Category: Market Action

You guys all think I’m going to talk about the Lehman bankruptcy, the scramble for funding by AIG and, given the devil-take-hindmost nature of short attacks on Large Complex Financial Institutions recently, Merrill’s determination not to be hindmost. But I ain’t, except to note in passing that Merrill’s days have been numbered ever since I quit my Operations Assistant Supervisor position with them in a huff about 20 years ago. Serves ’em right.

All that stuff has been discussed to death; I have no particular insights or comments. Accrued Interest‘s post sounds a little shell-shocked. The Fed turned on the tap full force as the Fed Funds market seemed to lock up:

The Federal Reserve added $70 billion in reserves to the banking system, the most since the September 2001 terrorist attacks, to keep bank borrowing costs low after the bankruptcy of Leman Brothers Holdings Inc.

Fed funds traded as high as 6 percent, or 4 percentage points above the central bank’s target rate for overnight loans between banks, according to ICAP Plc, the world’s largest inter- dealer broker. The margin is the greatest since Bloomberg began tracking the data in 1998. The rate dropped to as low as 1.75 percent after the Fed added the temporary reserves.
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“If the fed funds rate closes high today, I would be really worried as it would mean that there really is no money out there to be lent,” said Stan Jonas, who trades interest- rate derivatives at Axiom Management Partners LLC in New York.

I’m not too sure about that ‘no money available’ line. I suspect that it’s unwillingness rather than inability that drove the spike … but there will doubtless be more data and commentary in the near future.

There’s a good review piece on VoxEU titled Transmission of liquidity shocks: Evidence from the 2007 subprime crisis:

The results of a very pronounced interaction between market and funding liquidity are consistent with the emergence of re-enforcing liquidity spirals during the crisis period. On the one side of this liquidity spiral, financial institutions were exposed to refinancing needs in the form of issuing ABCP, a situation where market illiquidity in complex structured products led to funding illiquidity. In this regard, the results also show that increased correlations between the ABCP and Libor spreads reduced the possibilities of funding from the interbank money market, thus highlighting systemic risks. On the other side of this spiral, many European banks that had large exposures to US asset-backed securities had difficulties accessing wholesale funding, inducing subsequent market illiquidity in different market segments. Due to the major importance of the interbank money market, central banks in turn intervened by reducing interest rates and providing additional liquidity to the markets in order to reduce pressures.
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The analysis presented here suggests that innovation, such as structured credit products and banks’ increased ability to move risk off their balance sheets as well as augmented interconnectedness of large complex banks, made market and funding liquidity pressures readily turn into issues of insolvency.

The full paper, on which the column is based, is available from the IMF. It makes an interesting point not highlighted in the column:

Finally, increased correlations between returns of differing asset classes due to algorithmic trading, such as by quantitative hedge funds, has heightened the vulnerability with regard to the transmission of illiquidity.

Which is kind of interesting. The great strength of a quantitative approach is that it allows the quick relative valuation of two assets (whether that relative valuation achieved so quickly is any good or not is another question entirely!) and the great strength of algorithmic trading is that it allows the quick execution of a quantitatively derived plan. Stock market “circuit breakers” were introduced in the wake of the the realization that portfolio insurance had exacerbated the crash of 1987; it is hard to tell how circuit breakers might be implemented across markets, but doubtless some regulator will be jumping up soon to tell us.

The source paper references a fascinating MIT paper by Khandani & Lo, What Happened to the Quants in August 2007?, which has the abstract:

During the week of August 6, 2007, a number of high-profile and highly successful quantitative long/short equity hedge funds experienced unprecedented losses. Based on empirical results from TASS hedge-fund data as well as the simulated performance of a specific long/short equity strategy, we hypothesize that the losses were initiated by the rapid unwinding of one or more sizable quantitative equity market-neutral portfolios. Given the speed and price impact with which this occurred, it was likely the result of a sudden liquidation by a multi-strategy fund or proprietary-trading desk, possibly due to margin calls or a risk reduction. These initial losses then put pressure on a broader set of long/short and long-only equity portfolios, causing further losses on August 9th by triggering stop-loss and de-leveraging policies. A significant rebound of these strategies occurred on August 10th, which is also consistent with the sudden liquidation hypothesis. This hypothesis suggests that the quantitative nature of the losing strategies was incidental, and the main driver of the losses in August 2007 was the firesale liquidation of similar portfolios that happened to be quantitatively constructed. The fact that the source of dislocation in long/short equity portfolios seems to lie elsewhere – apparently in a completely unrelated set of markets and instruments – suggests that systemic risk in the hedge-fund industry may have increased in recent years.

