Category: Market Action

I’m becoming more and more convinced that the Credit Crunch has evolved from its fundamental role as Reducer of Excesses to a new position as Political Football.

My thoughts on this are influenced by many things. For instance, compare the sub-prime credit loss estimates of the Bank of England with those of the IMF. These estimates are, as has been noted, not just wildly at variance with each other, but prepared without even taking note of each other. For all my respect for these two institutions, this smacks of intellectual dishonesty – and in my book, there is no greater crime.

Quite frankly, I believe the methodology of the IMF report (which leaned heavily on the paper by Greenlaw et al.) to be deeply flawed; and not just deeply flawed but deliberately skewed. So why would the IMF adopt it? They have a lot of smart people on staff; I won’t be the only person in the world to have noticed the dicey bits; why was this methodology used holus-bolus instead of simply providing the top end of a range of estimates?

My hypothesis is that it’s simply politics. The two basic factions in the investment world are those who want lots of regulation to save us from the evil Bonfire of the Vanities and those who feel that over-regulation is simply promoting inefficiency of the capital markets. These opposing forces are not comprised exclusively of idealogically pure crusaders, either! In Canada, for instance, the banks can be counted upon to promote wise regulation, not too much, not too little …. as long as whatever happens favours capital markets players who have deep, deep pockets.

There will be members of both factions on staff at the IMF, and at any regulatory group or ultimately responsibile government. Sometimes you win, sometimes you lose, in general things proceed in an ultimately half-way reasonable manner, albeit with one step back for each two steps forward. Forecasting the effects of regulation is no easier than forecasting markets … and at least when you attempt to forecast the market you have a pretty good idea of your ultimate objective!

The hard-liners in either faction are never satisfied, however – and the more cynical players, taking whatever position best serves their business will always be looking for more. Thus, every development in the capital markets is carefully examined to determine its value as a weapon in the struggle.

Canadian ABCP? It’s been used to justify a call for higher pay for regulators, to justify calls for the OSFI to expand its mandate to ensure nobody ever loses money on anything and to justify a federal regulator. The Bank of Canada has brought forth some rules to ensure that the banks never again have to worry about competition in the ABCP market from snot-nosed small corporation scum.

And so it is with Bear Stearns. I wrote about the Econbrowser post yesterday. The Econbrowser piece wanted Bernanke (i.e., the Fed) to Do Something about leverage in the brokerage industry … which is not the Fed’s purview at all, it’s in the SEC’s bailiwick. There was a note from Dave Altig of the Atlanta Fed in the Econbrowser comments, drawing attention to the Fed’s preventative measures … and still, not a word about the SEC. You can find inumerable instances of hand-wringing on the web, bewailing the fact that the Fed is (sort-of) forced to backstop a system over which it has no direct supervisory function – although, as I have pointed out, separation of lending/monetary functions and bank supervision functions are more standard throughout the world than otherwise.

The more I think about it, the more convinced I am that most of the discussion of Bear Stearns has absolutely nothing to do with a genuine desire for better regulation (you want more margin and less leverage? OK, how much more margin and how much less leverage? Let’s discuss it!) and a lot more to do with a desire to change the identities of the regulators. It’s a world-wide bureaucratic turf fight; the credit crunch, sub-prime and Bear Stearns are merely the latest weapons of convenience.

For the record, my position at the moment is that supervisory responsibility for the brokerage sector should remain with the SEC. Assiduous Readers will by now be sick and tired of reading this, but I believe the brokerages should represent a riskier and less constrained layer surrounding a banking core in the financial system. If the Central Bank has supervisory functions, there will be both a higher degree of expectation of emergency assistance in times of stress and a higher probability as well, since staff at the Central Bank – however upright and angelic their characters – will be somewhat more inclined to double-down with assistance from the discount window than to admit a possible failure of regulation and let an insolvent firm go bankrupt.

I might work this up into a formal article at some point. Remember, you read it on PrefBlog first!

As remarked by Accrued Interest, now that reports are increasing that the credit crunch is over and companies might actually be able to pay back some money, there are also growing concerns that the money we get might not be worth very much:

Bernanke and San Francisco Fed President Janet Yellen, in separate speeches yesterday, said markets remain “far from normal” after some improvement since March. Yellen, Cleveland Fed President Sandra Pianalto, Kansas City Fed President Thomas Hoenig and the Dallas Fed’s Richard Fisher said they’re concerned about rising prices.
…
Yellen, 61, who doesn’t vote on rates this year, also said she anticipates consumer prices will moderate as the labor market weakens and “commodity prices level off.”

The Fed can’t be “complacent about inflation,” she told the CFA Institute Annual Conference. Recent measures of price expectations “highlight the risk that our attempts to deal with problems in the real economy could lead to higher inflation expectations and an erosion of our credibility,” she said.

Fisher, speaking in Midland, Texas, said the U.S. may be in for a “prolonged” period of slow growth, which may end with faster-than-desirable inflation.

“How deep that slowdown will be is a question mark,” said Fisher, who voted against the last three rate cuts. “I am not sure it will be very deep at all, but it may be prolonged, because we have to correct the excesses of this credit crisis.”

Naked Capitalism notes a post by Willem Buiter, who burnishes his monetarist credentials:

In a fiat money world, central banks cause inflation, or, more precisely, only central banks are resposible for inflation. Other shocks, real and nominal, can influence the general price level if the central bank does not respond swiftly and determinedly, but these non-central bank-induced changes in the general price level can always be offset by the central bank, given enough time, freedom to act and courage.

