Category: Market Action

Shock and awe in the markets today as the Fed cut 75bp to 3.5% and the Bank of Canada cut 25bp to 4.0%. James Hamilton at Econbrowser labels the Fed move an attempt to mitigate damage:

a 75-basis-point cut can not prevent a recession, if one is indeed already under way, any more than the 50-basis-point cut in April 2001 prevented that downturn. But, while many members of the public may believe in the Fed’s omnipotence, I doubt that members of the FOMC share that illusion. I expect that Bernanke instead simply intends to do what he can to mitigate the damage.My bottom line? I believe the FOMC cast its vote today with those who declare that a recession has already begun.

But even after this massive move, many market players are calling for more, e.g.:

The Fed will cut rates again at next week’s meeting by either [a quarter of half percentage point]. The Fed has been unwilling to disappoint the market and fed funds futures are leaning very strongly toward a half-point cut next week. However, we disagree with the Fed over the longer-term outlook for inflation — to us, events have a strong stagflationary feel about them. –Bear Stearns

Bloomberg has some interesting colour regarding the Bond Insurer Implosion:

The first to fall was ACA Capital Holdings Inc., whose ACA Financial Guaranty Corp. unit guaranteed $26.6 billion of CDOs backed by subprime mortgages, according to S&P. The New York- based firm was founded in 1997 by H. Russell Fraser, a one-time chairman of Fitch, to insure municipal bonds that triple-A rated insurers wouldn’t cover.
…
“I knew that if they played with fire long enough, they were going to get burned,” says Fraser, 66.

He left the company in 2001 over a dispute with the board about insuring CDOs, he says. Back then, it was debt of Enron Corp. and WorldCom Inc. — companies that later filed the two largest bankruptcies in U.S. history — that was being shoveled into CDOs.

‘But’ roars the crowd, ‘We’re not interested in ancient history! Can we go back to sleep yet?’ Not according to Moody’s!:

Moody’s placed under review for possible downgrade BAC’s senior debt, rated Aa1, and Bank of America N.A.’s financial strength, rated A, on January 11, 2008, when the company announced its planned Countrywide acquisition. The bank’s Aaa deposit ratings and all Prime-1 short-term ratings are not under review.

“The rating review is focused on BAC’s capital position, which is further stressed by a barely profitable fourth quarter and the payment of substantial dividends”, said Rosemarie Conforte, Moody’s Senior Vice President. Moody’s said continued CDO write-downs and increased credit provisions severely affected BAC’s earnings performance during the fourth quarter 2007. Ms. Conforte added, “Bank and holding company liquidity are soundly managed and any capital-raising initiatives would be evaluated during the rating process.”

All in all, it was a pretty interesting day in the financial markets. James Hamilton at Econbrowser took a look after the close and pointed out that 10-year Treasuries yield less than 3.50% and:

All of which invites the question, What’s left for the Fed to do at their regular meeting still scheduled for next week? Futures market participants, whom we left on Friday in the belief that a 75-basis-point cut by the end of January was more likely than a 50-basis-point cut, roared out of the box today, bidding the February fed funds futures contract up to 96.95, implying an expected fed funds rate of 3.05%. That sounds like an additional 50-basis-point cut at the meeting coming up next week, or, if not, a good chance of another intermeeting move in February.

I’m appalled, frankly. If the Fed is trying to inflate its way out of the credit crunch, the yield curve should be WAY steeper than it is now … let’s say inflation becomes a large-but-not-disastrous 3% … and we want 2% real-yield on 10-years (at least! 2% is skimpy) … my calculator must be broken, I get an answer that’s nowhere near 3.5%. Where are the bond vigilantes when you need them?

Somebody, somewhere, is saying that US real-estate is a major deflationary force. Let’s hope they’re right … but until I see some convincing analysis, I’m gonna agree with Bear Stearns, quoted above.

Those who have read my most recently publicized article When Will Preferreds Recover will remember that March-November 2007 marked the greatest peak-to-trough decline in the BMOCM-50 Preferred Share Index going back to at least 1993-12-31. Such readers will doubtless be interested to note that, as of today, the calculated NAV for CPD now shows a decline of 1.06% for January to date, vs. a gain of 1.14% in December. In other words, we are now within a whisker of deepening the trough. Have a nice day!

Mind you, though, the PerpetualDiscount index now has a weighted average bid-yield-to-worst of 5.63% … with interest-equivalency of 1.4x, that’s the equivalent of 7.88% interest, compared to the Long Corporate Yield of about 5.75% … so the spread to bonds still looks pretty good! The Bank of Canada has the long Canada benchmark at 4.06% (!!), so spread-to-long-Canadas is a whopping 3.82%, a noticable increase from the high point shown in Chart 4 of my latest masterpiece.

By and large, preferreds ignored the excitement of the wider financial markets and just did their own thing … with a certain amount of weakness! Volume picked up a bit, to the low side of normal

There were twenty-one other index-included $25.00-equivalent issues trading over 10,000 shares today.

Unlike Quebecor, the monoline ACA Capital Holdings (of CIBC and Merrill Lynch fame) was given a little breathing room by its creditors, presumably on the grounds that it doesn’t make much difference. Three comments from the story are of interest:

Most of those guarantees are in the form of derivatives. Unlike insurance, these contracts are required to be valued at market rates.
…
“The monolines are dead, their business model is dead,” said David Roche, head of investment consultancy Independent Strategy in London. “The government is going to have to recapitalize this industry or there will be communities in the U.S. where they can’t even flush their toilets” because they can’t afford the services.
…
New York State Insurance Superintendent Eric Dinallo is examining whether to limit the types of debt that can be guaranteed by bond insurers, department spokesman David Neustadt said last week.

The first item of interest is the explicit recognition of the problem inherent in the originate-and-distribute model … or perhaps we should refer to it as a problem in the originate-and-hold model! When a bank grants a mortgage, funds it with, say, a GIC and keeps everything on their books, mark-to-market problems are minimized. But if it buys that same mortgage as a security, it is exposed to market fluctuations in the value of that mortgage. I’m sure I’ve mentioned this issue before, but can’t find my reference! Perhaps this exposure to price volatility should have been mentioned as a “friction” in the Fed research paper by Ashcraft & Schuermann.

