Category: Market Action

Pump up the volume! It has been a weekend of massive bank (almost-) failure and state intervention.

Details are still sketchy, but Citigroup is taking over Wachovia:

Citigroup Inc., the biggest U.S. bank by assets, will acquire banking operations of Wachovia Corp. for about $1.6 billion after shares of the North Carolina lender collapsed under the weight of overdue mortgages.

The all-stock deal equals about $1 a share for the Charlotte-based bank, ranked sixth by assets in the U.S. All depositors will be protected, according to the Federal Deposit Insurance Corp., which helped broker the takeover by Citigroup. The New York-based bank plans to cut its own dividend in half and raise $10 billion in capital as it takes on Wachovia’s senior and subordinated debt.

The FDIC states:

Citigroup Inc. will acquire the bulk of Wachovia’s assets and liabilities, including five depository institutions and assume senior and subordinated debt of Wachovia Corp. Wachovia Corporation will continue to own AG Edwards and Evergreen. The FDIC has entered into a loss sharing arrangement on a pre-identified pool of loans. Under the agreement, Citigroup Inc. will absorb up to $42 billion of losses on a $312 billion pool of loans. The FDIC will absorb losses beyond that. Citigroup has granted the FDIC $12 billion in preferred stock and warrants to compensate the FDIC for bearing this risk.

Dealbreaker has the Citi Investor Presentation.

The status of the Canadian subsidiary, Congress Financial Capital Company, is not entirely clear at the moment; they raised CAD 400-million in 2005; but since they are (via intermediaries) 100% owned by Wachovia Bank National Association I am assuming (pending confirmation from the company) that their debt is covered under the deal, but I note that S&P put the issue on Watch-Negative this afternoon; its current S&P rating is A+.

In the meantime, the Europeans were busy:

European governments stepped in to rescue Fortis, Bradford & Bingley Plc, and Hypo Real Estate Holding AG as tremors from the U.S. credit crisis reverberated around the world.

The U.K. Treasury seized Bradford & Bingley, Britain’s biggest lender to landlords, while governments in Belgium, the Netherlands and Luxembourg threw an 11.2 billion-euro ($16.3 billion) lifeline to Fortis. Germany guaranteed a loan to Hypo.

… and the Fed is revving up the helicopters:

The Fed increased its existing currency swaps with foreign central banks by $330 billion to $620 billion to make more dollars available worldwide. The Term Auction Facility, the Fed’s emergency loan program, will expand by $300 billion to $450 billion. The European Central Bank, the Bank of England and the Bank of Japan are among the participating authorities.

The question remains: How many helicopters?

Nouriel Roubin loathes TARP:

Indeed, the plan also does not address the need to recapitalize those financial institutions that are badly undercapitalized: this could have been achieved by using some of the $700 billion to inject public funds in ways other and more effective than a purchase of toxic assets: via public injections of preferred shares into these firms; via required matching injections of Tier 1 capital by current shareholders to make sure that such shareholders take first tier loss in the presence of public recapitalization; via suspension of dividends payments; via a conversion of some of the unsecured debt into equity (a debt for equity swap). All these actions would have implied a much lower fiscal costs for the government as they would have forced the shareholders and creditors of the banks to contribute to the recapitalization of the banks.

As I noted on September 25, I would prefer a system whereby Treasury would buy senior preferred shares in distressed – but still solvent – banks, with a punitive coupon and the proviso that no dividends be paid on shares junior to the new issue until the issue was retired.

Via Dealbreaker comes a link … it appears that Richard A. Posner holds the same views:

A more palatable approach would be for the government to drive a Warren Buffett style hard bargain, in which, rather than buying anything from banks, the government would invest in them in a form, such as purchase of newly issued preferred stock, or bonds with a long maturity, that would augment the banks’ capital and thus enable banks to make more loans. That would avoid conferring a windfall on the banks by overpaying them for their bad securities; no one thinks Buffett is conferring a windfall on Goldman Sachs. After the industry was back on its feet, the government could sell the bank stocks or bonds that it had acquired.

… although I will note that his implication that long-term bonds are, or are equivalent to, capital is at best imprecise.

And in the end TARP failed:

Markets plunged as the House rejected, by a vote of 228 to 205, the $700 billion measure to authorize the biggest government intervention in the markets since the Great Depression. The Dow Jones Industrial Average fell 564 points, or 5 percent to 10,579, at 3:05 p.m. New York time.

The defeat of the legislation set off a scramble among the plan’s backers for additional support before another vote, which likely won’t come until later in the week.

We now await Son of TARP.

James Hamilton of Econbrowser has a good piece on understanding the TED spread.

There are interesting reports that Treasury repos are being done for fail-money; Dealbreaker notes that failed trades are increasing. Now there’s an indication of a locked up credit market if ever there was one!

Laeven & Levine have an article on VoxEU, Governance of banks, looking forward to the end of the crunch and the new – or changed – regulation that will be coming. They warn:

We find that banks with more powerful owners (as measured by the size of their shareholdings) tend to take greater risks.

This supports arguments predicting that equity holders have stronger incentives to increase risk than non-shareholding managers and debt holders and that large owners with substantial cash flows have the power and incentives to induce the bank’s managers to increase risk taking.

Furthermore, the impact of bank regulations on bank risk depends critically on each bank’s ownership structure such that the relationship between regulation and bank risk can actually change sign depending on ownership structure.

· For example, our results suggest that deposit insurance is only associated with an increase in risk when the bank has a large equity holder with sufficient power to act on the additional risk-taking incentives created by deposit insurance.

· The data also suggest that owners seek to compensate for the loss in value of owning a bank from capital regulations by increasing bank risk.

· Stricter capital regulations are associated with greater risk when the bank has a sufficiently powerful owner, but stricter capital regulations have the opposite effect in widely held banks.

Ignoring bank governance leads to incomplete and sometimes erroneous conclusions about the impact of bank regulations on bank risk taking.

PerpetualDiscounts fell in line with general credit markets today, with an average pre-tax bid-YTW of 6.29% … on the way up it hit that figure on July 9, on the way down on August 5. That’s about 8.81% at the standard 1.4x equivalency factor and Long corporates now yield about 6.5% … so the pre-tax interest equivalent spread to long corporates remains fairly constant at about 331bp.