But, in the medium and long term (at horizons of two years and over, say) central banks choose the average rate of inflation. Not globalisation; not indirect taxes; not bad harvests; not OPEC and the price of oil; not the Chinese and their exchange rate management. There is no oil inflation, food inflation or cost-push inflation. There is just inflation. Inflation may be accompanied by changes in key relative prices – in the real prices of oil, of food, of oil and of labour for instance – if other relative demand and supply shocks accompany the inflationary impulses created by the central bank. Large increases in the real price of food will be bad news to food importers (including most urban households) and good news to rural food producers and exporters. But don’t confuse it with inflation.

In the petty annoyances department, Andrew Willis discusses the Sprott IPO:

Brokers are using the “anonymous” function on the TSX to do much of their selling, with 1.5 million shares sold this way. Disguising orders by not disclosing the name of the brokerage house doing the transaction fits that segment of the hedge fund and dealer crowd that prefers to be discreet. Dealers are sensitive to the issue of flipping an IPO from a money manager who also counts as a major trading client.

Does Mr. Willis know or care that it would be grossly unethical for Sprott to allow annoyance with IPO selling to influence – in any way – its trading with client money?

From Prefblog’s Out-of-time-here’s-the-links Department:

• What we know and what we would like to know about Central Bank communication
• Fed’s Direct Loans to Banks Climb to Record Level
• Bernanke Urges ‘Hunkering’ Banks to Raise Capital

Floaters finally had a bad day … they are now up a mere 8.26% on the month.

BNS issues did well:

In general, volume dropped off a little, but it was a very strong day.

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

Sorry, people! I spent most my reading time today looking at Leverage, Bear Stearns & Econbrowser, so there won’t be much commentary here.

The potential for repricing of the BCE / Teachers’ deal was discussed in the comments to May 12; now Desjardins is saying a repricing is more likely than not:

Joseph MacKay of Desjardins Securities says an agreement between Clear Channel and its private equity purchasers, which will reduce the takeout price by more than eight per cent, may put pressure on BCE to follow suit.
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However, the chance of re-pricing the deal has also increased, MacKay wrote in a report.
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“We would advise investors to assume a potential re-price in the five to 8.16 per cent range,” he wrote.

Accrued Interest is nonplussed by seemingly contradictory reports, but is sticking with his recessionary views.

Another good strong day in the market, with volume continuing to show signs of life. I note that PerpetualDiscounts are now up 0.98% month-to-date, while long corporates are up 0.91%.

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

A number of regulatory links today! In another post, I discussed Derek DeCloet’s column in today’s Globe, but there were other things.

In a column in VoxEU, Xavier Vives writes a fairly general description of the problem of informational asymmetry, without giving much of a prescription for a cure. I suspect that Dr. Vives supports the Financial Stability Forum’s recommendations on simultaneous public disclosure … but this is not clear.

He makes the assertion:

The problem has been aggravated by the lack of control of who was monitoring the subprime loans. In the old-fashioned banking system institutions would monitor loans, in the world of securitised packages the market failed to provide the monitoring because rating agencies did not do their job properly and fund managers took the risk knowing that the upside was to be cashed in bonus form and the downside protected by limited liability.

… but doesn’t back it up. It should be noted that the linked paper provides no evidence that the “rating agencies did not do their job properly”; that paper by Portes seems to be getting quite a number of links on VoxEU, for reasons that I simply can’t fathom. I’ll review it at some point – I didn’t at the time, simply because it was so thoroughly generic – but in this case I’ll content myself with stating that Dr. Vives’ phrasing is not consistent with his link.

I take issue with his “second aspect”:

A second aspect of the question, made evident in the present crisis, is that, if the central bank intervenes to help institutions that are not under its supervision, it may lack the necessary information to assess whether the origin of the need is a liquidity or a solvency problem. How does the Federal Reserve know when mounting the rescue operation of a non-bank financial firm, for example, that the institution is solvent? By helping an insolvent institution taxpayers’ money is put at risk and the disciplining effect of failure eliminated. The consequence is that the moral hazard problem is exacerbated and bank managers will feel more secure in the future to take excessive risks.

Well, the “non-bank financial firm” business seems to be a tangential reference to Bear Stearns – and in that case, they know about solvency by asking the SEC. Separation of supervisory and lender of last resort functions is standard throughout much of the world – Canada and the UK, for instance – and, while not ideal, isn’t necessarily all that terrible either.

I do agree that propping up an insolvent institution would represent a misuse of the discount window – or equivalent mechanism.

Still on VoxEU, Axel Leijonhufvud wrote a rather prescient piece on inflation targetting in June, 2007:

The sanguine view is that securitisation and credit derivatives have made the world of finance a safer place than it used to be and that, besides, liquidity is ample all around. But it is not likely that the world will stay awash in liquidity forever. At some stage, central banks will have to mop it up or see inflation do it for them. Securitisation and credit derivatives have certainly dispersed risk through the economy and away from the banks where it used to be concentrated. But by the same token, the system has taken on more risk and we know less about where large concentrations of risk-bearing may be located. Risk spreads have narrowed in part permanently because of these new risk-sharing technologies, but in part transitorily because of the extraordinary level of liquidity. Narrow spreads have in turn induced some institutions to assume high leverage in search of yield.

A number of very large failures – LTCM, Enron, Amaranth – have occurred causing nary a macroeconomic ripple, and this is frequently cited as proof of the resilience that recent financial innovations have imparted to the system. It may be, however, that the more appropriate conclusion to draw is that macroeconomic developments are more likely to trigger trouble in financial markets than vice versa.

In his current article, Central banking doctrine in light of the crisis, he joins the chorus blaming Greenspan for allowing the housing bubble in the 2001-05 period:

This strategy failed in the United States. The Federal Reserve lowered the federal funds rate drastically in an effort to counter the effects of the dot.com crash. In this, the Fed was successful. But it then maintained the rate at an extremely low level because inflation, measured by various variants of the CPI, stayed low and constant. In an inflation targeting regime this is taken to be feedback confirming that the interest rate is “right”. In the present instance, however, US consumer goods prices were being stabilised by competition from imports and the exchange rate policies of the countries of origin of those imports. American monetary policy was far too easy and led to the build-up of a serious asset price bubble, mainly in real estate, and an associated general deterioration in the quality of credit.