The second note … well, I’m certainly not an expert on the US Municipal market! Sounds to me a little bit like hysteria, though!

And the third not shows what we can expect over the next few years – the dead hand of regulation stifling the securities business, or at least threatening to do so.

Naked Capitalism reprinted an interesting piece by Wolfgang Munchau regarding the nature of the … projected? imminent? current? …US recession, arguing that it will be extended due its nature:

Interest rate cuts work their way through to the real economy by a number of transmission channels. During the 2001 recession in the US, the most important was housing credit. The rate cuts came at a time when the housing market was already booming. They turned the boom into a super-boom. Inflationary expectations were low. People expected interest rates to remain low. It was a great moment to take on extra debt, and this was precisely what Americans did.

The current US downturn could not be more different. House prices are falling, and have further to fall before reaching a more sustainable level (in terms of the price-to-rent ratios as well as several other measures).
…
The corporate credit channel works more slowly. A company faced with an acute downturn in demand for its products is not going to start investing immediately when interest rates fall.
…
With core inflation stubbornly over 2 per cent, the current 10-year yield of 3.8 per cent seems a touch optimistic. So we might be seeing a simultaneous fall in short-term rates and a rise in long-term rates.
…
Cui bono? The banks, of course. The bank-bailout channel will be the only monetary transmission mechanism to function like clockwork. The steeper the yield curve, the greater the profits for banks, which make a living by borrowing at short interest rates and lending at long rates.
…
As time goes on, the financial sector’s health will gradually improve. Eventually, the credit squeeze will be over – and the next irresponsible lending boom can begin.

These are important concepts … particularly for those who are outraged by the banks’ so-called defiance of the Bank of Canada, reported here January 16.

Great excitement in Canadian equities today:

The Standard & Poor’s/TSX Composite Index fell 604.98, or 4.8 percent, to 12,132.14 in Toronto for its worst drop since Feb. 16, 2001. The benchmark has retreated 17 percent from near a record on Oct. 31 to the lowest in 15 months, approaching a “bear market” drop of 20 percent.

Given that Tokyo is now getting hammered, it should be an official bear market at the opening tomorrow.

Oddly enough, the carnage spilled over into preferred shares, with the S&P/TSX  Preferred Share Index down 0.87%. Panic? Confusion? Cool-headed efficiency? You tell me. Volume was on the light side of normal.

There were fifteen other index-included $25.00-equivalent issues trading over 10,000 shares today.

Bobby Fischer, RIP. 

Naked Capitalism reviews the Credit Default Swaps market with an emphasis on the new two-ton gorilla in the room: counterparty risk. CIBC shareholders learnt all about counterparty risk on December 19; Merrill Lynch shareholders got a reminder more recently:

concerns ratcheted up when Merrill announced that $3.1 billion of its $16.7 writedown was due to the apparent worthlessness of hedges written by an obscure (to those not following credit guarantors) counterparty, ACA Financial Guaranty.

He also highlights the issue of insider trading, mentioned in the CDS Primer:

The Journal also mentions regulatory issues:

This market poses challenges for would-be regulators. It isn’t clear, for instance, how securities laws on fraud and insider trading would apply to credit-default swaps, because it’s not clear in what way they are even securities; they are private contracts.

Of all the regulatory concerns, fraud and insider trading are low on the list.

Mr. Smith does not explain his reporting of the ranking of fraud and insider trading. I will certainly grant that the question of regulatory capital requirements for “normal” transactions should be the number one concern [hint regarding my position: shorting a CDS and buying the notional amount of BAs is roughly the same exposure as an outright investment in the underlying corporate credit, for a term equal to the term of the contract], but fraud and insider trading are always concerns.

And the monolines continue to career down the road to oblivion:

Ambac Financial Group Inc. scrapped a plan to raise equity capital after the bond insurer’s shares plunged 70 percent in the past two days, putting its AAA credit rating in jeopardy.
…
MBIA raised $1 billion last week in the sale of surplus notes and last month entered a deal to sell $1 billion of equity to private-equity firm Warburg Pincus LLC. Both companies slashed their dividends and took out reinsurance on some securities to help shore up capital.

The surplus notes plunged as low as 70 cents on the dollar today, indicating a yield of about 25 percent, traders said. MBIA dropped $1.63, or 18 percent, to $7.59 on the New York Stock Exchange, extending its 56 percent decline this week.

And, as the market closed, Naked Capitalism republished news and commentary on the Fitch downgrade of Ambac.

More speculation in the press about the BCE / Teachers deal:

The Montreal-based company’s shares were down for the fifth consecutive trading day, losing 16 cents to $36.37 Friday.

The shares are down from a peak of $41.80 in July.

Crandall said the share price suggests many investors now believe there’s only a 50/50 chance the company will be sold to a group led by the Ontario Teachers’ Pension Plan. The group offered $42.75 per share in June for BCE and plans to finance the deal with up to $40 billion of debt.
…
Toronto Dominion Bank chief executive Ed Clark this week reinforced his bank’s commitment to provide $3.8 billion to the BCE deal.

“I know everyone stews and worries about it. I would like to tell you that I’m stewing and worrying, but I’m not,” he said at a conference of bank CEOs on Tuesday.
…
But Teachers spokeswoman Deborah Allan said the prospective buyers of Canada’s largest telecommunications won’t be distracted by “the noise that’s in the marketplace.”

“As far as this transaction is concerned, we have an agreement, we’re committed to it and we’re focusing on closing the deal,” she said in an interview.

Now, as PrefBlog’s Assiduous Readers will know, the way to read a press release is to see what it is that they DON’T say. Have a look at Deborah Allan’s remarks (as quoted by the CP reporter, Ross Marowits). Did she actually say anything at all meaningful? We know they have an agreement (it’s on SEDAR), we know they’re committed to it (they signed) and it’s not clear to me what “we’re focusing on closing the deal” means. We know that TD is happy about financing 10% of the price, but … where’s the other 90%?

