Category: Market Action

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

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

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

Calculated Risk references a Times article that indicates:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Derivative indices have come in for some heavy criticism:

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

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

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

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

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

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

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

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

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

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

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

A very quiet day for preferreds.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Not much today!

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

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

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

California was able to refinance some auction debt:

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

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

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

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

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

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

Another “key priority” is:

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

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

With respect to bank supervision:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

… although some big players favour the idea:

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

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

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

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

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

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

Willem Buiter has no problems with the idea in principle:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

According to the most recent FDIC quarterly report:

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

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

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

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

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

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

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

Not much interesting today!

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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