He then argues that the elements of choice in monetary policy cast doubts on the policy of central bank independence:

Since using the bank’s powers to effect temporary changes in real variables was deemed dysfunctional, the central bank needed to be insulated from political pressures. This tenet was predicated on the twin ideas that a policy of stabilising nominal values would be politically neutral and that this could be achieved by inflation targeting. Monetary policy would then be a purely technical matter and the technicians would best be able to perform their task free from the interference of politicians.
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When monetary policy comes to involve choices of inflating or deflating, of favouring debtors or creditors, of selectively bailing out some and not others, of allowing or preventing banks to collude, no democratic country can leave these decisions to unelected technicians. The independence doctrine becomes impossible to uphold.

It’s a tricky question! I am fully supportive of the de facto situation … the central banking chief is an unelected technician; he is appointed by the government; but the only power that the government has is to fire him – otherwise they have no say in anything. It depends a great deal on ensuring that the central banker is a paragon of integrity, not dependent upon his salary to keep food on the table.

It is accepted as pretty much a given that if the BoC governor at a given time was to be dismissed, the currency would tank and interest rates would skyrocket which – even to the most zealous investor advocate in parliament – would make it not worth firing him except for the gravest of reasons. But perhaps some thought should be given to ensuring a golden parachute that would withstand even the supremacy of parliament … I don’t know, frankly, what the current arrangements are.

And I’ll take a moment to snipe at the horrible political games-playing in the States, which has resulted in two vacancies out of seven places in the Federal Reserve Board of Governors.

Further to all the regulatory talk in this update is a post by Naked Capitalism, referencing some fashionable grandstanding by the EU:

A group of key EU finance ministers will today launch an assault on the rewards earned by bankers and top managers in a move that poses a potential threat to the City of London.

A confidential document prepared for the gathering in Brussels finds the “short-term” pay structure of modern capitalism has become deformed, causing firms to take on “excessive risk” without regard to the interests of stakeholders or society.

Geez, I’m getting old. I can remember when the short-term nature of quarterly reporting was on the verge of destroying the United States, leaving the (far-sighted and judicious long-term planning) Japanese as rightful masters of the universe.

Has anybody heard anything more about that? What happened to that story, anyway?

The other clipping republished by Naked Capitalism is with respect to a NYT interview with Kenneth C. Griffin:

Kenneth C. Griffin, who runs one of the biggest and most successful hedge fund firms, has a blunt assessment: “We, as an industry, dropped the ball.”

The breakdown happened, Mr. Griffin contends, when big investment banks gambled away money and jobs during the late great credit boom. The bosses let all those young gung-ho traders take far too many risks and now everyone is paying the price.

US brokerages are, from all the accounts I’ve heard, a lot more fun to work at than Canadian ones. In the US, if you have a good idea, you go to your supervisor … and bang! If he likes it you’ve got your funding and a deal: if it works, you, personally, will get rich. If it doesn’t, you’ll get fired. In Canada, of course, if you have a good idea, you write it up for Human Resources to look at and determine whether it’s culturally sensitive, if it harms the environment, and whether it will increase diversity and respect in the workplace. You wait a bit for their answer, then retire.

There are times – such as now! – when the free-wheeling nature of the US system got … er … a little out of hand, but we can be sure the regulatory wannabes will be only too happy to throw the baby out with the bathwater.

But Mr. Griffin isn’t just a serial complainer. He has thought about solutions.

First, “the investment banks should either choose to be regulated as banks or should arrange to conduct their affairs to not require the stop-gap support of the Federal Reserve,” he says.

But that’s not all. He also wants new government oversight of the arcane world of credit default swaps, a business with a notional value and risk of $50 trillion.
…
In particular, Mr. Griffin wants the government to require the use of exchanges and clearing houses for credit default swaps and derivatives.

The first solution is just smarmy, and reminds me of everything I’ve heard about being on (Canadian) Unemployment Insurance … they make you go to moronic seminars lead by twerps who are congenitally unemployable outside government. When you point out an obvious stupidity, they just ask ‘if you’re so smart, why don’t you have a job, while I do?’.

I feel quite certain that Bear Stearns (and the SEC, its regulator) were convinced that they had, in fact, arranged their affairs such that the stop-gap support of the Federal Reserve would not be necessary. They were wrong, they’ve lost nearly all their investment. It’s called business. Business Risk, to be precise.

I’ll be perfectly happy to consider suggested changes to the regulatory regime, capital and liquidity calculations, and to proffer plaudits and criticism as I see fit. Until these suggested changes are available for discussion, however, I suggest that Mr. Griffin and his adulatory interviewer arrange their affairs to make him sound a little less like a smarmy twerp.

Exchange Traded CDS? The Exchanges have been trying to put such a thing together for years. I understand that some of the major brokerages are trying to put together a clearinghouse … but it’s really none of the government’s damn business. The regulators can impose reasonable margin and capital rules, sure; and it’s entirely reasonable that the margin requirements for a clearing-house counterparty will be somewhat less than those for even the strongest of individual counterparties; but determining that the Official Counterparty has a monopoly on trading is going way, way, way too far.

Will I be allowed to guarantee my nephew’s car loan, or will the Official Counterparty insist on doing it and charging a fee?

Getting back to preferred shares for just a moment (sorry!) what’s up with the DFN Rights Issue? Four rights and $24.25 get you one DFN and one DFN.PR.A. Prices are:

There are two monthly dividends yet to go … $0.10 each on DFN, $0.04375 each on DFN.PR.A. Total $0.2875. So it doesn’t really look as if there’s any good arbitrage possible … but given that the NAV as of April 30 was $24.81 ($24.63 fully diluted), it seems to me that the rights are cheap. Do your own homework, though, preferably involving the modelling of the underlying portfolio!