This paper looks like it has a good chance of being interesting enough to highlight … I’m working through it!

Following a press release regarding its holdings, there has been some press commentary on SunLife’s exposure to Lehman:

RBC Capital Markets analyst Andre-Philippe Hardy said he expects Sun Life to take a pre-tax charge of $167-million, assuming a 50 per cent recovery rate on Lehman exposure.

Most unpleasant, but they earn about $500-million per quarter. So, unless this relatively small exposure (about 0.3% of their investments) is a precursor of Bad Things to Come, this is a non-event for credit. They’ve got $5.2-billion in equities on the books as of June 30 … their mark-to-market losses for today alone will be comparable to their Lehman exposure.

A gory day for PerpetualDiscounts – the worst since July 16, in fact, the infamous nadir of the market – but not as bad as for stocks. Names that will be familiar in the Price Changes section below (hint: they’re all negative) include:

Brookfield Properties dropped 16 percent to C$18.99, the most since August 1993. Brookfield was cut to “market perform” by BMO Capital Markets analyst Karine MacIndoe, who said that the company may face “what is likely to be an accelerated deterioration of fundamentals” in its “core Manhattan market.”

Parent company Brookfield Asset Management Inc. slid 11 percent to C$28.49, the most since the Sept. 11, 2001, attacks on the U.S.

Canadian Imperial Bank of Commerce, which accounted for two-thirds of total Canadian writedowns, fell the most since July 24, losing 4.8 percent to C$61.11. CIBC Chief Executive Officer Richard Nesbitt said at a conference that his bank expects a loss of about C$25 million from Lehman.

Update: Inspired by a thread on Financial Webring Forum, I will post a link to Across the Curve‘s closing commentary for today. The Canadian Market saw massive steepening, but not as much action as the US; two year yield down 28bp to 2.82%; five year down 21bp to 3.09%; ten year down 15bp to 3.60%; thirty-year down 8bp to 4.05%. Bets on an easing run rampant!

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

Treasury has released FAQs regarding the FNM/FRE Preferred Stock Purchase Agreement.

Naked Capitalism reprints an article in the Financial Times claiming that a consortium including BofA is looking at Lehman. Who knows? We could be having yet another Sunday Special!

Moody’s has cut Washington Mutual’s senior unsecured rating to junk:

Moody’s Investors Service downgraded the long-term deposit and issuer ratings of Washington Mutual Bank to Baa3 from Baa2. The bank’s financial strength rating was downgraded to D+ from C-, base line credit assessment (BCA) to Ba1 from Baa2, and short term rating to Prime-3 from Prime-2. Washington Mutual Inc.’s senior unsecured rating was downgraded to Ba2 from Baa3. The rating action concludes the review that was initiated on July 22, 2008. The outlook is negative.
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Moody’s also expects WaMu to report future quarters of large losses. This could exacerbate negative market sentiment and lead to franchise impairment.
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Washington Mutual Inc.’s preferred stock was downgraded to B2 from Ba2, reflecting Moody’s view that the risk of a suspension of dividends on these instruments has risen materially.

The Auction Rate Securities shakedown in the States continues, with Fidelity close to a $300-million buy-back:

Fidelity Investments is close to a settlement with New York Attorney General Andrew Cuomo to buy back $300 million in auction-rate securities, according to a person familiar with the negotiations.

If there was misrepresentation of the product, or if clients were given grossly unsuitable advice, then somebody should be losing their license. After public hearings. If there was no such fraudulent misrepresentation, if the only problem was that investments didn’t work out as hoped, then nobody should be doing anything. Attorney General Andrew Cuomo would be well advised to look back at his schoolbooks, under “Rule of Law”. This whole business of negotiated settlements in regulatory matters is an affront to civilized values.

