mr. Carney gave some very strong indications of his desires for financial market reforms going forward; the speech is important enough that I will attempt to review it thoroughly tomorrow.

The preferred market was weak again on more light volume, with the general malaise resulting in some violent pricing moves when some players absolutely had to get some selling done (RY.PR.F was particularly noteworthy). The PerpetualDiscount index has had only one up-day in the twelve trading days following February 26 and is currently down 2.78% from its 2/26 level.

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

Econbrowser‘s James Hamilton has an interesting philosophical piece on the limits to the Fed’s ability to influence the economy, Asking too much of monetary policy:

I am certainly a believer in the potential real effects, sometimes for good, sometimes for ill, of monetary policy. But I just as certainly do not believe, nor should any reasonable person believe, that no matter what the economic problem might be, you can always solve it just by printing more money.
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I would nevertheless caution that we need to be open to the possibility that no matter how low the Fed brings its target rate, it may not arrest the unfolding financial disaster. Unless the intention is to go all the way with enough inflation to avert the defaults, that means we need an exit strategy– some point at which we all admit that further monetary stimulus is doing nothing more than generating inflation, and at which point we acknowledge that the goal for monetary policy is no longer the heroic objective of making bad loans become good, but instead the more modest but also more attainable objective of making sure that fluctuations in the purchasing power of a dollar are not themselves a separate destabilizing influence.

Indeed, with the Treasury curve virtually decoupled from the corporate curve, it doesn’t look like there’s anything more the Fed can do. Cutting rates again probably will not have any major effect on corporate yields, or on banks’ willingness to lend; I think that the only justification for such a move would be to help increase profit margins at the banks in order to assist their recapitalization, as was done in 1993 – the year of the steepest yield curve on record, which led to 1994 – the year of the worst government bond market on record.

At the moment, I don’t think there’s a lot of evidence that such drastic treatment is necessary. Below are some graphs available from the FDIC showing the recovery of the American banking system from 1990-94 … sorry they’re not too clear, click on them for a better version, or just go directly to the full report.

Some of this was due to Resolution Trust, to be sure, but a good chunk was due to a very steep yield curve that made it very profitable to borrow short and lend long.

It is interesting to note, from the FDIC report, that data for 4Q93 (the point at which the Fed said, “OK, play-time’s over, we’re going to start hiking now”) indicated that the 13,220 institutions reporting had $375-billion in capital backstopping $4,707-billion in total liabilities and capital, an equity leverage ratio of 12.61. The current FDIC report, 4Q07, shows 8,533 institutions with capital of $1,352-billion backstopping $13,039-billion, equity leverage of 9.6:1.

One may well quibble over the 4Q07 equity figure … perhaps there are massive unrecorded losses about to appear. And one may quibble even more about the relative quality of assets between then and now – subprime and perhaps credit card and auto debt coming up for kicking in The Great Leverage Unwinding of 2007-08. But all in all, as I’ve pointed out in posts on loss estimates and loss distribution, I’m having a hell of a time finding credible, sober analysis concluding that Armageddon is Now.

Anyway, what I’m trying to say is that I agree with Prof. Hamilton (subject to quibbles about loss estimates), when he states:

The problem then is many hundreds of billions of dollars in loans that are not going to be repaid, the prospect of whose default could completely freeze the market for credit.

That, it seems to me, is a problem you can’t solve by lowering the fed funds rate.

By me, the Fed is doing the right thing with the TSLF introduced yesterday. The problem is liquidity, and there are many players with indigestible lumps of sub-prime paper on their books. These are, I’ll bet a nickel, on their books at marked-to-disfunctional-market prices well below ultimate recovery, but so what? They can’t sell them to hot money – hot money’s got its own problems:

At least a dozen hedge funds have closed, sold assets or sought fresh capital in the past month as banks and securities firms tightened lending standards. The industry is reeling from its worst crisis because bankers — staggered by almost $190 billion of asset writedowns and credit losses caused by the collapse of the subprime-mortgage market — are raising borrowing rates and demanding extra collateral for loans.

They can’t sell them to real money – real money read in the paper just last week that it’s all worthless junk. So the paper has to sit on the books for a while and be financed in the interim.

Perhaps not entirely coincidentally, there’s an article on VoxEU titled Why Monetary Policy Cannot Stabilize Asset Prices. VoxEU is up to its old tricks … the page is blank. To read the article, you have to click “View|Source” on your browser, pick a section to copy/paste, save this extract as a .html file on your hard drive and then open this with a browser. The graph has to be viewed separately.