The preferred share market put in a good honest day’s work today with good returns and even some decent (and all too infrequent, lately) volume.

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

Pundits are saying the money market shows the worst is over for credit:

The worst of the credit crisis that prompted banks to restrict lending and the Federal Reserve to rescue Bear Stearns Cos. may be over, short-term borrowing rates show.

The difference between the yield on three-month Treasury bills and the rate on dollar-denominated loans in London, an indication of credit risk known as the TED spread, narrowed 7 basis points to 0.93 basis points, the smallest since Feb. 25. The gap reached 2 percentage points on March 19.

… but the visible effects may be just getting under weigh:

As the Fed’s latest loan survey makes clear, lenders have dropped the guillotine. With the usual delay, the poison is spreading from banks to the real world.

Diane Vazza, S&P’s credit chief, says defaults are rising at almost twice the rate of past downturns. “Companies are heading into this recession with a much more toxic mix. Their margin for error is razor-thin,” she said.

Two-thirds have a “speculative” rating, compared to 50pc before the dotcom bust, and 40pc in the early 1990s. The culprit is debt. “They ramped it up in the last 18 months of the credit boom. A lot of deals were funded that should not have been funded,” she said.

Some 174 US companies are trading at “distress levels”. Spreads on their bonds have rocketed above 1,000 basis points. This does not cover the carnage among smaller firms outside the rating universe.

Meanwhile, some research is being done into the Equity premium in Victorian England:

The stock market experienced negative total returns in only four years between 1825 and 1870. Three of these years (1825, 1826 and 1847) had financial crashes after a period of promotional mania on the stock market. The negative returns in 1853 can be attributed to concerns over the impending Crimean war.
Despite the serious financial crisis of 1866 following the collapse of several banks, the market produced positive total returns in that year.

Those were the good old days, eh? The 1866 crisis was the collapse of Overend-Gurney, which I promised to discuss on March 31, but is still … er … pending.

I have updated the post on the BoE Financial Stability Report to acknowledge Willem Buiter’s objections to the BoE methodology in forecasting ultimate sub-prime losses.

MBIA, whose delays in transferring $1.1-billion from the parent to the insurance subsidiary was reported on May 7 has (as passed on by Naked Capitalism) finally made a move:

MBIA Inc., the ailing bond insurer, rose in New York Stock Exchange trading after saying it will pump $900 million into its insurance unit and reporting a first-quarter loss that was narrower than some analysts’ estimates.

Those who have been taking the Clear Channel takeover as a template for the unfolding of the BCE / Teachers’ deal will no doubt be highly interested in rumours of funding at a reduced price:

Clear Channel Communications Inc. surged as much as 18 percent on reports of settlement talks with six banks on a proposal to finance the radio broadcaster’s acquisition by two buyout firms at a reduced price.

Citigroup Inc. and five other banks may fund the buyout for $36 a share as part of a settlement of lawsuits pending in New York and Texas state courts, the Wall Street Journal reported, without saying where it got the information. That’s below the $39.20 price buyout firms agreed to pay last year and more than an intraday high of $35.30 in New York Stock Exchange trading.

Yet another day with a mysterious discontinuity in the TXPR index:

The jump was probably partly due to BAM.PR.K, which traded 300 shares at $19.40 at 9:30am, then 100 shares at $20.32 at 2:37pm. Ain’t it wonderful! Closing quotation was 19.58-20.49, 1×5. This issue comprises 1.46% of CPD (which can be assumed to be a reasonable proxy for the index, so this 4.74% jump in trading price translates to 6.9bp on the index, or about one-seventh of the total jump. Analysis of the other elements of the discontinuity is left as an exercise for the student.

All in all, though, it was a quiet day.

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

Absolutely nothing happened today, so there’s no commentary.

I was, however, able to devote some thought to the issue of naming rights to TTC stations. It’s a great idea! Just think of the money the TTC could make from station names like:

• Old Mill-waukee
• Dundas Westjet
• The Elephant and Castle Frank
• Victoria’s Secret Park
• Viagra Makes Your Coxwell

Why, they might even be able to afford a new bucket at Osgoode Station, to replace the old one they’re currently using to catch the drips from the ceiling when it rains.

Oh, and there’s more news on the Jim Kelsoe story.

But that’s it.

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

Chalk one up for the License Raj! India has halted futures trading of some commodities:

Communist allies of Prime Minister Manmohan Singh want to ban futures trading in cooking oil, sugar and other commodities, saying speculators are driving up prices. Still, the order comes a week after a government-appointed panel found no evidence a 2007 ban on wheat and rice futures curbed prices of the grains….

In hard times, there is extreme pressure on politicians to Do Something. So they do. Whether or not the actions are useful is a mere quibble. They’d be better off cutting the kerosene subsidy.

Jon Danielsson writes a piece in VoxEU attacking the concept of model-based regulation:

Most models used to assess the probability of small frequent events can also be used to forecast the probability of large infrequent events. However, such extrapolation is inappropriate. Not only are the models calibrated and tested with particular events in mind, but it is impossible to tailor model quality to large infrequent events nor to assess the quality of such forecasts.

Taken to the extreme, I have seen banks required to calculate the risk of annual losses once every thousand years, the so-called 99.9% annual losses. However, the fact that we can get such numbers does not mean the numbers mean anything. The problem is that we cannot backtest at such extreme frequencies.

A very sexy topic nowadays and, to be fair, he is familiar with the proper solution:

I think the primary lesson from the crisis is that the financial institutions that had a good handle on liquidity risk management came out best. It was management and internal processes that mattered – not model quality. Indeed, the problem created by the conduits cannot be solved by models, but the problem could have been prevented by better management and especially better regulations.