Hard on the heels of my speculation yesterday that the BoE was preparing the ground for a more punitive rate for its liquidity operations comes the news that the Fed’s discount window is working overtime:

Borrowing from the Fed’s discount window hit record levels in six of the past eight weeks, and reached $23.5 billion as of Sept. 10, Fed data show. By comparison, lending averaged just $779 million a week in the three months after New York Fed President Timothy Geithner urged banks to use the program.

The increasing use of the funds risks delaying banks’ disposal of nonperforming assets and capital raising. It also may make it tough to restore the rate on the loans to the historical 1 percentage point premium over overnight funds, analysts said. The Fed has lowered the rate nine times since August 2007.

The data comes from the Federal Reserve Statistical Release H.4.1. Bloomberg has a neat graph:

Nine times in twelve months! There is even some speculation that that the next move move might be a loosening:

Inflation looks likely to ebb, thanks to falling commodity prices and contained labor costs. The U.S. economy, meanwhile, may be set to take another lurch down as consumer spending gives way and the credit crunch intensifies with the plunge in Lehman Brothers Holdings Inc.’s shares.
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San Francisco Fed President Janet Yellen left open the possibility of a rate cut in comments to reporters after a Sept. 4 speech in Salt Lake City. “There is some chance” of easing credit “if things start going seriously wrong,” she said.

Well … in and of itself, Yellen’s comment doesn’t mean anything. Of course there’s always the possibility of easing. There is also the possibility of … well, just about anything!

Including Lehman’s survival! They have reportedly received some serious bids for their Asset Management business:

Lehman Brothers Holdings Inc. received bids for its asset-management unit from private-equity firms including Bain Capital LLC and Clayton Dubilier & Rice Inc., as the investment bank seeks offers for the entire firm.

The bids value the unit, which includes the Neuberger Berman fund-management business, private-equity funds and a brokerage firm serving wealthy individuals, at about $5 billion, according to people familiar with the auction who asked not to be named because the process is private.

A very good day for the PerpetualDiscount sector on decent volume.

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

A Bloomberg story pointed me towards remarks by Mervyn King of the BoE regarding long- and short-term bank funding:

we will also set out arrangements to ensure the banking system as a whole will continue to be able to access liquidity insurance from the Bank of England from October 22nd.

The objective of the new facility will be to provide short-term liquidity insurance to smooth the adjustment of financial institutions hit by unexpected shocks. The facility will be an important part of the contribution which the Bank can make to enhance the stability of the banking system. But it is not the purpose of central bank liquidity insurance to provide a source of long-term funding to the financial system – indeed it cannot do that. Only private savers or taxpayers via the government can provide such funds. So I hope everyone will understand that the proposals to be published next week, important though they are, will not and cannot solve the shortage of funding to finance bank lending, including mortgage lending.

So there’s a warning shot! I suspect that the touted new facility – the Special Liquidity Scheme (SLS) will not make new loans after October 21 – will follow Bagehot and include a far more penalizing rate for liquidity injections. The SLS fee is minimal:

Banks will be required to pay a fee to borrow the Treasury Bills. The fee charged will be the spread between the 3-month London Interbank interest rate (Libor) and the 3-month interest rate for borrowing against the security of government bonds, subject to a floor of 20 basis points.

Meanwhile there is the chance that Fannie & Freddie debt might be explicitly nationalized:

The federal takeover of the government-sponsored enterprises, or GSEs, on Sept. 7 failed to address whether the debt of Fannie and Freddie should be included in the budget, or whether it carries an explicit government guarantee. In an interview this week, Treasury Secretary Henry Paulson cited the “incongruities” in the law and said “we should be clear, is there a government guarantee or isn’t there?”

Any decision to add Fannie and Freddie to the budget wouldn’t automatically translate into an explicit government backing for the companies’ combined $1.7 trillion in unsecured debt and $3.5 trillion of mortgage guarantees. Granting the full faith and credit of the U.S. would require an act of Congress to change the companies’ legal status.

This would bring the Fannie/Freddie debt into a position resembling CMHC mortgage bonds:

CMHC’S GUARANTEE OF CANADA MORTGAGE BONDS CARRIES THE FULL FAITH AND CREDIT OF CANADA, AND CONSTITUTES A DIRECT, UNCONDITIONAL OBLIGATION OF CANADA
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CMB have been given Canada’s S&P AAA/Moody’s Aaa credit rating and a 0% capital weighting under the BIS guidelines. CMB are not subject to withholding tax by Canada.