Given everything that’s happened to the credit markets and to BCE over the past seven months, I suspect that a loss of a mere $1-billion break fee is a pretty cheap exit. But, I say again: what do I know? Either way it’s a speculation on basically zero information; I can have more fun playing blackjack.

As part of its continuing effort to prevent business from being done in Canada, Regulation Services has released Guidance on the Supervision of Algorithmic Trading, with the lovely little paragraph:

If a Participant has provided Dealer-Sponsored Access, commonly known as direct market access, to a client (“DSA Client”), the Participant, as part of its on-going supervision of client orders, must be aware of the origin of the orders entered by the DSA Client, including whether the DSA Client employs the use of algorithmic trading systems. The Participant must ensure the proper testing of any algorithmic trading system used by a DSA Client to enter orders on a marketplace by means of the Dealer-Sponsored Access provided by the Participant.

In other words, it’s not sufficient to take responsibility for your orders. Your process must be questioned, tested, validated and approved by Responsible Authorities. Assiduous Readers will remember that the purpose of rules only very rarely has anything to do with accomplishing anything … the purpose of rules is to give authorities their authority. Hail RS!

It is my understanding that a lot of proprietary traders (day traders who work for dealers) are finding out that their bonuses (and profits of the banks dealers) have not been due so much to their uncanny understanding of the market and brilliant exploitation of subtle shifts in supply and demand as they were to control of the order flow, better access to data and execution than their buy-side competitors and tick-sizes on prices of more than a penny.

Principal revenues earned from proprietary desks and market-making activities also succumbed to the market downturn. Equity trading revenues were off $209 million, a whopping 120 per cent lower than the previous quarter and off 123 per cent against the same period in 2006. For the quarter, equity trading resulted in a net loss of $35 million. This represents the first time since the third quarter of 2002, about the same time the TSX bottomed out from the tech market collapse, that the industry reported a net loss from their principal equity trading business.

Don’t expect much squawking from the street on this one.

After yesterday’s fall, the preferred share market took a little breather today – volume was way down and, overall, losses were minor. All eyes are on equities at this point … the Monday back from a weekend of worrying and second-guessing can often be rather exciting. What effect the US holiday will have on this process is something that I’m afraid even to contemplate!

There were eleven other index-included $25.00-equivalent issues trading over 10,000 shares today.

Prof. Hamilton’s use of the unadjusted 10-year Nominal/TIpS spread, mentioned here yesterday, attracted some criticism in the comments to his post. The Cleveland Fed adjusts the raw data for (a) the inflation risk premium, and (b) liquidity premium.

The naive method of pricing real return bonds is:

Nominal Yield = Real Yield + Inflation Expectations (Wrong!)

If this were the actual equation, there would be no incentive for the issuers to issue the bonds; they would just go with nominals. However, the correct equation:

Nominal Yield = Real Yield + Inflation Expectations + Inflation Risk Premium (Right!)

adds a term. A buyer of nominals must not only forecast inflation, but (if he’s prudent) add a little bit extra just in case his expectations are wrong. By issuing real return bonds, the issuer can capture that Inflation Risk Premium for itself.

The liquidity premium doesn’t need a lot of explanation – especially in this environment, where the liquidity premium on some issues – especially US financials – is enormous. When you buy treasuries – or Canadas, to a lesser extent – you can trade a boatload of them without moving the price. Want a quote on 10-years, $50-million a side? The quote will come back at you with a ten cent spread. Why not? The dealer’s ‘phone is always ringing, he can keep turning over his inventory and earning the spread with ease, and he can alter the directional bias of his trades by shading his quote a few pennies one way or the other.

This is – ahem! – not the case with instruments of lesser liquidity. Therefore, you are willing to pay less for instruments of low liquidity (which increases the yield required) to compensate for the risk that you’re going to want to – or have to – sell them prior to maturity anyway and be subject to the tender mercies of the dealers and their book of inventory.

I have added a link to the Cleveland Fed’s calculations at the sidebar. Curious readers will see that the adjusted series is volatile and has been sharply increasing in recent months.

The implosion of the weaker monolines, Ambac and MBIA, continued today.

Michael Woodford of Columbia University wrote an interesting piece on the ideal methodology of central bank communication with investors:

All of the big-3 central banks (the Fed, Bank of Japan and the ECB) have experimented over recent years with more explicit forward guidance through their official communications. Generally it is through the use of “code words,” such as removal of policy accommodation at a “measured pace,” or the exercise of “strong vigilance” toward inflation risks.
…
I suspect that other central banks are becoming more cautious as well about the use of code words that are taken to directly indicate future interest-rate decisions, under the current rapidly changeable conditions in financial markets.

He suggests that the use of fan charts would be preferable. To my chagrin I have been unable to find a linkable example of a fan chart, but the name should be self explanatory. Draw your projection of … whatever … into the future. Draw in confidence limits at, say, 50%, 75% and 95% confidence. Colour them in. Voila! See, for example, Chart#3 in the Norges Bank 2006-03 Inflation Report.

At a 2006 Bank of Canada conference, such fan charts were lauded:

The Reserve Bank of New Zealand is the pioneer not only in inflation targeting but also in introducing and publishing explicit instrument-rate paths that can be interpreted as optimal instrument-rate plans. The bank has done so since 1998 (Archer 2004, 2005; Svensson 2001a). The Reserve Bank has for many years been alone in taking this bold step. However, Norges Bank, an enthusiastic and competent newcomer to the inflation-targeting camp, has recently started to publish explicitly optimal instrument-rate paths with uncertainty bands, together with criteria for optimal inflation and output-gap projections and other innovations in transparent monetary policy (Norges Bank 2005; Qvigstad 2005). This should be an example to other central banks.

There was a bit more speculation about BCE today:

Shares of BCE Inc. Canada’s biggest telecom company, continue to trade well below the offer price in its $34.8-billion buyout as investors remain worried the deal may be repriced, abandoned or face further delays.