This ties in with the International Report on Risk Management Supervision. Unfortunately, he doesn’t really have any good ideas to offer for future use:

What is missing is for the supervisors and the central banks to understand the products being traded in the markets and have an idea of the magnitude, potential for systemic risk, and interactions between institutions and endogenous risk, coupled with a willingness to act when necessary. In this crisis the key problem lies with bank supervision and central banking, as well as the banks themselves.

Very nice, but just a tad lacking in specifics, wouldn’t you say?

You can’t regulate common sense. As I have said before, I think that the current credit crunch represents a triumph of the current regulatory regime: there has been pain, there have been a few failures, and there has most definitely been a pricking of the bubble … but the financial system has withstood the shocks, bloodied and in need of capital, but not in bankruptcy court with a crowd of depositors forming a lynch mob. The Basel Accords need adjustment, not elimination.

In another vein, Luigi Spaventa argues for a Brady Bond style bailout:

In CEPR Policy Insight 22, I recommend the creation of a publicly sponsored entity that could issue guaranteed bonds to banks in exchange for illiquid assets, drawing on US Treasury Secretary Nicholas Brady’s solution to the Latin American sovereign debt crisis in 1989. This new entity, preferably multilateral, would value assets based on discounted cash flows and default probabilities rather than crisis-condition market prices.

As a firm floor is set to valuation and illiquid assets otherwise running to waste are replaced by eminently liquid Brady-style bonds, funding difficulties and, at the same time, the market liquidity problems besetting the banks’ balance sheets would be removed. Shielding the banks’ assets from the vagaries of disorderly markets is a necessary condition to dispel the uncertainty that prevents a proper working of credit markets.

Nope. I don’t buy it. The amount of moral hazard engendered by such a scheme – not to mention investment risk taken by a publicly funded body – is not justified by the scale of the current problems. Dr. Spaventa’s arguments that current procedures are inadequate:

For funding liquidity, emergency liquidity support from central banks has helped lower the temperature in the worst moments, but it is not a long-term solution. Setting a collateral value of illiquid securities does not provide a market for them and hence does not set a floor to their market prices; the collateralized securities remain on the intermediaries’ books, affecting the quality of their balance sheets. Capital increases are also insufficient to break the spiral, as injections of capital may prove inadequate only a few weeks after their announcement.

For market liquidity, suggested remedies are equally inadequate. Mandated full disclosure of losses might reduce uncertainty, but unless market liquidity is instantly restored, full disclosure of the situation at time t offers no guarantee that it will be the same at time t+1. Similarly, retreating from marking financial products to market or model during this time of crisis would face a number of difficulties.

are not impressive. On the capital-raising front, we have today AIG raising $12.5-billion, while there are rumours that CitiBank is going to sell assets.

What we have is a short term crisis brought about by the (over-) financing of long term assets with short term money … this is the root of just about every general financial crisis ever known. The only solution is the passage of time.

One problem with neo-Brady-Bonds is that there will be considerable difficulty regarding negotiation of price – that is probably what killed Super-SIV / MLEC. According to the Bank of England, announced write-downs now exceed expected credit losses. It’s bad enough for the banks to take a stiff haircut when lending the securities; they’re spinning off cash; as long as they can finance them, why should they negotiate a politically palatable horrible price?

Meanwhile, Accrued Interest reviews conflicting signals from the stocks, CDS & bond markets and concludes:

A better explanation is that the market is struggling to price a world where liquidity is improving but real economics are deteriorating. It felt to me like the market, especially stocks, had become a bit too optimistic in recent days, with some even talking like we won’t have any recession at all.

Don’t confuse economic data that’s “better than expected” with “good.” Now if you ask me where the stock and credit markets will be in a year, I’d say both will be better than today. Looking one year out, we’ll probably be through this recession, housing will have bottomed, and there will be much more earnings clarity. But in the near term, I think we need a little more of a recession concession.

A quiet day in the market. Prices drifted up, with spikes in the SplitShare and InterestBearing sectors, on little volume.

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

Big excitement for US Municipals as Vallejo, California, intends to enter bankruptcy:

The city council’s unanimous decision makes the San Francisco suburb the largest city in California to file for bankruptcy and the first local government in the state to seek protection from creditors because it ran out of money amid the worst housing slump in the U.S. in 26 years.

The city of 117,000 is facing ballooning labor costs and declining housing-related tax revenue that have left it near insolvency. The city expects a $16 million deficit for the coming fiscal year that starts July 1. Under bankruptcy protection, city services would keep running. It would freeze all creditor claims while officials devise a plan for emerging from bankruptcy.
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The area has been one of the hardest hit in Northern California by the housing market slump. Home prices in Solano County, where the town resides, dropped 19 percent in January from the year before, according to DataQuick Information Systems, a firm which tracks real-estate markets in the state.

This ties in nicely with the report from Accrued Interest that MCDX has commenced trading:

From the people who brought you the ABX, now comes the MCDX, a basket of municipal credit default swaps (CDS). The index will begin trading on May 6 with three, five, and ten year tenors. Markit set the coupon for the MCDX last Thursday night at 35, 35, and 40bps respectively. It started trading today, and traded wider, closing at 42bps for the 5yr tenor and 48bps for the 10-year.

This is a potential game changer in the municipal market. First, we’ll go over what the MCDX is, and then how it might change municipals forever.