… and its direct debt:

CMHC’S DEBT OBLIGATIONS CARRY THE FULL FAITH AND CREDIT OF CANADA, AND CONSTITUTE DIRECT, UNCONDITIONAL OBLIGATIONS OF AND BY CANADA.
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Canada credit and a 0% capital weighting under the BIS guidelines

Though mind you, the CMHC is virtually invisible to retail-level Canadians – they buy their mortgages wholesale from the banks, except for those made in order to help cities build slums. The FannieFreddieFiasco has politicized foreclosures in an election year:

U.S. Senate Banking Committee members urged Fannie Mae and Freddie Mac, the mortgage companies placed under federal control this week, to freeze foreclosures on loans in their portfolios for at least 90 days.

“This action would provide immediate relief to many homeowners” and let the companies “turn these non-performing loans into performing assets to minimize losses,” Senators Charles Schumer, Robert Menendez and other panel Democrats said today in a letter to the companies and the Federal Housing Finance Agency, which is overseeing them under the government conservatorship. The companies also should ease their policies on modifying mortgages, the senators wrote.

I guess, if you squint, you can put this politicization in the “unintended consequences” category, together with the Municipal Ratings Mess I posted about today. I just can’t resist noting another unintended consequence of feel-good politics that I learned about today: European Universities get paid for granting diplomas:

Indeed, with the notable exception of the UK, European universities display a poor performance in most international education rankings. According to both the Times Higher Education Supplement and the Shanghai Jiao Tong university rankings, only four institutions in continental Europe would rank among the top 50 universities in the world.
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More precisely, the funds allocated to a university [in Italy] increase with the total number of full-time equivalent students (FTE), which is defined as the ratio between the number of exams passed and the number of exams that students should have taken.
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The evidence suggests that a financing scheme that was meant to reward universities that produce higher value added is, instead, favouring universities with lower standards.

Surprise, surprise! It reminds me of Communist Russia’s Five Year Plans … tractor factory heads had to meet a production quota measured by weight of shipped products … and responded by building the world’s heaviest tractors.

Lehman continues to twist in the wind and is looking – urgently – for a buyer. The Bank of America has been mentioned. Why not? They’ve warmed up with Countrywide:

“This deal is so rancid and unpredictable,” said Christopher Whalen, managing director at the consulting firm Institutional Risk Analytics. “Bank of America’s executives can’t even articulate what the total liabilities from this deal are.”

Another possibility is for them simply to sell off their crown jewel, but there are financing problems:

Lehman Brothers Holdings originally sought to sell as much as 70% of its investment-management division but scaled that back to a sale of a 55% stake thinking that the private-equity firms mulling a bid would have trouble finding the financing for a bigger deal.

Final bids are due Friday, setting the stage for a weekend of wheeling and dealing if Lehman can fend off today’s brutal market evisceration of its stock, according to people familiar with the matter.
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In a comment completely unrelated to Lehman, Blackstone Group COO Tony James said Wednesday that LBO financing has a hard limit of $5 billion these days.

A lot of European junk bond product is now classified as distressed:

More than 30 percent of European high-risk, high-yield bonds are trading at distressed levels, the most in five years, stoking speculation defaults will rise.

Investors demand an extra yield over government debt of more than 10 percentage points to hold 53 of the 169 bonds in Merrill Lynch & Co.’s Euro High Yield Constrained Index. That’s the biggest proportion of distressed debt since March 2003, in the aftermath of the Sept. 11 terror attacks and the dot-com crisis.

A surprisingly quiet day on the market, with very few issues trading in substantial size. PerpetualDiscounts eked out a small gain, closing with a pre-tax bid-YTW of 6.09%, equivalent to interest of 8.53% at the standard 1.4x tax-equivalency factor. Long corporates are at 6.20%, so the spread is still a relatively high 233bp.