The buyer group, which includes the Ontario Teachers’ Pension Plan, Providence Equity Partners, Madison Dearborn Partners and Merrill Lynch Global Private Equity, has offered $42.75 a share to take the company private.

However, its shares were at $36, down $1.01, on the Toronto Stock Exchange on Thursday afternoon, despite repeated assurances from both BCE and Teachers’ that the deal remains on track.

A BCE spokesman said on Thursday the company is still “looking forward to closing the deal” in the second quarter.

A Teachers’ spokeswoman was not immediately available for comment.

My guess is that the Teachers’ spokeswoman was in the Ladies’, throwing up. But what do I know?

Today’s response in the preferred market to the new BNS 5.60% Perpetual certainly makes my “frothy” correspondent of January 7 and January 8 look like a genius! The correspondent now feels that (a) long-term, prefs are a buy; (b) short term, it might be better to wait; and (c) if another issue comes out before the new issue settles, take the day off and buy a bottle of something tasty. 

Volume, rather surprisingly, was good, but by no means heavy. Make of that what you will.

There were thirty-two other index-included $25.00-equivalent issues trading over 10,000 shares today.

Rule #1 states that the world always looks more interesting than it really is, an idea mentioned in a previous post, The Bond Market is Excitable. James Hamilton of Econbrowser took a look at the retail sales numbers that had everybody so excited yesterday and yawned.

I don’t know whether this marks the beginning of a trend or not, but there are two new posts out there complaining about executive pay amidst all the current shock and horror. Accrued Interest focusses on Countrywide CEO Angelo Mozilo, while Naked Capitalism republishes a more general article by Martin Wolf regarding bankers pay in general.

The latter essay espouses the popular ethic that this would be a much better world if only there were more rules. When considering the current devastation:

Up to now the main official effort has been to combine support with regulation: capital ratios, risk-management systems and so forth. I myself argued for higher capital requirements. Yet there are obvious difficulties with all these efforts: it is child’s play for brilliant and motivated insiders to game such regulation for their benefit.

So what are the alternatives? Many market liberals would prefer to leave the financial sector to the rigours of the free market. Alas, the evidence of history is clear: we, the public, are unable to live with the consequences.

An alternative suggestion is “narrow banking” combined with an unregulated (and unprotected) financial system. Narrow banks would invest in government securities, run the payment system and offer safe deposits to the public. The drawback of this ostensibly attractive idea is obvious: what is unregulated is likely to turn out to be dangerous, whereupon governments would be dragged back into the mess.

No, the only way to deal with this challenge is to address the incentives head on and, as Raghuram Rajan, former chief economist of the International Monetary Fund, argued in a brilliant article last week (“Bankers’ pay is deeply flawed”, FT, January 9 2008), the central conflict is between the employees (above all, management) and everybody else. By paying huge bonuses on the basis of short-term performance in a system in which negative bonuses are impossible, banks create gigantic incentives to disguise risk-taking as value-creation.

I certainly agree with the need for a continuous update of regulation – I have argued for increased capital requirements for loan committments (e.g., liquidity guarantees for SIVs) and more recently, for recognition of the credit risk on bank-sponsored Money Market Funds. And while it is indeed “child’s play for brilliant and motivated insiders to game such regulation”, it is also child’s play for a bored routiner at the regulator to update regulation. Remember: bank regulation does not need to be perfect. It only needs to be good enough. To date, I have seen no evidence that it hasn’t been good enough.

However, as I made clear in my comments on Willem Buiter’s Prescription, I am a fan of the “narrow banking” approach – although my idea of “narrow” is a lot wider than Mr. Wolf’s! You want the regulated banking sector to be fairly wide: firstly because, in general, regulation is slow to change and we should, as a society, be putting potentially good ideas to the test quickly; and secondly because the shadow banking system should not encouraged to grow so large that it will seriously endanger the entire economy.

And finally, I take exception to the last sentence quoted: “By paying huge bonuses on the basis of short-term performance in a system in which negative bonuses are impossible, banks create gigantic incentives to disguise risk-taking as value-creation.” No, Mr. Wolf. It is not the banks that are creating these gigantic incentives. It is the banks’ owners who are doing this. And if the owners of Citigroup and CIBC are so enthralled with the idea of paying fortunes of intergenerational size to bozos with no conception of risk control – why not let them?

On a related note, the monoline credit insurance agency Ambac Financial Group:

ousted its chief executive officer, slashed the dividend 67 percent and will raise more than $1 billion to preserve its AAA credit rating after announcing the biggest-ever writedowns by a bond insurer.

And remember those deeply subordinated MBIA notes, that I pointed out were really equities? They should have sold more!

MBIA Inc.’s surplus notes have tumbled as much as 12 percent since they were sold last week on concern that the world’s largest bond insurer may need to tap investors for more money.

The AA rated debt fell as low as 88.5 cents on the dollar today, according to bond traders. That’s the equivalent of a yield of 18 percent, data compiled by Bloomberg show. The notes were trading at 97.5 cents yesterday, according to Bloomberg data.

Perhaps not surprisingly, S&P will be re-evaluating the insurers:

because losses on subprime mortgages will worse than the firm anticipated.

The ratings company will examine whether insurers including MBIA Inc. and Ambac Financial Group Inc. have enough capital to withstand reductions in the ratings of the mortgage-backed securities they guarantee. The credit test will be completed within a week, said Mimi Barker, a spokeswoman in New York.

S&P is now assuming losses on 2006 subprime mortgages will reach 19 percent, up from 14 percent, as housing prices decline further than previously thought.

US headline inflation was in the headlines today:

Overall inflation in 2007 ran at its fastest rate since 1990, although core CPI inflation [excluding food and energy prices] moderated to 2.4% in 2007 from 2.6% in 2006.

By me, these figures indicate that there are no real inflationary problems – yet! – for the US, but there are two wild cards for the coming year: first, any Fed easing will increase the risk that inflation will again rear its ugly head; second, it is not apparent that the decline in the greenback relative to its trading partners has been fully reflected in these figures. It seems to me that there should be some curve steepening in the next while, particularly if central bank easing becomes the order of the day, as monetary policy controls the short end of the curve while inflation expectations rule at the long end.