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

In a post tweaking Republicans for opposition to TARP, Menzie Chinn of Econbrowser passes along the fascinating observation that yield levels for non-financial commercial paper have become incalculable:

On Tuesday, the US Federal Reserve quietly admitted that it had been temporarily unable to calculate yield levels for non-financial commercial paper, issued by AA-rated companies for one to three months.

The problem, it seems, was a dire lack of activity; or, as Morgan Stanley says, “extreme levels of stress and illiquidity”. More specifically, while investors are still purchasing ultra short-term notes – say, for one or two days – on a massive scale, they are reluctant to buy instruments that last longer than a few days. That may be temporary (yesterday yield prices were apparently returning to the AA sector again although they were unusually high). However, even a temporary freeze is remarkable. After all, these non-financial companies typically have nothing to do with Wall Street or toxic mortgage debt.

The data is not to be found in the Federal Reserve Release H.15 for September 22: rates are listed for one- and two-month nonfinancial CP, but for three-month all we get is “n.a.”. The only ray of sunshine I can find is that the outstandings are in line with seasonal norms.

In a classic example of Banks’ advantage in hedging liquidity risk, it has been reported that corporations are drawing heavily on committed lines:

Goodyear Tire & Rubber Co., General Motors Corp., and International Lease Finance Corp. lead companies drawing on so- called revolving loans obtained before the credit crisis began in July 2007. Banks had more than $1.4 trillion in untapped loan commitments as of a year ago, the most on record, according to the Shared National Credit survey by four U.S. regulators including the Federal Reserve.

Corporate treasurers, blocked from accessing capital markets, are turning to the funding as the failure of Lehman Brothers Holdings Inc. sparks concern that other banks may be unable to provide funds. Pressure to find cheaper, longer-term capital is also building as costs rise in the $1.7 trillion short-term debt market. Banks are being forced to come up with the money after swallowing $521 billion of writedowns and losses.

We will have to see some of these borrowers biting the bullet and paying up to issue bonds before the strain on the Fed’s discount window (mentioned yesterday) will start to ease.

The JPM/WM takeover was discussed yesterday. We are told that:

Pressure on WaMu intensified in the last three months as market conditions worsened. An outflow of deposits began on September 15, 2008, totaling $16.7 billion. With insufficient liquidity to meet its obligations, WaMu was in an unsafe and unsound condition to transact business. The OTS closed the institution and appointed the Federal Deposit Insurance Corporation (FDIC) as receiver. The FDIC held the bidding process that resulted in the acquisition by JPMorgan Chase.

I would be most interested in learning what fraction of that $16.7-billion was uninsured deposits. One would imagine the answer would be “all”, but one sometimes imagines rational things in an irrational world!

There has been a similar revelation regarding a run on Lehman:

Lehman Brothers Holdings Inc.’s brokerage lost more than $400 billion in assets in the months before its parent filed for bankruptcy protection, according to the trustee overseeing customer accounts.

Lehman’s holding company filed for bankruptcy Sept. 15 claiming $639 billion in assets, using four-month-old data. The wholly owned brokerage unit had shrunk to less than $100 billion in assets from $500 billion “a few months ago,” according to a Sept. 19 court statement by James Giddens, the trustee overseeing the settling of Lehman brokerage customer accounts by the Securities Investor Protection Corp.

Dosado and allemande left! The banks continue square-dancing, with rumours that Wachovia has asked Citigroup if they could spend some time together at the social … now that WB’s been spurned by MS.

And here’s a little throwaway line in a virtually unrelated article:

TD Ameritrade said it would spend up to $50 million to offset losses for its customers who have money in the Reserve Primary Fund. Other investors still don’t know the fate of their savings.
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TD Ameritrade used the Reserve’s Primary Fund as one of its cash “sweep” accounts, a place where consumers could automatically park cash from a maturing certificate of deposit, for example.

In the past, I’ve expressed concern about bank-branded MMFs … perhaps I should have cast my net wider!

PerpetualDiscounts lost ground today, closing with a weighted-average bid-YTW of 6.23%, equivalent to 8.72% interest at the 1.4x equivalency rate. Long Corporates now yield 6.50%, so the pre-tax interest-equivalent spread is now 222bp … narrowing in slightly, but still at very elevated levels.

Massive crosses today by Scotia, with National Bank playing a supporting role. Today was the first day for an October settlement date and there wasn’t too much price movement for these issues … so my guess is that they were all internal crosses. Who wants to spend the weekend matching up the trades to the holdings of one of the big funds?

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

Henry Blodgett of Clusterstock emphasizes a point I made September 23 regarding market value vs. intrinsic value of the securities targetted for TARB purchase in a post Warren Buffet reveals bailout’s dirty little secret:

Bernanke and Paulson want to pay a phantom “hold-to-maturity” price that is above the prices at which the banks are currently valuing their trash assets. The logic is that the banks’ carrying value is somehow artificially depressed by a lack of liquidity. (This logic is weak: If anything, the banks are trying to conceal how badly off they are by overstating the value of the assets).

Hat Tip: Naked Capitalism. Thanks to the miracles of modern hagiography, Mr. Blodgett sees no need to provide analysis supporting his thesis that banks are engaged in a coverup. Mr. Buffet is quoted (irelevantly) in the same post, so it must be true.

Dealbreaker is usually both vulgar and entertaining; on occasion they publish analysis that reflects their roots in the trading community. This is one of those times:

Mark-to-market accounting incentivizes markets to go illiquid when asset prices sink, exactly when liquidity is critical. You create an environment where an institution isn’t just poised to lose the difference between their current mark on the instrument they are selling and the transaction price, but a large multiple of that as that transaction triggers markdowns on the rest of the toxic paper. How do you handle that as a institution holding sludge? Wait. And if you see some sludge that is offered so cheaply that you couldn’t normally resist buying it? Wait, if you are holding similar assets. Liquidity has been frozen up to prevent revealing that many of these institutions might be insolvent at the current market prices. That’s the kind of thing that is going to happen when the institutions likely to go insolvent control most of the liquidity.