The MCDX is going to be very similar to the CDX or ABX indices currently trading. It will represent a basket of 50 equally weighted municipal CDS. You can see the list of credits here. These will be recognized by municipal traders as more or less the 50 largest regular issuers of bonds. There are a few AAA credits in there, but mostly AA and A-rated credits. If rated on Moody’s Global Scale, the one where Moody’s attempts to match muni ratings with corporate ratings, almost all of these issues would be AAA.
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buyer of protection on the MCDX has essentially bought equal amounts of protection on the 50 names in the index. So a $10 million notional trade in the MCDX is de facto $200,000 in protection on each of the 50 names. Should any of the names default, the buyer of protection would deliver an eligible obligation of the issuer to the seller of protection at par. Markit has provided a list of CUSIPs as examples of eligible obligations. Any bond which is pari passu with the listed CUSIP would be eligible.
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To date, trading in municipal CDS has been very light, and with good reason. Default rates of general obligation and essential service municipals are almost non-existent. There is a limited number of large and frequent issuers outside of these two categories. So demand from hedgers for specific names is light. There might be demand from speculators who want to bet on the contagion hitting munis. But such a buyer would prefer to make a generalized bet on municipal credit as opposed to picking out individual credits.

To me, this product sounds like just another speculative recipe for disaster.

In the first place, consider the theoretical underpinnings of the CDS market: if I buy a 5-year corporate for cash and then buy credit protection for it, then what I’ve got – to a first approximation, ignoring liquidity effects – is 5-year bank paper.

If I buy 5-year bank paper and sell credit protection, then I’ve got – first approximation – full exposure to the corporate bond.

But there are tax effects with munis, since their coupons are not taxable, which is why (in normal times) they trade through Treasuries. Buying bank paper and selling municipal credit protection means I have to worry about tax effects and cash flow differences. Hence, there is no natural seller of municipal credit protection.

The other problem with the contract is that it is entirely cash settled – there is no mechanism whereby I can exchange for physicals. If I take a position on a bond future, I can sit on it until the last delivery date, when I will either take or make delivery (I might be forced to take delivery earlier, if I’m long). This enforces convergence between the cash and futures markets. But nothing of the kind happens with MCDX … I cannot sit on my 100-million position and, when it comes due, elect to take or make delivery of 50 x 2-million CDS contracts of the underlying.

Why is this important? Well, we’ve seen what’s happened in the ABX markets, as the Bank of England has followed PrefBlog’s lead and pointed out that ABX prices are connected to reality only in the very loosest sense.

So … we’ve got a market that I predict will quickly become dysfunctional. Speculators and hedgers will be buying up vast quantities of contracts and forcing the prices to dizzying heights, probably with ludicrous gyrations. Those willing to take a short position from time to time might – if they restrain themselves and don’t over-lever – just might do very well out of this.

Accrued Interest follows up with yet more US municipal news:

UBS is exiting the muni business, and are looking to sell the unit. They were the #3 underwriter, so it would have to be someone quite large to buy the business. Let’s see, who among the large dealers doesn’t have much in munis? I know! Bear Stear–… Er… Actually I don’t know who the hell will buy UBS’ muni unit. If they do want to make a move they need to do it fast. Otherwise rivals will start picking off the best muni bankers one by one until finally there is nothing left of the unit worth buying. One reader and I had a off-line chat about this and he suggested that there could be a re-regionalization movement in municipals. In other words, a movement away from consolidation in New York and toward mid-sized dealers gaining more power in that market. Lately spreads (meaning commission spreads) have been wider, especially in secondary trading. If that keeps up, look for regional brokerages to benefit.

I know! As briefly discussed on April 22, Bank of Montreal has recently become “the sixth-largest bank qualified municipal bond dealer in the United States and the largest in Illinois” … they might be interested! Of course … they might be even more interested in becoming one of the rivals picking dealmakers off the UBS desk one by one …

There was a long discussion on April 29 about the Fed’s plans to pay interest on reserve balances; today Bloomberg reports that:

Fed staff started discussions this week with Congress about bringing forward the date that interest can be paid, the person said on condition of anonymity. Technical details of how the program would work, and what rate the Fed would pay, would likely need further study and discussion by the FOMC, the person said.

If the Fed paid an interest rate equal to the federal funds rate, commercial banks would avoid dumping any excess cash into the money market, which in the past has driven rates below the Fed’s target.

The New York Fed bank’s Open Market Desk is charged with buying and selling Treasuries with 20 Wall Street securities firms to keep the main rate close to the target set by the FOMC.

The desk has struggled to keep the federal funds rate stable as banks attempted to manage their reserves at a time when credit markets were seizing up.

On May 2, the federal funds rate ranged from 0.1 percent to 2.5 percent even though the target was 2 percent. On April 23, the rate fell as low as 1 percent and rose as high as 10 percent, compared with the then-target of 2.25 percent.

“The inter-bank interest rate is going to be stabilized with this policy,” said Marvin Goodfriend, a professor at Carnegie Mellon University’s Tepper Graduate School of Business and a former Richmond Fed policy adviser who has published research on interest on reserves.

Assiduous Readers will remember my prescription for the US mortgage market:

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

… which was referred to on March 18. The call has been taken up (in part) by Thomas Palley, “an economist living in Washington DC” (hat tip: Naked Capitalism):

First, the capital gains exemption should be abolished for all new home purchases. Instead, the base cost of houses should be indexed to inflation so that homeowners are not taxed on inflation gains. Existing homeowners should be grand-fathered under current law to discourage selling to protect unrealized gains, which would destabilize the housing market.

Second, the ceiling (currently $500,000 per taxpayer) on mortgages qualifying for interest deductibility should be gradually lowered to zero over a ten-year period.
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Third, since everyone needs housing, the Federal government should phase in a refundable housing cost tax credit available to all, regardless of whether they own or rent.

I must admit, I don’t think the third point’s conclusion necessarily follows from the premise! But at least the issues are being aired.

There’s an interesting state of affairs at MBIA:

MBIA Inc. has yet to pass on $1.1 billion of capital to its insurance subsidiary, three months after raising the money to defend the unit’s AAA credit rating.