James Hamilton of Econbrowser points out that:

The Fed bases its actions not on what inflation has been, but rather on what it anticipates for the future.

… and quotes a Bernanke speech that caused market excitement on January 10 when everybody else quoted a different part. Prof. Hamilton draws attention to:

Thus far, inflation expectations appear to have remained reasonably well anchored, and pressures on resource utilization have diminished a bit. However, any tendency of inflation expectations to become unmoored or for the Fed’s inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and reduce the central bank’s policy flexibility to counter shortfalls in growth in the future. Accordingly, in the months ahead we will be closely monitoring the inflation situation, particularly as regards inflation expectations.

Prof. Hamilton looks at two series: the 10-year Treasury yield and its spread against 10-year TIPS to conclude:

As long as those two series stay in their recent territory, the Fed thinks it has the maneuvering room to be aggressive about addressing the dangers of an economic downturn and financial collapse. And that’s why we’ll see at least a 50-basis-point cut in the fed funds target at the next meeting, despite the “highest inflation rate of the last 17 years”.

Further to yesterday’s note about Menzie Chinn’s post about automatic stabilizers, the Congressional Budget Office has release a report outlining the the political options (hat tip: WSJ Economics blog). It is interesting to note:

Automatic fiscal stabilizers also reduce the risk of recession. As the economy slows, slower growth of income, payrolls, profits, and production causes tax receipts to fall relative to spending––and causes outlays on programs such as unemployment compensation and Food Stamps to rise. That combination temporarily boosts demand for goods and services, thereby helping to offset some of the weakness in demand. The Congressional Budget Office (CBO) estimates that, since 1968, automatic stabilizers have added between 1 percent and 2.5 percent of gross domestic product (GDP) to the deficit during recessions, which translates to about $140 billion to $350 billion in today’s economy, and thereby helped mitigate past economic downturns. The automatic stabilizers already built into current law will partially offset any further weakening of the economy.

With the rather exciting headline Big banks consider defying rate cut, Heather Scoffield and Tara Perkins of the Globe noted:

Some of Canada’s big banks are contemplating holding their prime rates steady in the face of a rate cut by the Bank of Canada, a move that could destabilize the country’s monetary policy.

The central bank is expected to cut its key interest rate by a quarter of a percentage point on Jan. 22. But since the global credit crunch has driven up the cost of borrowing for commercial banks, some are questioning whether they should match the central bank’s move, banking sources say.

The comments on this story are, as usual, a hoot. Given that banks are now paying higher rates than non-financial corporations (due to credit concerns) and that RBC’s (for instance) cost of funds is so low:

Deposits include savings deposits with average balances of $46 billion (2006 – $46 billion; 2005 – $46 billion), interest expense of $.4 billion (2006 – $.4 billion; 2005 – $.3 billion) and average rates of .9% (2006 – .8%; 2005 – .6%).

… it is perhaps not as surprising as it might be otherwise that overnight vs. prime will decouple – at least to a limited extent. The credit crunch is affecting the markets in new and exciting ways!  Mind you – I have checked Bank of Canada data for the past ten years and the difference has only fleetingly been different from 175bp … so such a change, if effected, will be a relative novelty. Some may wish to review  BoC Working Paper 2003-9:

Although the magnitude of the impact differs between the models, the CPF and CF models respond similarly to the tighter credit conditions. As expected, the tightening of credit conditions leads banks to reduce lending and increase the loan rate. Firms react by cutting back on external funds to finance intermediate-good inputs, which causes in a fall in production. The central bank allows the deposit rate to also rise as it injects money (i.e., creates an inflation expectation) to offset the negative consequences of credit shocks. The restriction of credit impacts negatively on aggregate supply, as firms cut back on production, leading to a fall in final output. In an attempt to accommodate the deterioration in credit conditions, the monetary authority reacts by injecting more liquidity into the economy. The rise in liquidity plus the negative shift of the aggregate supply curve combine to push up the inflation rate.

The persistence of credit shocks is estimated to be quite high (i.e., rz = 0.7817). The result is that the tighter credit conditions generate persistent movements in all variables. In each case, we find that the variables do not return to their steady-state values even after 10 quarters. The implication of this result is that a worsening of credit conditions can be very persistent and have a lasting impact on economic activity. There could also be a persistent increase in the inflation rate if the monetary authority offsets the credit shock by infusing additional liquidity into the economy.

As the Banks’ researchers noted in 1994:

Banks try to avoid frequent changes in the prime rate, and they fund prime-related loans more often with 1-month or 3-month term deposits than with overnight deposits.

Most readers will be aware that the Bill/BA spread has gone completely nuts over the last six months … is it really all that surprising that the Overnight/Prime spread is at risk?

PerpetualDiscounts managed to return to their winning ways … barely! Volume was steady.

There were twenty other index-included $25.00-equivalent issues trading over 10,000 shares today.

Well, stores didn’t sell anything in December (which attracted a lot of comment, so investors thought they’d fill the need. And the equity infusions just kept coming:

Citigroup, the biggest U.S. bank, is getting $14.5 billion from investors including the governments of Singapore and Kuwait, former Chairman Sanford Weill and Saudi Prince Alwaleed bin Talal, the New York-based company said today in a statement. Merrill, the largest brokerage, will receive $6.6 billion from a group led by Tokyo-based Mizuho Financial Group Inc., the Kuwait Investment Authority and the Korean Investment Corp.

Wall Street banks have now raised $59 billion, mostly from investors in the Middle East and Asia, to shore up balance sheets battered by more than $100 billion of writedowns from the declining values of mortgage-related assets. Citigroup was propped up in November by a $7.5 billion investment from the Abu Dhabi Investment Authority. New York-based Merrill was helped by a $5.6 billion cash infusion last month from Singapore’s Temasek Holdings Pte. and U.S. fund manager Davis Selected Advisors LP.