In general, huge corrections like this usually only reverse when prices get so low that value investors and their ilk creep out and cant help but start buying. The problem here is that there isn’t enough price discovery to tempt them out, or that the normal buyers (Goldman, etc.) face mark-to-market triggers that prevent them wanting any transactions at all. Buffett seems mercifully free of both constraints.

The opportunities TARP affords for this sort of unsupported assertion is one reason why I don’t like the plan and would prefer to see Treasury – if necessary – purchasing senior preferred shares with a punitive distribution and a proviso that shares junior to the new issue get no dividends while the issue is outstanding. If Treasury buys so much as a nickel’s worth of sub-prime paper, debate over side-issues will overwhelm any practical benefits. Even if they make a collosal profit, the move will be decried as ‘too risky but lucky!’ and condemned on grounds of idealogical impurity.

There are reports that TARP will be approved, one way or another, complete with politically driven executive compensation limits and maybe even a 25bp tax on stock trades. Fearless prediction: TARP will fail for the same reason MLEC failed: a politically satisfactory backstop makes no business sense for the participants.

Willem Buiter, writing in VoxEU, sees the problem as being one of insolvency, not illiqudity:

As the full horror story of the bad investments and bad loans made by so many American banks has gradually been revealed, it is clear that the US banking sector faces an insolvency crisis and not just an illiquidity crisis. The number of impaired mortgages is exploding, and not just in the subprime and Alt-A categories, but across the whole residential mortgage spectrum. Impaired commercial and industrial mortgages are rising fast. Bad loans to the construction industry and to developers are mushrooming. ABS backed by automobile loans, by credit card receivables are tottering in growing numbers as are many other unsecured household loans. With the economy slowing down and probably entering recession soon, even exposures to the non-financial corporate sector will become more vulnerable.

In a nutshell, the US banking sector needs recapitalisation.
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That leaves just two sources of capital. The first is the US federal government. It could inject capital into US banks, say by purchasing preference shares. I would uncouple such a capital injection from Paulson’s toxic asset purchase plan. The market illiquidity problem is related to but not the same as the banks’ capital deficiency problem. The government could implement a system-wide capital injection by specifying maximum leverage ratios (or minimum capital ratios) for various categories of financial institutions. It could then inject capital in return for preference shares to bring all these leverage ratios down to the maximum levels (all the capital ratios up to the minimum levels).
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Finally, there is my preferred solution to the capital deficiency problem: the compulsory conversion of some of the banks’ debt into equity. Again, this could be done by the government specifying maximum leverage ratios (or minimum capital ratios) for various categories of financial institutions. Different kinds of debt then would be mandatorily converted into equity (preference shares or ordinary shares) with the proportion of each category of debt to be converted into stock inversely related to the seniority of the debt. These proportions would have to satisfy the requirement that all leverage ratios be brought down to the maximum levels (all capital ratios up to the minimum levels).

It’s a very well written article in Mr. Buiter’s inimitable style. But although his concerns about solvency may well be justified, he presents no evidence that this is indeed the case. In any event, I have grave concerns about due process with respect to his mandatory conversion programme … this is insolvency restructuring stuff, usually carried out when the institution has, in fact, been proved to be insolvent. And, until somebody can show me otherwise, I will continue to believe that rumours of widespread insolvency in the US financial sector are greatly exaggerated.

In a speech available on the BoC website, Carney applauded TARP, albeit with very little discussion of its merits and alternatives:

Similarly, private asset sales have been limited by the complexity of the underlying assets, the ongoing impairment of securitization markets, difficulties in supplying financing to leveraged buyers and the desire of investors to “time the market.” In sum, banks have an increasing need for capital, but it has become more difficult to raise it.

In this environment, the U.S. government’s initiative to buy distressed assets is critically important. The plan announced by Treasury Secretary Paulson and being developed through discussions in the U.S. Congress is bold and timely. The size and breadth of support provided by this measure will help firms “rightsize” their balance sheets, re-liquefy closed markets and establish market prices for these distressed assets. This should eventually encourage private buyers to re-enter the market and complete the deleveraging process. A well-executed program will undoubtedly speed the resolution of this crisis and limit its economic cost.

But how urgent is the problem? Well, judging by the action at the discount window, pretty damn urgent!

Commercial banks and bond dealers borrowed $217.7 billion from the Federal Reserve as of yesterday, more than double the prior week, as the financial crisis worsened and private funding dried up.

Loans to commercial banks through the traditional discount window totaled $39.3 billion as of yesterday, up from $33.4 billion, the Fed said. Borrowing by securities firms totaled $105.7 billion, up from $59.8 billion. Under a new emergency program announced Sept. 19, banks borrowed $72.7 billion as of yesterday to buy commercial paper from money-market mutual funds.

The figures are from the Fed’s H.4.1 Statistical Release. It’s not clear to me, however, how much of that borrowing is happening because the banks can’t get funding anywhere else, and how much is because it’s cheap credit. We can assume that the AIG need is real, though!

The three-month London Interbank Offered Rate in dollars was 3.77 percent today, the highest since January. Commercial banks can take out up to 90-day loans from the Fed at 2.25 percent. Primary dealers pay the same rate for overnight loans. The AIG loan accrues interest at three-month Libor plus 8.5 percentage points.

In 2001, the discount rate was a half-point below the Fed’s benchmark federal funds rate. In 2003, the Fed reset the discount rate at 1 percentage point above federal funds. The Fed reduced the spread to a half point in August 2007 and to a quarter point in March 2008.

We shall see how it all works out. There is opposition to TARP from a group of economists and a group of Republicans. Meanwhile Fortress Investment Group is building a war-chest to go shopping for distressed paper:

Fortress has risen 38 percent in the past two weeks in New York trading as investors anticipate private-equity and hedge- fund firms will profit from financial turmoil by snapping up companies and assets at distressed prices. Fortress rose 51 cents, or 3.9 percent, to $13.50 in New York Stock Exchange composite trading today.

Private-equity firms are shifting from the large leveraged buyouts that dominated Wall Street during 2006 and 2007, raising funds to snap up distressed debt and mortgage securities. Fortress oversees about $35 billion.