Mechanical difficulties aside, it seems that this will soon be a CEPR discussion paper; the authors state:

Figure 1 analyses the effects of a 100 basis points increase in interest rates. Note that after about 8 quarters, interest rates have declined but remain about 35 basis points above their initial level. After 12 quarters, they have fallen further to a level some 10 basis points above the starting point. Overall, the increase in interest rates will dissipate in about three years.

Turning to real property prices, we note that these start to fall in response to the tightening of monetary policy. After 16 quarters, they reach a bottom of about 2.6% below the initial level and then start to return gradually to their starting level. Overall, property prices react quite slowly to monetary policy actions.

Next we consider the responses of real GDP.³ The figure shows that it also reaches a trough after 16 quarters, when it is some 0.8% below its initial level.⁴ Thus, the responses of real GDP are almost exactly 1/3 of those of real property prices.⁵ This is an important finding. To see why, suppose that monetary policy makers come to believe that a real property price bubble of 15% has developed, and decide to tighten monetary policy in order to bring down asset prices. In doing so, the average central bank in the 17 countries we study should also expect to depress the level of real GDP by 5%, a truly massive amount.
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Whatever merits such a stabilisation policy has in theory, our research suggests that in practice, monetary policy is too blunt an instrument to be used to target asset prices – the effects on real property prices are too small, given the responses of real GDP, and they are too slow, given the responses of real equity prices. In particular, there is a risk that setting monetary policy in response to asset price movements will lead to large output losses that exceed by a wide margin those that would arise from a possible bubble burst.

In other news, Accrued Interest points out that It’s just a dead animal:

Now I’m not here to say whether Bear Stearns has liquidity problems or not. The recovery in both the stock and bond market for Bear paper would indicate that they probably don’t. But this kind of panicky trading is exactly why its hard to own financial bonds right now. I mean, anyone who had traded through bear markets knows that the rumor mill becomes very active. Right now everyone is nervous. The longs are nervous because they’ve been losing money and/or under performing their index for months now. I’m sure there are many portfolio managers and/or traders worried about losing their jobs over poor performance.

The shorts are nervous too. Right now corporate credit spreads are at all-time wides. That means that getting short a credit is expensive to begin with.
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So amidst all this nervousness, it seems that Wall Street starts giving more credence to rumors.

Sit tight, do your homework, turn off the TV and stare at financial statements until you’re crosseyed, that’s the path to success. The bond market is excitable and always will be … ignore it, keep your company-specific bets small, your leverage non-existant and have another look at them financial statements.

In other news, it looks like Barney Frank, Chairman of the House Financial Services Committee wants to start his own credit rating agency:

U.S. Representative Barney Frank gave ratings companies a month to fix “ridiculous” standards that they apply to local government debt, as his House committee opened a hearing today on how the firms evaluate municipal bonds.

“I am going to say to the rating agencies and to the insurers: they have about a month to fix this,” Frank, the Massachusetts Democrat who chairs the House Financial Services Committee, told reporters in Washington yesterday. “We’re going to tell them they have to straighten it out.”

California Treasurer Bill Lockyer and other state officials are calling for Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings to change a system they say costs taxpayers by exaggerating the risk that municipal issuers will default on their debts. Every state except Louisiana would be AAA if measured by the scale used for corporate borrowers, according to research by Moody’s.

“This notion of having a separate standard for the municipals because they would do too well on the other standard is ridiculous,” Frank said.

Cool! Credit ratings courtesy of the politicians! Doesn’t that make you feel safe? Sign me up!

Back on Earth, Berkshire Hathaway is worried that municipal bond insurance will return to ultra-cheap levels in a price-war:

The risk of guaranteeing municipal debt is increasing because the economy is slowing and some insurers may cut prices to regain lost business, said Ajit Jain, head of Berkshire Hathaway Inc.’s new bond insurer.

Fiscal stress in Vallejo, California, and Jefferson County, Alabama, may be the “tip of the iceberg” for municipal defaults, said Jain, who runs Warren Buffett’s Berkshire Hathaway Assurance Corp. He said downgrades of some insurers hurt the industry’s integrity and those firms may spark “pricing wars” if they regain their financial footing and seek to recoup lost business.
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Ambac and MBIA, the two largest bond insurers, may trigger a price war if they stabilize their AAA ratings and start backing municipal bonds again, Jain said.

“That will be unavoidable,” he said in his testimony. “Unless you continue to believe that this is zero-loss business, that conduct assures a bleak future for this business.”

Another light day for volume. Split-shares got hammered, particularly the BNA issues that have something of a penchant for volatility. PerpetualDiscounts were also weak.

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