As was reported on January 11, the capital to bail out Countrywide is actually domestic, but Bank of America is by no mean immune to the shift in fortunes:

Bank of America Corp., the second- largest U.S. bank, plans to cut 650 jobs from its corporate and investment bank and sell the prime brokerage unit that caters to hedge funds.

The bank is slashing its so-called structured products business, which packaged and sold real estate loans to investors, and will reduce investment banking in Europe and the U.S., Chief Executive Officer Kenneth Lewis said in a meeting with reporters today in New York.

Meanwhile, Menzie Chinn of Econbrowser attempts to cheer us up by reminding us of the preferred government response to recessions:

One reason to favor temporary modifications to automatic stabilizers, as opposed to permanent changes in the tax code, is that the current full-employment budget balance is probably around negative one percentage point of GDP, and we are facing an expanding deficit in the future, given the press of demographics and medical costs (see Orszag’s speech [pdf]).

The interesting stories in Canada are, of course, Quebecor and BCE. Quebecor is close enough to crisis that I gave it its own post today; Bloomberg has an interesting filler story:

A telephone repairman for Canada’s BCE Inc. barreled through a red light in May when the brakes on his company truck failed. He managed to stop only by shifting into low gear and hauling on the handbrake.

As investors led by a teachers’ retirement fund prepare to purchase BCE for C$52 billion ($51.1 billion), analysts say the cost of avoiding such perils may require selling all or part of its C$3.5 billion-a-year wireless business. Canada’s largest phone company needs to repair an aging fleet of trucks and add a TV service while paying down about C$34 billion in debt.
…
The wireless unit, whose growth is second only to the smaller satellite-TV division, may be the only BCE business that could attract investors, said Lawrence Surtees, an analyst at IDC Canada in Toronto who wrote a book on BCE. “Everything else is either flat or declining,” he said. He didn’t have an estimate for what the unit might fetch.

PerpetualDiscounts finally had a down day today, due largely to three issues of a certain bank that will remain nameless. The last down-day for this index was December 21 (the penultimate day of tax loss selling – and the last full day, since Dec 24 was an early-close); since then, the PerpetualDiscount index increased 4.56% to January 14, with thirteen consecutive trading days of gains. 

There were eighteen other index-included $25.00-equivalent issues trading over 10,000 shares today.

I spent a lot of time this afternoon worrying about my Assiduous Readers. “Geez”, I thought, “There’s nothing going on today and I can’t think of anything interesting to say about it. What will I do? Without pearls of PrefBlog wisdom, they might fall into evil habits!”

Fortunately, there was CM Equity Issue and the OSFI change in issuance limit to fill in the space.

And it looks like Citigroup’s getting serious, too:

Citigroup Inc. plans to eliminate more than 20,000 jobs, slash its quarterly dividend and collect at least $10 billion in cash from outside investors to shore up capital eroded by subprime losses, the Wall Street Journal reported, citing unidentified people familiar with the matter.

About 6,500 of the more than 20,000 job cuts will be in the investment bank, the Journal said. The largest investor to add new capital is the Government Investment Corp. of Singapore, the report said. The Kuwait Investment Authority, Saudi Prince Alwaleed bin Talal and at least one U.S. fund management firm are also investing in Citigroup, the Journal said.

So the world is recapitalizing as it should. But it definitely looks like the centre of the financial world is shifting a little!

PerpetualDiscounts were up again today as volume returned to entirely reasonable levels. The market is still volatile however – the “price moves” list is always longer than I expect!

There were twenty-one other index-included $25.00-equivalent issues trading over 10,000 shares today.

A few stories continued today …

MBIA announced its deeply subordinated bond issue (noted on January 9 will carry a yield of 14%:

MBIA’s yield is equivalent to 956 basis points higher than U.S. Treasuries of a similar maturity. The extra yield, or spread, on investment-grade bonds is 217 basis points, according to Merrill Lynch index data. The premium to own high-yield, or junk-rated, debt is 663 basis points. A basis point is 0.01 percentage point.

“That would be close to distressed levels,” said Martin Fridson, chief executive officer of high-yield research firm FridsonVision LLC in New York. Distressed bonds trade at 1,000 basis points over Treasuries of similar maturity.

The trouble with that quote, of course, is that these so-called bonds are not bonds at all. They’re equity. That’s the whole point.

And the January 10 speculation that BofA would buy Countrywide have proven accurate … which was greeted in the marketplace with a distinct lack of enthusiasm with respect to the acquirer:

Credit-default swaps tied to the bonds of Charlotte, North Carolina-based Bank of America increased 9 basis points to 89 basis points, according to broker Phoenix Partners Group in New York, suggesting deteriorating perceptions of credit quality.
…
Moody’s Investors Service today said it may cut Bank of America’s A financial strength rating. Countrywide’s “volatile mortgage asset valuations” and pending litigation may weigh on the company’s already-strained capital position. The ratings company said it may raise Countrywide Home Loans’ Baa3 ranking.

Naked Capitalism points out that a lot of the rationale for the deal is tax benefits, as BofA will be able to utilize Countrywide’s tax loss carry-forwards, a state of affairs considered evil by some. However, Accrued Interest points out that that this demonstration that acquirers do exist was very good for the beleaguered Washington Mutual:

Today WaMu stock opened up about 7%, and their bonds rallied significantly. J.P. Morgan is rumored as the acquisitor, and there is probably only a couple other banks which would even be possibilities. I heard Wells Fargo’s name mentioned, and they’d have the capital, but it would be a strange marriage for such a conservative bank. You could also imagine some Mid-West or East Coast bank having interest in WaMu’s geographical footprint, but I’m not sure any such banks have the spare capital to absorb WaMu’s problem assets. US Bank? Fifth Third? PNC? I doubt it. If I’m Jamie Dimon, even if I’d really like to own WaMu, I wouldn’t let BofA’s move force my hand. JPM may be the only actual bidder, and WaMu is probably only going to get more desperate.