… and rumours are floating that JPMorgan will buy up WaMu’s deposits. The will be a major announcement tonight, of some kind anyway:

JPMorgan Chase & Co. (NYSE: JPM) will host a conference call at 9:15 p.m. (Eastern Time) tonight, September 25, 2008. You may access the conference call by dialing 1-877-238-4671 (U.S. and Canada) / 1-719-785-5594 (International) – access code: 814030 or via live audio webcast at www.jpmorganchase.com under Investor Relations/Investor Presentations. Materials and further communication will be available on this website at the time of the call.

A replay of the conference call will be available beginning at approximately 1:00 a.m. on September 26 through midnight, Thursday, October 9 by telephone at (888) 348-4629 (U.S. and Canada); access code: 942856 or (719) 884-8882 (International). The replay will also be available via webcast on www.jpmorganchase.com under Investor Relations, Investor Presentations.

Bloomberg reports that this will happen by fiat of the FDIC. Flash! JPMorgan buys WaMu’s deposits for a premium of about 1%! Now … that’s what I call a bargain. Cash is king! Flash! JPM is marking down WM’s assets by $30-billion (out of $296-billion assets at WM carrying value) as part of the transaction. See page 18 of the presentation.

Covered bonds in the States are not having a nice time:

Bank of America Corp. was the last U.S. bank to issue the bonds, selling $1.5 billion of the securities in June 2007. The spread on the Charlotte, North Carolina-based lender’s three-year notes has widened almost eight-fold to 184 basis points, according to Citigroup Inc. prices on Bloomberg.

The only other U.S. issuer is Washington Mutual, which put itself up for sale last week. Its 6 billion euros ($8.8 billion) of covered bonds were downgraded one level to Baa1, the third- lowest investment-grade ranking, by Moody’s.

The spread on its $2 billion of 4.375 percent bonds due 2014 has surged to 678 basis points, from 26 basis points when the notes were sold in May 2007, according to Royal Bank of Scotland Group Plc prices on Bloomberg.

Speaking of bear markets, how about that California real-estate, eh?:

California home prices tumbled a record 41 percent in August from a year earlier as foreclosure sales pushed down values in the biggest U.S. state.

The median price of an existing, single-family detached home fell to $350,140 and will likely fall further, the Los Angeles- based California Association of Realtors said today in a report. Sales increased 56.7 percent from August 2007 and 1.8 percent from July.

And the sales number! Far be it from me to put any credence in technical analysis, but that’s consistent with mass forced liquidation near the bottom of the market. And, bless their hearts, the guys at Dealbreaker have actually put together some numbers on housing bubble profits:

In summary, our incomplete and work-in-progress calculations figure for something like $2 trillion in fees flowing to various parties in the real-estate, mortgage, securitization and securitization^2 businesses between 2003 and mid-2008. That’s some serious swag, and you don’t have to look very far to see why no one was in much of a hurray to shut any of it down or to rock the boat.

In fact, the Dealbreaker guys did a fantastic job today, highlighting an extraordinarily testy letter from the FDIC to Bloomberg. Let’s have a little more honest reporting and a little less yellow journalism!

I’m searching for the precise metaphor to use regarding the backlash against hedge funds in the UK – should it be ‘shooting the messenger’ or ‘killing the goose that laid the golden eggs’?:

As Lehman Brothers Holdings Inc. filed for bankruptcy and HBOS Plc was pushed into a government-brokered takeover, U.K. regulators and lawmakers found a culprit: the estimated 980 hedge funds that reside in Britain, mostly in London. Harbinger Capital Partners Fund chief Philip Falcone was singled out by the Daily Mirror. The tabloid used a front-page story on Sept. 18 to brand him a “greedy pig” for short selling, or making bets that Edinburgh-based HBOS would lose market value.

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

Interesting news on the CDS market today … it isn’t as big as we thought:

The credit-default swap market, used to hedge against bond losses and speculate on corporate credit risk, shrank for the first time as efforts to eliminate duplicate trades cut contracts outstanding by 12 percent.

The volume of outstanding trades fell to $54.6 trillion from $62 trillion in the first half, the International Swaps and Derivatives Association said in a statement today. It was the first decline since ISDA started surveying traders in 2001.
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After the March collapse of securities firm Bear Stearns Cos., 17 banks that handle about 90 percent of the trading in credit derivatives agreed to a list of initiatives to curb market risks. That included tearing up trades that offset each other, which cuts down on the day-to-day payments, paperwork and monitoring by bank staffs and reduces the potential for errors. It also may reduce the amount of capital that commercial banks are required to hold against the trades on their books.

The first stage of compression, completed Aug. 27, with the participation of 14 dealers, reduced contracts submitted on North American telecommunications companies by 56 percent, Markit Group Ltd. and Creditex Group Inc., which are processing the tear-ups, said this month. The second stage, completed Sept. 4, with 15 dealers, cut contracts on European telecommunications companies by 53 percent.

Well, PerpetualDiscount yields were recently higher (6.22% on September 18), but today’s closing bid-YTW of 6.20% was otherwise last seen on August 11 (when falling) and July 7 (6.23%, when rising). A fair bit of sloppy action today, especially with BAM.PR.K falling out of bed!

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

The drive to send the CDS market to London and Dubai continues, with Christopher Cox of the SEC jumping on the bandwagon:

U.S. Securities and Exchange Commission Chairman Christopher Cox said Congress should grant authority to regulate the credit-default swaps market amid concern the bets are helping fuel the global financial crisis.

Lawmakers should “provide in statute the authority to regulate these products to enhance investor protection and ensure the operation of fair and orderly markets,” Cox told the Senate Banking Committee today at a hearing in Washington.
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Cox today said investors who buy swaps without owning the underlying debt may be similar to naked short sellers who sell stocks they don’t own or borrow. Such short sales can flood the market and illegally drive down stocks.

Similar to naked shorts of stocks? Well … hasn’t that been obvious from the beginning? The mechanics of CDSs have been discussed on PrefBlog; Mr. Cox’s full remarks have been posted at the SEC site.