The cash, raised in a February stock sale, is being held at the parent company while Armonk, New York-based MBIA develops a plan for the company’s legal and operating structure, MBIA Chief Executive Officer Jay Brown said in a letter to shareholders released yesterday.

“Given the more than adequate liquidity in both our insurance and asset management businesses, there is no compelling reason to move this cash at this point,” Brown said.

MBIA was criticized by Fitch Ratings, which said on April 4 the decision raised the risk that the cash may not end up as capital for the insurance unit as MBIA had promised. While Fitch downgraded MBIA to AA from AAA, Moody’s Investors Service and Standard & Poor’s cited the capital raising as a reason for keeping the insurance unit at AAA.

Regulators are waiting for MBIA to contribute the funds, according to New York State Insurance Department Deputy Superintendent for Property and Capital Markets Michael Moriarty.

“It was never our expectation that the funds raised would go anywhere other than to the insurance subsidiary,” Moriarty said. MBIA spokesman Jim McCarthy declined to comment.

Jiggery-pokery, or simply flexibility? One way or another … if I was an MBIA counterparty, I’d be making sure their collateral was good!

And it looks like the big Wall Street dealers are going to have to lift their skirts a bit:

The U.S. Securities and Exchange Commission will require Wall Street investment banks to disclose their capital and liquidity levels, after speculation about a cash shortage at Bear Stearns Cos. triggered a run on the firm.

“One of the lessons learned from the Bear Stearns experience is that in a crisis of confidence, there is great need for reliable, current information about capital and liquidity,” SEC Chairman Christopher Cox told reporters in Washington today. “Making that information public can certainly help.”

We’ll see what the details are, but this is a good development for investors.

Unfortunately, due to complications arising from a symphony orchestra and a pretty girl, I am unable to report on the indices, issue performances or volume highlights tonight. Sorry, folks! Don’t you wish I had the HIMIPref™ indices all up to scratch, so that the bulk of the report generation would be a button-push? Me too. But I’ll update sometime tomorrow.

Update, 2008-5-8

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

Accrued Interest seems to have sparked a controversy, as his post from yesterday on the influence of recession timing on corporate spreads attracted some comment. He notes that his estimate of fair value (for spread due to default risk) of 34bp has been countered with an estimate of 140bp, and defends his figures while asking for backup from his interlocuter.

Fannie Mae lost a lot of money and has to return to the well:

it will raise $6 billion in capital as the worst housing slump since the Great Depression deepens.

The first-quarter net loss was $2.19 billion, or $2.57 a share, Washington-based Fannie Mae said in a statement. Analysts were expecting a loss of 64 cents a share, the average of 12 estimates from a Bloomberg survey.
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The government-chartered company, which sold $7 billion of preferred stock in December, may need as much as $15 billion to cope with delinquencies and foreclosures, analysts including Paul Miller of Friedman, Billings, Ramsey & Co. in Arlington, Virginia, said.

Naked Capitalism has republished extracts from a NYT article on Fannie and Freddie. There are concerns that their accounting is insufficiently conservative:

Both companies have also recently changed their policies on delinquent loans, which they previously recorded as impaired when borrowers were 120 days late. Now, some overdue loans can go two years before the companies record a loss.

Fannie Mae declined to discuss the accounting of impaired loans. A representative of Freddie Mac said marking loans as permanently impaired at 120 days does not reflect that many of them avoid foreclosure. But the biggest risk, analysts say, is that both companies are betting that the housing market will rebound by 2010. If the housing malaise lasts longer, unexpected losses could overwhelm their reserves, starting a chain of events that could result in a federal bailout.

Meanwhile, the level of Level 3 assets held by the major brokerages has been rising dramatically:

Merrill Lynch & Co. said so-called Level 3 assets climbed 70 percent in the first quarter, as the largest U.S. brokerage reclassified commercial mortgages and other assets as hard to value.

Merrill’s Level 3 assets, the firm’s most difficult to value, rose to $82.4 billion as of March 28 from $48.6 billion at the end of December, according to a regulatory filing today. The New York-based company’s ratio of Level 3 to total assets rose to 8 percent from 5 percent.
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Merrill’s Level 3 assets include mortgage-related holdings which sit within trading assets of $9.3 billion, according to the filing. Derivative assets accounted for $20.6 billion, loans measured at fair value for $12.5 billion, credit derivatives for $18 billion and private equity and principal investments for $4.3 billion, it said.

Other New York-based securities firms have also had a rise in Level 3 assets. Goldman Sachs Group Inc.’s holdings of the assets surged 39 percent to $96.4 billion in the fiscal quarter ending in February. Morgan Stanley reported a 6.1 percent increase to $78.2 billion.

Citigroup Inc., the biggest U.S. bank, yesterday said Level 3 assets rose by 20 percent in the first quarter to $160.3 billion.

Countrywide is cutting off some HELOC lines:

Countrywide Financial Corp. has suspended the home equity credit lines of almost all its Las Vegas customers
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Since January, Countrywide, Bank of America Corp., Washington Mutual Inc. and IndyMac Bancorp Inc. have frozen about 600,000 equity credit lines nationwide, said Michael Kratzer, president of a Bankrate Inc.-owned Web site that’s fielding consumer complaints. The lenders are targeting borrowers in cities where property values are falling, including Las Vegas, Chicago and Los Angeles, he said.

There was a monster bond deal announced today:

GlaxoSmithKline Plc, Europe’s biggest drugmaker, increased the size of its bond offering by 50 percent to $9 billion, which would make it the largest U.S. corporate bond offering in six years.

The sale, scheduled to occur as soon as today, will be split between $2.5 billion of 5-year notes, $2.75 billion each of 10- and 30-year bonds, and $1 billion of two-year floating-rate notes, according to a person familiar with the transaction who declined to be identified because terms aren’t set.