Another step was taken in the Great Credit Crunch Unwinding 0f 2007-??, when Northern Rock sold off some assets:

Northern Rock Plc, the U.K. bank bailed out by the Bank of England, agreed to sell mortgages valued at 2.2 billion pounds ($4.3 billion) to JPMorgan Chase & Co. to help repay loans from the central bank.
…
“This really does look like a desperate measure,” Simon Maughan, an analyst at MF Global Securities in London, said in an interview today. “Shareholders would seriously start to object if the balance sheet was sold piecemeal out from underneath them.” He has a “neutral” recommendation on the shares.

I haven’t been shy about telling people via this blog what I think the investment business is really about (hint: not performance) and a perfect illustration has come my way via Financial Webring Forum. The guy running Ivy Canadian has never made any bones about his investment style:

The issue with Ivy Canadian is a lack of exposure to the energy and mining stocks that have largely been responsible for the doubling of the S&P/TSX composite index in the past five years. Mr. Javasky prefers to buy and hold the shares of top businesses rather than speculating in stocks dependent on commodity prices.

OK, now to me, all this sounds reasonable enough. He wants blue-chip businesses, not rocks and trees. If you want the same thing, he’ll be on your list. If you don’t, he won’t. This seems simple enough. I have no idea whether Mr. Javasky is any good at what he wants to do … that’s a question I would have to analyze further and I really can’t be bothered.

So … what does a trenchant critique of Mr. Javasky’s abilities look like, down in the trenches of real-world selling, as opposed to the rarefied academic air of PrefBlog? Here ya go …

“I applaud Jerry for sticking to his convictions, but common sense seems to have escaped him,” wrote Brandon Moore, a financial planner with TD Waterhouse Financial Planning in Penticton, B.C. “His inability to capitalize on market change isn’t what people who are paying for his services want to hear.”

There you have it in a nutshell. Tell people what they want to hear, you’ll be fine. I eagerly await a flood of eMails criticizing my worth as a human being because preferred shares haven’t outperformed the Belorussian Head-Squeezer Manufacturer’s sub-index in eight of the past ten years. But who knows? Maybe I’ll change specialties. It would only be common sense.

Another winning day for prefs in general and PerpetualDiscounts in particular. Volume moderated, but was fine.

There were sixteen other index-included $25.00-equivalent issues trading over 10,000 shares today.

Accrued Interest compares a list of the top ten corporate bond issuers (by weight) with the top ten components of the S&P 500 (by weight) and speculates that the apparent divergence between the stock and bond markets (referred to yesterday) is not so strange after all … or, at least, has something to tell us in and of itself:

Perhaps the kinds of companies who are large bond issuers are struggling in the stock market as well. Perhaps the kinds of companies which are keeping the stock averages afloat are not big bond issuers: XOM, MSFT, PG, etc.

We may be looking at a sort of weird recession coming up. One where layoffs aren’t as bad as some past recessions, but consumer spending drops substantially anyway, because of credit availability. I could see such a recession not being terribly bad for stocks. But financials are right on the forefront of these problems. If that’s how it plays out, then the financial-laden corporate bond indices will at best stay wide for a while, even if the stock market improves.

There are reports that Citigroup and Merrill are going cap in hand to foreigners, begging for equity infusions – which could run afoul of protectionists in Congress (and, depending on what happens, perhaps the White House). It will be fascinating to watch this play out over the next few years … we are seeing an increase in Canadian rhetoric over the matter, despite the fact that Canadian investment in the US is booming.

Brad Setser discusses the matter and comes up with a rather startling statistic:

The most money the IMF ever lent to the emerging world in a quarter?

$13.7b – in the third quarter of 2001 (Turkey and Argentina … )
…
Capital infusions from emerging market governments to US and European banks smarting from losses on US mortgages in q4? $28.4b, by my count.

Years of fiscal profligacy in the US are now having their effect. And the mutterings of further fiscal profligacy from the White House are forecast to have negligible effect anyway:

If stimulus is required, better policy instruments are available — foremost monetary policy. Tweaking tax policy is also a distraction from the serious long-term fiscal issues facing the nation: a persistent budget deficit of 1-1/2% of GDP, the expiration of the Bush tax cuts, and a long-term fix to the Alternative Minimum Tax, plus the looming cost of the retirement of the baby boom generation.

My obsession with preferred shares makes me a rather biased observer … but I think that the US has to decide on a long term tax policy with respect to dividends. I reported the discussion of taxes in the WaMu preferred issue on December 13 … it is a mystery to me how the US, the country whose business is business, have ended up having such a basic investment consideration as the tax treatment of dividends as a polarizing political issue.

We’re not talking a piddly little difference like ‘either a rate of 17% or a rate of 20%’ here … we’re talking 35% (Democrats) and 15% (Republicans). This is sheer craziness, but I’m not holding my breath for rationality in an election year.

Some degree of normalcy is returning to the credit markets – as indicated by the amount of US commercial paper outstanding, anyway! ABCP outstanding is up $5-billion, while foreign financial is up $16-billion.

Bernanke gave a speech today and had a few interesting things to say:

One of the many unfortunate consequences of these events, which may be with us for some time, is on the availability of credit for nonprime borrowers. Ample evidence suggests that responsible nonprime lending can be beneficial and safe for the borrower as well as profitable for the lender. For example, even as delinquencies on subprime ARMs have soared, loss rates on subprime mortgages with fixed interest rates, though somewhat higher recently, remain in their historical range. Some lenders, including some who have worked closely with nonprofit groups with strong roots in low-to-moderate-income communities, have been able to foster homeownership in those communities while experiencing exceptionally low rates of default. Unfortunately, at this point, the market is not discriminating to any significant degree between good and bad nonprime loans, and few new loans are being made.

… however, one sentence of his six page speech attracted a lot of attention:

Based on that evaluation, and consistent with our dual mandate, we stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks.

That, together with reports that Bank of America might buy Countrywide outright, lit a fire under the markets:

Countrywide climbed the most in at least 25 years after the Wall Street Journal reported Bank of America Corp. is in advanced talks to acquire the biggest U.S. mortgage company. JPMorgan Chase & Co., Wells Fargo & Co. and Citigroup Inc. led financial firms to the biggest rally in a month as traders increased bets that the Fed will reduce its benchmark lending rate by a half point this month.