The theory that Sarbanes-Oxley makes the US capital markets less attractive is one to which I subscribe; but there is a column on VoxEU by Craig Doidge, George Andrew Karolyi and Rene M. Stulz that takes the opposite view:

In a recent paper, we examined the 59 firms that deregistered in the six months after Rule 12h-6 was adopted.1 Our analysis shows that deregistering firms have poor growth opportunities and experienced poor stock return performance over a number of years before deregistration. Compared to other foreign firms cross-listed on US exchanges, deregistering firms also have a significantly lower “cross-listing premium”, the valuation difference between cross-listed firms and their home-market counterparts, and this lower cross-listing premium cannot be explained by an adverse impact of Sarbanes-Oxley.
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Overall, the evidence supports the hypothesis that foreign firms list shares in the US in order to raise capital at the lowest possible cost to finance growth opportunities and that, when those opportunities disappear, a US listing becomes less valuable to corporate insiders, so such firms are more likely to deregister and go home.

I’m not sure that the Sarbanes-Oxley is as easily excused as all that. I quite agree that companies will – in general – make a rational investment choice when listing in the US and will leave when the costs outweigh the benefits. If Sarbanes-Oxley is a cost, however, a decision to leave becomes more likely. More insidiously, and much harder to examine in an academically satisfactory way, is the initial decision to list.

For example, Marsh Carter of the NYSE stated in 2006:

Finally, foreign companies are unquestionably concerned about the costs and added regulatory burdens associated with the U.S. regulation, including Sarbanes-Oxley.
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Indeed, one of the underlying motivations for companies listing in the U.S. is the increase in value – which averages about 30 percent — that accrues as a result of adhering to the high standards of governance that the U.S. markets demand. But companies are increasingly viewing the costs associated with these regulatory requirements, as well as their impact on the speed with which they can reach the market, as outweighing the valuation premium they offer. The way that the requirements of Section 404 were implemented is perceived to have resulted in substantial cost and duplication of effort that has caused international companies to conclude that the additional costs of our regulatory structure outweigh the benefits.
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When the London Stock Exchange surveyed 80 international companies that conduced IPOs on its market, it reported that 90 percent of the companies that had listed on the LSE felt that the demands of U.S. corporate governance rules made listing in London more attractive. The Wall Street Journal recently reported that small U.S. companies are turning to London’s small-cap market, AIM, for a variety of reasons, including the regulatory costs of going public. The article noted that “one of the reasons most commonly cited is the strain of Sarbanes-Oxley regulations in the [United S]tates.”

Also in VoxEU, Jeffrey Frankel wants a piece of the bank action, not just Bagehot:

What Mallaby calls the core insight is also the crux of Krugman’s logic (“Cash for Trash”):

“…the financial system needs more capital. And if the government is going to provide capital to financial firms, it should get what people who provide capital are entitled to – a share in ownership, so that all the gains if the rescue plan works don’t go to the people who made the mess in the first place.”

This follows a call by Charles W. Calomiris for preferred stock buys rather than loans:

Instead of buying toxic assets, the US government should buy preferred stock capital in ailing banks that could raise matching private sector equity. This would avoid the intractable problems of how the government should value the toxic assets and directly address the banks’ immediate problem – a lack of bank capital.

I like that idea a lot better. Look, a lot of the problem here is simply that sub-prime paper is not being rationally priced and the owners are being forced to mark to market. I recently noted that Moody’s is projecting a 22% loss on 2006 vintage mortgages. As I have discussed at length, the AAA portion of subprime debt is subordinated by roughly 20% (the precise amount will depend on the deal). So, OK, the mezzanine and equity portions have been wiped out … but the AAA tranches are only a little impaired. But as was noted by the OECD paper previously discussed, the mark-to-market on these things is a discount of 14%!

I suggest that banks do not want to sell paper worth $98 for only $86. They want to hoard their cash, let the paper run off gradually, and get their $98. So they won’t want to sell to Treasury at “market price” and Treasury will not – politically – be able to come close to “intrinsic value”. Stand off. To fix the problem in a Bagehotish sort of way, allow the banks term financing at Fed Funds + 100bp … which is the old discount window + 50bp, and the new discount window + 75bp. This is similar to the preferred stock idea of Calomiris, but gets the capital threat to Treasury more deeply subordinated, particularly if there’s a nice stiff haircut in the loan value.

CEBS has released a rather bureaucratic Statement on the Current Crisis Situation with the main points (bolded in the original):

• In our view, banks’ exposures to Lehman Brothers are manageable and mostly non-material, compared to the banks’ total assets and capital base.
• …
• With respect to EU banks’ exposures on AIG: given the US government support provided to AIG, EU bank supervisors view that this counterparty risk can be sufficiently mitigated for the moment.

So we can all sleep better at night. C-EBS has spoken!

James Hamilton of Econbrowser makes an interesting point regarding Monday’s spike in oil prices:

The most striking thing about yesterday’s oil prices was the disparity between different futures contracts. The October contract, which expired yesterday, did indeed settle at $120.92, up more than $16. But oil for delivery in November closed at $109.27, an increase of only $6.62, and longer-forward contracts saw an even more modest increase. Unquestionably what was going on was a short squeeze, in which traders who had sold the October contract short were scrambling to close out their positions before expiration, and having a hard time finding people willing to take the other side.
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I’m guessing that part of the answer must be that some of these operators were following rules of thumb which usually work just fine in a properly functioning market, and weren’t alert to the profit opportunities at hand. I certainly would not expect a discrepancy of this magnitude to persist for as long as 24 hours.

But another possibility that suggests itself is some degree of local monopoly power in the Cushing market. If you’re selling that $121 October oil, you might not be anxious to cook the golden goose by bringing any extra oil to the temporarily thirsty market. This might be a reasonable case for the FTC and CFTC to investigate the mechanics of exactly what happened yesterday.

PerpetualDiscounts were off a bit today on average volume. The excitement of the day was Nesbitt’s crosses of BCE issues – some of them usually very sleepy traders.

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

Morgan Stanley and Goldman Sachs are turning into banks; on September 16 I said:

I suspect that all this will change; in ten years, says I, all the global Large Complex Financial Institutions will be banks with access to multiple discount windows.

Sometimes things move faster than you think! The Bank of England published a list of their selected LCFIs … all banks now, or bust, every one. Although some of those players might no longer qualify as sufficiently large for the A list!

Accrued Interest calls for more regulation of CDSs, repeating his call for exchange trading, standardizing contracts and increasing margin requirements. While I agree that margin requirements are in order – with the regulators demanding that such-and-such margin be put up, or the equivalent is deducted from capital – I’m not entirely sure he’s right about the implications:

Increasing collateral requirements would force protection buyers to be more judicious about which names they short.

