Category: Market Action

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Fascinating disclosure about Bear Stearns’ ownership today:

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

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

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

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

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

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

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

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

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

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

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

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

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

… Hmmmmm … still doesn’t quite work.

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

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

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

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

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

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

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

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

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

I agree. As written here on March 19:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

There is further commentary on the WSJ Blog.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The WSJ has reported:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

And according to Citigroup’s analysis:

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

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

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

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

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

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

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

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