Fed Fund futures were up slightly on the day, with the February contract implying 3.775% and the June contract implying 3.195% (derived from mid-afternoon prices). Note that the current rate is 4.25% and the next FOMC meeting is scheduled for Jan 29/30.

Not a bad day in the preferred market! PerpetualDiscounts continued their winning streak and there was a return good volume. Perhaps all the cowboys have come back from branding their funds, or whatever it is they do when not trading.

There were twenty-six other index-included $25.00-equivalent issues trading over 10,000 shares today.

Update: Current Senate Majority Leader Harry Reid: The Bush Tax Plan Leaves the Middle Class Behind:

FICTION: Bush Says Uncertainty Over the Extension of His Tax Cuts Harms the Economy. “The prospect of higher taxes, the notion that there’s uncertainty in the tax code makes it difficult for small business owners and company executives to plan. How can you plan if you’re uncertain about what the future’s going to be when it comes to the tax code.” [5/3/06]

 

– FACT: Not True. Economists at the Federal Reserve considered whether the temporary nature of the tax cuts might be one reason they have not had much impact on stock market value, but found that companies with no dividends performed better than high-dividend companies during the period immediately following the announcement of the tax cuts and their passage. [Gravelle, Jane G., Congressional Research Service, “Dividend Tax Relief: Effects on Economic Recovery, Long-Term Growth, and the Stock Market,” 2/14/05.]

Mike Cosgrove, Investors Business Daily, Politics Point To Higher Tax On Dividends:

Equity investors seem comfortable with the idea that the existing tax rates on dividends, capital gains and earned income will stick around until at least the end of 2010 — their scheduled expiration date. The odds of that occurring are, at best, 50-50 at this point.

One side of the 50-50 is that all major Republican candidates support extending the present tax-rate structure past 2010. The other 50 is from all major Democratic candidates who have said they will not extend existing tax rates — meaning higher tax rates on earned income, capital gains and dividends for taxpayers.

Herbert Lash, Reuters via Yahoo Investors see trade, taxes as key in White House Race:

The top Republican candidates have endorsed extending President George W. Bush’s tax cuts, except Huckabee, who proposes eliminating federal income and payroll taxes and to replace them with a federal consumption tax at the retail level.

 

Giuliani, a former New York City mayor, has proposed cutting the corporate rate to 25 percent from 35 percent. McCain supports extending Bush’s tax cuts, although he voted against them in 2001 and 2003, saying they also did not include spending reductions.

 

Among Democrats, Edwards wants to increase the tax rate on long-term capital gains to 28 percent from 15 percent, and tax dividends as ordinary income. Obama favors a rate of between 20 percent and 28 percent on capital gains and dividends.

 

Carnage continued for the shadow-banks as Countrywide hit another low. Accrued Interest looks at their bond prices and figures that estimated recovery on debt is 60%. Their CDS levels agree:

Credit-default swaps on $10 million of Countrywide debt cost $3 million plus $500,000-a-year for a five-year contract. The upfront cost increased from $2.8 million yesterday, according to broker Phoenix Partners Group.

Meanwhile MBIA, a monoline insurer that has fallen on hard times, is cutting its dividend and issuing deeply subordinated notes that it will consider capital:

MBIA Inc., the world’s largest bond insurer, will cut its dividend and raise $1 billion in a sale of notes to boost capital and preserve its AAA credit rating.
…
MBIA’s decision to raise more capital and shave its dividend is the second step in an effort to shore up its finances. The company last month said private-equity firm Warburg Pincus LLC agreed to purchase $500 million of new shares at $31 each and to backstop a rights offering of another $500 million.
…
MBIA said the so-called surplus notes will rank below all other debt, enabling them to be treated as capital. The interest will be fixed until 2013 and then switch to a floating rate.

There is no word as yet regarding what the rate is going to be on the surplus notes. In what may be regarded as a “carrot & stick” approach to getting what you want out of financial markets, Berkshire Hathaway is considering investing in the sector in addition to supporting its start-up insurer. This news was cheered by investors.

E*Trade is also taking desperate measures:

E*Trade Financial Corp., the worst performer in the Standard & Poor’s 500 Index last year, sold $3 billion of mortgage-backed securities and municipal bonds to bolster its finances.

The sale was completed at a loss of less than $5 million, the New York-based online brokerage said in a statement today. E*Trade also said it’s “aggressively” reducing risks from real- estate loan holdings and shuttered the institutional equities trading division.

Meanwhile, Goldman Sachs calls for a recession (but there’s lots of divergent views) while Philadelphia Fed President Charles Prosser warns of inflation:

The below-trend growth of the economy in the first half of 2008 will likely mean slower payroll employment growth for the first two to three quarters of the year. With slower job growth for a time, the unemployment rate may rise somewhat above 5 percent during the course of the year.   

At the same time we also face risks of higher inflation…I am concerned that developments on the inflation front will make the Fed’s policy decisions more difficult in 2008. Recent data suggest that inflation is becoming more broad-based. Recent increases do not appear to be solely related to the rise in energy prices. Consequently I see more worrisome signs of underlying price pressures…

And all this in a US election year!

PerpetualDiscounts continued their streak – up on each one of the past 10 trading days, commencing December 24 (which was the last day of tax loss selling). A lot of the big movers today were affected by the index rebalancing announced recently … I don’t know whether this was an influence or not, but it was a noticable correlation.

There were ten other index-included $25.00-equivalent issues trading over 10,000 shares today.

Update 2008-01-10: A troublemaker in the comments points out that the PerpetualPremium index had a massive change in average YTW, changing from 3.83% on 1/8 to 5.09% on 1/9.

This is due to CL.PR.B, which had a price change of 26.11 to 25.63, resulting in a yield-to-worst change of from -9.03% to +5.44%.

Index composition as of Jan 8 and Jan 9 has been uploaded for inspection.