Now, it seems to me that if I buy protection with a five-year CDS at 500bp, my maximum loss is 25% of notional, and that’s in gross dollars, not present value. If I sell protection, my maximum loss is 100% of notional. It seems to me that any rational margining requirement is going to force protection sellers to be more judicious about which names they go long; the same will also work out relative to current reality, since a large part of the problem is that protection buyers have been relatively powerless hedge funds, while sellers have been insurers – who were enabled to put on massive leverage due the their policy of not doing the deal if they had to put up collateral.

Naked Capitalism reprints a report that New York State is moving into CDS regulation, presumably in an effort to drive all the business to London or Dubai.

A quiet day, although there were a few violent price moves. PerpetualDiscounts eked out a small gain.

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

The previously scheduled end of the world has been postponed.

Accrued Interest foresees a period of intense confusion:

Bonds are highly illiquid right now. Even Treasuries are showing unusual bid/ask spreads. There are many many many players who are going to be caught on the wrong side of this thing.
…
Some hedge funds are going to get crushed. I mean, anyone who was leveraged short financials may wind up getting busted out. That will result in some weird trading in seemingly unrelated instruments.

The Reserve Primary Fund buck-breaking has caused a huge onslaught of MMF redemptions:

Confidence in money-market funds was shaken this week when Reserve Primary Fund became the first in 14 years that failed to repay investors in full because of losses on debt issued by Lehman Brothers Holdings Inc. Investors responded by pulling a record $89.2 billion from funds on Sept. 17, according to data compiled by the Money Fund Report, a newsletter based in Westborough, Massachusetts. That equaled 2.6 percent of industry assets.

… and so Treasury is writing CDSs on Money Market Instruments:

The U.S. Treasury Department today announced the establishment of a temporary guaranty program for the U.S. money market mutual fund industry. For the next year, the U.S. Treasury will insure the holdings of any publicly offered eligible money market mutual fund – both retail and institutional – that pays a fee to participate in the program.

This is wild. I’m going to have to think about it a little more … but will this lead to a new financial industry? In which CP that’s issued will not only have bank-lines guaranteeing liquidity, but CDSs guaranteeing credit? Maybe this will be a good replacement business for the currently unfashionable municipal bond insurance game!

The American Bankers’ Association is upset because the Treasury move undercuts their FDIC advantage:

“Today’s action will undermine the role of banks during this current crisis and has the potential to have an extremely negative impact,” [ABA CEO Edward] Yingling said in the statement. “Our bankers are, understandably, very upset.”

Banks compete with money funds by offering accounts that are already covered by the Federal Deposit Insurance Corp. The extra margin of safety gives banks a competitive advantage with some consumers who want to avoid any chance of losses. Money- market funds hold about $3.35 trillion in assets.

Maybe that’s what will happen … MMFs will have to sign up with the FDIC / CDIC and all the other deposit guarantors, fill out all those forms and pay the insurance fees, and hire ex-regulators at fat salaries (only the smartest and most knowledgable ones, of course). Maybe they’ll even have to keep some capital with the fund to absorb losses and maintain capital and leverage ratios – and show the MER as a P&L item. Investor advocates will doubtless consider this a step forward. Because then everybody will get free money, right? Extra return without the slightest scrap of risk or necessity of thought is a fundamental human right, isn’t it?

Mind you, I’m not disagreeing with the Treasury move. Clearly, redemptions on the scale reported will have a long term negative effect and a short-term horrific effect … all the usual sales conduits busted, liquidity guarantees exercised, bank balance sheets bloating, the discount window getting a workout to finance the bloat … the move seems to me to be the lesser of the two evils.

And – as I have often said – the ultimate cause of the credit crunch is that there is a lot more demand for short-term investments than there is supply; which has led the industry to create pretend-short-term paper. Heightened uncertainty about the long-term ability to finance short-term will have effects that I’m going to have to think through carefully, but are guaranteed to be … interesting.

Sorry this report is late. I was up all night typing up the list of big winners! … No, I cannot tell a lie. I went home early and was asleep by 9pm and am now bright-eyed, bushy-tailed and eager to find out who goes bust next week.

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

The FDIC is working a bit of overtime sorting out the situation with bank holdings of FannieFreddie prefs:

The Federal Deposit Insurance Corporation (FDIC) will work with the limited number of institutions that have significant holdings of common or perpetual preferred shares in Fannie Mae and Freddie Mac to develop Capital Restoration Plans pursuant to federal regulations. These equity investments should be reported as available-for-sale equity securities, if not held for trading purposes, and any net unrealized losses should be deducted from regulatory capital. Attached is the FDIC’s “Statement on Investments in Fannie Mae and Freddie Mac Equity Securities.”

There’s rather a disturbing quote from John McCain:

LAUER: So if we get to the point middle of the week as we heard in that report where AIG might have to file for bankruptcy, they’re on their own?
McCAIN: Well…quote, “on their own”…we have to – we cannot have the taxpayers bail out AIG or anybody else…this is something we’re gonna have to work through — there’s too much corruption, there’s too much access, we can fix it, I believe in America – we can have a 9/11 commission such as we had after 9/11, ’cause this is a huge crisis and we can come up with fixes and we can make sure that every American has a safer future and that is to make them know that their bank deposits are safe and insured.

The disturbing part is “corruption”. “Corruption” implies criminality. There is a huge difference between ‘investments that didn’t work out’ and ‘incompetence and recklessness’ and ‘corruption’. If the next President approaches the issue of regulation of the financial sector with the idea that it was – somewhere, perhaps unprovable, but somewhere – widescale criminality that caused the current crunch, the economy’s in trouble. Sarbanes-Oxley has had a bad enough effect; a reprise will simply accellerate the slow erosion of New York as the world’s premier financial centre.

Reserve Primary Fund broke the buck on September 16; related events and reverberations are wild. State Street & BONY Mellon got hammered:

State Street Corp. fell as much as 55 percent and Federated Investors Inc. and Bank of New York Mellon Corp. declined in New York trading on concerns that money-market funds will be hit by a wave of losses.