GlaxoSmithKline also lowered the yields at which it is offering the debt. The fixed-rate notes are now all expected to yield 173 basis points more than similar-maturity Treasuries and the two-year debt is expected to pay interest of 62.5 basis points more than the three-month London interbank offered rate, according to the person.

The fixed-rate notes were earlier marketed at a spread of about 175 basis points to Treasuries and the floating-rate securities were expected to pay interest of 65 basis points more than Libor. A basis point is 0.01 percentage point. Libor, a borrowing benchmark, is currently set at 2.76 percent.

The offering is the biggest since General Electric Co.’s finance arm sold $11 billion of bonds in 2002 in the fourth- largest corporate offering ever, according to data compiled by Bloomberg.

Volume picked up in a down day enlivened by a Fortis new issue announcement.

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

Sorry, folks! Words of wisdom are in short supply today, so I’m just going to supply the links.

What are Corporate Bonds Worth in a Recession – Accrued Interest, excellent!

Yahoo! offer abandoned – Bloomberg

Credit Crunch Hitting Main Street – Bloomberg

Target monetizing its credit card receivables – Bloomberg

Bank of America affirms committment to Countrywide – Bloomberg

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

Finally, there is a good crop of links today!

James Hamilton of Econbrowser remarks on a WSJ article about prime no-doc loans, which arose through a Countrywide “Fast and Easy” programme which generated no-doc / low-doc loans which were then sold to Fannie Mae, which has classified them as “Prime”. He has been taken to task in the comments (there are claims that this is not only not news, but isn’t even interesting, since the borrowers were approved due to high credit scores and low loan-to-value). Regardless of whether the story is simply an example of media hysteria, I am as concerned as he is about the big issue:

From page 102 of Fannie’s 2007 Annual Report, as of the end of 2007, the enterprise had leveraged $44 B in stockholders’ equity with $796 B in short- and long-term debt to acquire $761 B in mortgages either held outright or intended for resale or trading. I read that as an equity cushion against a 5.8% loss on the mortgages held directly (44/761 = 0.058). But in addition (page 1), Fannie has guaranteed $2.1 trillion in separate mortgage-backed securities it has sold to outside investors, for a ratio of core capital to total book of business of 1.6%.

From the beginning, my conception of a really big financial meltdown would be one that pulls one of the GSEs into insolvency. Please tell me why it can’t happen.

The GSEs have to start being regulated like banks; there’s no question in my mind about that.

Congress pressured the Fed to rescue the moribund Student Loans securitization market:

A month after the Federal Reserve rescued Bear Stearns Cos. from bankruptcy, Chairman Ben S. Bernanke got an S.O.S. from Congress.

There is “a potential crisis in the student-loan market” requiring “similar bold action,” Chairman Christopher Dodd of Connecticut and six other Democrats wrote Bernanke. They want the Fed to swap Treasury notes for bonds backed by student loans. In a separate letter, Pennsylvania Democratic Representative Paul Kanjorski and 31 House members said they want Bernanke to channel money directly to education-finance firms.

… and, somewhat surprisingly, the Fed responded:

The Federal Reserve announced today an increase in the amounts auctioned to eligible depository institutions under its biweekly Term Auction Facility (TAF) from $50 billion to $75 billion, beginning with the auction on May 5. This increase will bring the amounts outstanding under the TAF to $150 billion.
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In addition, the Federal Open Market Committee authorized an expansion of the collateral that can be pledged in the Federal Reserve’s Schedule 2 Term Securities Lending Facility (TSLF) auctions.
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The wider pool of collateral should promote improved financing conditions in a broader range of financial markets.

Bloomberg points out that securitized Student Loans are now eligible:

Fed officials also expanded the collateral they accept under the Term Securities Lending Facility to include AAA rated asset-backed investments. About 95 percent of outstanding student-loan securities are AAA, according to the American Securitization Forum.

In other political news, there are rumblings of tweaking capital requirements for brokerages, which is being puffed up as a major change.

Meanwhile, in deeply upsetting news, I have been advised that the Hershey’s January price increase has percolated through the system to the point where “Mr. Big” chocolate bars are having their price yanked from $1.25 to $1.35. This implies that my total cost of living has increased by 4%; PrefBlog’s future quality may be adversely affected due to malnutrition.

The Globe reports that a decision on ABCP will be delayed:

The judge overseeing the $32-billion restructuring of the seized-up market for asset-backed commercial paper wants to put off a ruling on the plan’s fairness until mid-May, saying he needs more time to review the complex case.

Ontario Superior Court Justice Colin Campbell, who was originally scheduled to rule on the fairness on Friday, said he would like to hold the so-called “sanction” hearing on May 12 and May 13, but could do it sooner in a pinch.

To give more time, the judge asked that a key standstill agreement with banks that prevents a meltdown in the market be extended. The current standstill expires May 9.

“I can’t think possibly how I can get a decision out by May 9,” the judge said.
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The deal, however, includes a controversial clause that would give all the players in the market immunity from lawsuits, something that has angered many holders and led to challenges in court that the judge wants more time to consider.

The lawsuits, if allowed, could run into many hundreds of millions, according to court documents filed Thursday. Aeroports de Montreal, Air Transat A.T. Inc., Cinar Corp., Labopharm Inc. and dozens of other companies laid out the claims they believe they have, which total at least $700-million.

As indicated by Assiduous Reader madequota in the comments to May 1, today was a pretty good day for prefs … but volume was lacklustre. Banks still need to raise cash and we haven’t seen an insurer come to market for quite some time … so there is considerable room for carping regarding the market’s ability to absorb new issues and bad news. Long corporates now yield a hair less than 6.00% so the dividend of 5.72% on PerpetualDiscounts (= 8.01% Interest Equivalent) represents a spread of 200bp … within the range of the last six months.

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