The stocks plunged after BNY Mellon said a $22 billion institutional fund suffered losses on debt issued by bankrupt Lehman Brothers Holdings Inc. While not a money-market fund, BNY Mellon’s $22 billion Institutional Cash Reserves was designed to work like one.

.
Dealbreaker is amused.

And Putnam is closing down a huge fund:

Putnam Investments LLC closed its $12.3 billion institutional Putnam Prime Money Market Fund yesterday and plans to return all cash to investors.

The fund, which was valued yesterday at $1 a share, experienced “significant redemption pressure,” the Boston- based company said in a statement. A drop below $1 a share, known as breaking the buck, would have exposed investors to losses.

I discussed this issue – a bit – in my essay A Collateral Proposal, but I’m still having some trouble understanding it. Money market funds invest in commercial paper, not just T-Bills. This is because Commercial Paper pays more. It pays more due to both liquidity concerns and credit concerns. Credit Concerns! Occasionally, there will be a loss. If the Portfolio Manager is doing his job right, these losses will be few and far between; but there will be losses. That’s why you get paid extra!

So a loss of 1-2% on a money market fund is unpleasant, sure, but I’m afraid I just don’t understand why it’s the end of the world.

Another crummy day for prefs, and we can no longer talk about a yield curve. It’s more of a yield smudge, a yield Rorschach (pronounced “Raw-Shock”). Today’s closing average bid-YTW of 6.22% was seen on August 8 (moving down) and July 7 (moving up). The peak, remember, was 6.63%.

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

The market shows infinite capacity to surprise! We are told that today’s horror was due to credit concerns, which seems like a reasonable conclusion to draw. Most data seem consistent with this hypothesis.

So why did Fixed-Resets do so well relative to Perpetuals? Regardless of how wonderful – or not – the structure is, it addresses term risk only. Credit risk is not addressed. You have to make an awfully convoluted argument before you conclude that the relative performance of these two preferred share sub-classes is right and proper.

On the other hand, Floaters didn’t do very well. It’s a lousy sample – only two issues and both backed by BAM – but they are not money market instruments. The market always makes sense eventually. Just not right away and not all at the same time.

After today’s carnage, PerpetualDiscounts yield an average 6.18%, back to where it was on August 8 (when yields were falling; three days since the yield-trough of September 12 has undone a month of price-gains) and July 4 (when yields were rising). At the standard 1.4x equivalency factor, this is equal to 8.65% interest. Long corporates now yield 6.3%, so the pre-tax interest-equivalent spread is now about 235bp.

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

Covered bonds were mentioned in a speech Trichet delivered in Nice:

Another aspect I would underline in this context relates to the issuance of covered bonds. Indeed, the performance of covered bonds proved up to now to be relatively resilient to the financial market correction compared to asset-backed securities. Covered bonds are already the most important privately issued bond segment in Europe’s capital markets with over EUR 2 trillion outstanding at the end of 2007. From a financial stability perspective, they have a number of attractive features, not least the fact that the credit risk stays with the originator, which strengthens the incentives for prudent risk management; generally they are also more transparently accounted for in banks’ published accounts than securitisation transactions.

There was a story on Bloomberg about a massive JPMorgan advance to Lehman:

Lehman Brothers Holdings Inc., the securities firm that filed the biggest bankruptcy in history yesterday, was advanced $138 billion this week by JPMorgan Chase & Co. to settle Lehman trades and keep financial markets stable, according to a court filing.

One advance of $87 billion was made on Sept. 15 after the bankruptcy filing, and another of “a comparable amount” was made the following day — both to settle securities transactions with customers of Lehman and its clearance parties, a bankruptcy court filing today said. Lehman said in a statement today that the second amount was $51 billion.

My guess is that these advances were “overcerts” rather than day-loans (or longer!) … often necessary to get the settlement cycle working. Consider a trade in which you buy $100-million bonds and sell them ten minutes later and make $100,000. When settlement day comes, you have to deliver money to the guy you bought them from (and receive the securities) before you can receive money from the guy you sold them to (and deliver the securities). In order to do this you need a bank facility whereby you can certify a cheque without having actually having the funds in your account. Hence, “overcert”.

Back in the day, there was considerable thought expended on minimizing overcert charges on a minute by minute basis, particularly on settlement days for Treasury bill auctions when money flies around like crazy. Nowadays, electronics and net-settlement sessions has taken over … but I’m guessing the need for overcerts is still there and still with Lehman.

The nascent CDS ClearingHouse has been previously discussed on PrefBlog. Lehman’s bankruptcy has heightened the anticipation, but apparent bureaucratic games-playing by the Fed has lengthened the wait:

In July the 17 dealers agreed to form a clearinghouse, create a system to better manage the collateral that protects trading partners from losses and tear up offsetting contracts to reduce the number of positions that banks have to oversee.

The clearinghouse may fall behind schedule, delaying completion until next year, said a person familiar with the process who asked not to be identified last week because the discussions weren’t made public. The development was postponed after the Fed pushed Chicago-based Clearing Corp. to obtain a banking license, which would place it under the central bank’s watch, the person said.

In the Interesting Factoids Department is news from Across the Curve that non-financial commercial paper is trading way through LIBOR:

Here are a couple of examples. BMW one month CP trades libor less 65 at 2.10percent.

John Deere trades libor less 55 at 2.20 percent in the one month sector.

One month Pfizer CP trades at libor less 65 at 2.10

Must be some kind of record!

Defying the skeptics, Goldman Sachs has vowed independence:

Goldman Sachs Group Inc.’s success avoiding losses during the global credit crisis shows the firm doesn’t need to combine with a bank, Chief Financial Officer David Viniar said today.

“We think our business model works because our business works,” Viniar, 53, said in an interview after the New York- based firm disclosed a 70 percent drop in third-quarter profit. “I don’t think this is a model question. I think this is a performance question. Performance speaks for itself and will continue to speak for itself.”

I suspect that all this will change; in ten years, says I, all the global Large Complex Financial Institutions will be banks with access to multiple discount windows. Another long-back alma mater of mine was saying the same thing as Goldman some time ago and look what happened:

A decade back, after Royal Bank bought investment dealer Richardson Greenshields, CEO Chuck Winograd was asked if clients were leaving now the big bad bank had snapped up the feisty independent.

Mr. Winograd, who took justified pride in how close his Rich Green advisors were to clients, gave a funny smile and explained the opposite was true.

He said long-time customers, including a great many rural investors, were cracking open the vaults to hand their Rich Green stockbrokers even more of their savings, now the dealer enjoyed the backing of familiar, safe Royal Bank. It was a little humbling, admitted Mr. Winograd, now the head of Royal Bank’s investment dealer arm.

Reserve Primary Fund has a long history:

• The Primary Fund is the world’s first and longest running money fund
• The Primary Fund is the fourth largest rated money fund in the nation according to Crane Data as of December 2007

And now it has broken the buck:

Reserve Primary Fund, a money-market mutual fund with $64.8 billion in assets as of Aug. 31, fell below $1 a share in net asset value because of losses on debt issued by Lehman Brothers Holdings Inc.

Investor redemptions will be delayed as long as seven days, the fund’s owner, New York-based Reserve Management Corp., said today in a statement. Withdrawals requested before 3 p.m. New York time today will be paid at $1 a share.
…
The fund held $785 million in Lehman Brothers commercial paper and medium-term notes. The fund’s board revalued the Lehman holdings as worthless effective at 4 p.m. New York time. Lehman filed for bankruptcy protection yesterday.

The Lehman paper constituted about 1.2% of their holdings; by no means an extraordinarily aggressive amount, although there will be many who say otherwise. At the very least, it can’t have broken the buck by much! I was a bit puzzled by the “Medium Term Notes” reference, but their Annual Report dated 2008-5-31 discloses:

250,000,000 Lehman Brothers, 3.11%, 3/20/09

Which is an entirely reasonable thing for them to hold term-wise, however one might second-guess the decision credit-wise.

On a cheerier note, Morgan Stanley’s earnings were well above estimate:

Morgan Stanley, the second-largest U.S. securities firm, said third-quarter profit fell 3 percent, less than estimated, as revenue from investment banking and fixed-income trading declined.

We can look forward to the possibility of a McCain victory in the US Presidential race! If he wins, it will be illegal to lose money on the markets:

“Too many people on Wall Street have been recklessly wagering instead of making the sound investments we expected of them,” McCain told a crowd today in Tampa, Florida. “If I am president, we are not going to tolerate that anymore.”

In other news, it looks … likely? possible? … that Barclays will impose its own good bank/bad bank solution on Lehman by buying just the good bits:

Barclays Plc, the U.K.’s third- biggest bank, struck a deal to acquire the U.S. trading and investment banking business of bankrupt Lehman Brothers Holdings Inc., a person with knowledge of the matter said.

Trading in Lehman shares was halted by the New York Stock Exchange at 3:04 p.m. Barclays’s agreement to buy the Lehman units may be announced as soon as this evening, the person said, declining to be identified because the talks were private. The Wall Street Journal reported that Barclays would seek bankruptcy court approval for the deal at 5 p.m.

Flash!: As I go to press, the deal is done:

Barclays Plc, the U.K.’s third- biggest bank, will acquire the North American investment-banking business of bankrupt Lehman Brothers Holdings Inc. for $1.75 billion, two days after abandoning plans to buy the entire firm.

Barclays is paying $250 million in cash for the Lehman businesses and $1.5 billion for the securities firm’s New York headquarters and two data centers, the London-based bank said in a statement on its Web site today. The operations employ about 10,000 people.

And AIG might get its money:

American International Group Inc., the biggest U.S. insurer by assets, may get an $85 billion bridge loan from the Federal Reserve and cede an 80 percent stake, the New York Times reported, citing unnamed people briefed on the negotiations.

Banks led by Goldman Sachs Group Inc. and JPMorgan Chase & Co. couldn’t arrange emergency funding by today, resulting in the planned U.S. intervention, the Times said.

Flash! Just as I go to press, the “might” has become a fact.

Wham BAM! Scare stories about Brookfield crushed their prefs – and their dependent structures:

Commercial real estate could be next on the economic hit list because of Wall Street’s falling fortunes.

U.S. and Canadian property firms, such as Brookfield Asset Management Inc., own many of the buildings in Manhattan and across the United States where the investment firms are housed.

Lehman’s bankruptcy, for example, could result in more offices on the rental market in a time when the U.S. economy is demonstrably slowing.

That situation will hurt property management firms, [BMO Financial Group Inc. chief economist Sherry] Cooper said.

As I have pointed out before, on several occasions, most of Brookfields scary-looking debt is non-recourse. I have not yet seen an analysis done of the Doomsday Scenario in which Brookfield just mails the keys to all its New York property to the bond-holders, walking away from its current investment … but I’ll bet the company survives! Anybody who feels like doing that work, let me know!

The BCE Crush looks a bit more reasonable … Lehman cancelled its fire sale:

Lehman Brothers Holdings Inc., the securities firm that filed for bankruptcy yesterday, canceled an auction of $852 million of high-yield, high-risk loans, according to investors who considered bidding on the debt.

Bids for the loans, some of which helped finance leveraged buyouts for First Data Corp. and TXU Corp., were due by 2 p.m. today in New York, said the investors, who declined to be identified because the auction was private.

The sale was scrapped as Barclays Plc moved closer to a bid for the bankrupt firm’s broker-dealer unit. Leveraged loan prices tumbled near record lows in the past week as New York-based Lehman collapsed, stoking concern that other financial companies may fail. The firm has $7.1 billion of high-yield loans and bonds on its books, the bank said Sept. 10.

“Lehman is probably growing close to a sale of its brokerage business, which prompted the bank to cancel today’s auction,” said Louis Gargour, chief investment officer of LNG Capital, a London-based hedge fund. “Lehman’s leveraged loan book could prove integral to other parts of the business the bank is looking to sell, particularly the brokerage unit.”

… which may indicate that the LBO book is integral to the busines … or it may indicate that LBO debt is impossible to sell at the moment. Place yer bets, gents, place yer bets! Some BCE holders have decided not to chance it (hat tip: Financial Webring Forum).

It was a pretty crummy day all ’round, with generally poor performance and average volume. There are no winners on today’s big price moves table. Equities were down only 20bp, which is practically a win considering this morning and yesterday.

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