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

The question of whether the functions of Central Bank and Bank Regulator should be combined or not has been often discussed on PrefBlog. Elsewhere, too, like Frankfurt, with remarks by Ms. Gertrude Tumpel-Gugerell of the ECB:

The main position at that time, which remains valid today, is that there is no optimal arrangement for the organisation of supervision at the national level. All organisational models – sectoral supervision, supervision by objectives, supervision in a single authority – can in principle work well or fail depending on circumstances. However, regardless of the model, it is important that there exists a very close and smooth interplay between the central banking and the supervisory function.
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Provision of Emergency Liquidity Assistance is a clear point in case where central banks need supervisory information for decision-making. In this field, I believe that an important step forward is represented by the recent MoU on financial stability arrangement signed by the EU central banks, supervisors and ministries of finance in June 2008.

Finally, referring more to the supervisory domain but still linked to the central bank interest, the turmoil has evidenced the need for strengthening the macro-prudential dimension of regulation and supervision. This means the regulatory and supervisory requirements should be able to ensure adequate capital and liquidity buffers throughout the economic cycle. In this regard, the actual impact of the new capital adequacy regime under of Basel II will have to be monitored very closely.

Very bureaucratic! There isn’t the slightest hint of a recommendation in these remarks!

Lehman reported today:

Lehman Brothers Holdings Inc., reporting the biggest loss in its 158-year history, said it will sell a majority stake in its asset-management unit, spin off commercial real-estate holdings and cut the dividend in an effort to shore up capital and regain investor confidence.

There is little risk I can see that Lehman will flame out with the frightening speed of Bear Stearns – they have access to the discount window:

The program instituted in the aftermath of the Bear Stearns debacle, the Primary Dealer Credit Facility, could be used for funding while officials, regulators and executives find alternative sources of cash, Fed watchers said.

“The PDCF could be used to keep Lehman operating until a broader solution was found,” said Brian Sack, a former Fed research manager who’s now senior economist at Macroeconomic Advisers LLC in Washington. “The challenge is figuring out what the broader solution is.”

Lehman can borrow overnight from the central bank, with escalating costs if it keeps using the program. Because it’s a stopgap, speculation may mount that the government will again intervene to prevent a large financial company from failing, after the Bear Stearns rescue and takeovers of Fannie Mae and Freddie Mac.

Speaking of Fannie & Freddie, repercussions on the US preferred share market have been severe:

Prices of fixed-rate preferred stock fell an average of 9 cents to 71.5 cents on the dollar this week, according to Merrill Lynch & Co. index data, the biggest two-day drop in more than a decade. The 11 percent decline compares with a 1.4 percent drop in the Standard & Poor’s 500 index over the same time.
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Sales of preferred securities in the U.S. have risen 48 percent this year to about $44 billion from more than $30 billion in the same period of 2007, according to data compiled by Bloomberg. The average yield as measured by the Merrill index has risen to 10.1 percent from 8.8 percent on Sept. 5 and 7.9 percent at the end of last year.

Accrued Interest surveys the wreckage and recommends buying mortgage-backeds, while Fannie Mae has announced a $7-billion 2-year issue of its own debt (which, as Accrued Interest pointed out, had a lot taken up by central banks) … and at the same time, Vivendi has cancelled an offering of $846-million 7-years. And another US banking company slashed its common dividend:

Synovus Financial Corp., owner of 35 banks in the Southeastern U.S., will cut 650 jobs, or about 9 percent of its staff, and reduce the dividend by 65 percent to preserve capital depleted by mortgage losses.

The bank will record $15 million in costs for the two-year plan in 2008 and another $6 million later, and expects it will add $75 million in annual pretax earnings, the Columbus, Georgia- based Synovus said today in a statement. The quarterly payout was lowered to 6 cents a share.

All this excitement leaves little time for regulatory grandstanding, but some of them manage it:

Bank of America Corp. will buy back $4.5 billion of auction-rate securities to settle a nationwide probe led by Massachusetts Secretary of State William Galvin into its sales and marketing of the failed debt.

Bank of America, one of the largest underwriters of the securities, will offer to redeem the securities from its customers between Oct. 1 and Dec. 31, it said in a statement today. The Charlotte, North Carolina-based bank said it expects to record a pretax charge of about $275 million in connection with the buybacks.

Nothing like a little extortion to spice up a regulator’s life, eh?

“Liquidity” has often been mentioned in this blog – there was a story on Bloomberg today highlighting its importance in the day-to-day mechanics of bond trading:

Trading in the corporate bond market has fallen a third after averaging $26 billion a day in the first eight months of 2007, according to Federal Reserve data on primary dealers.
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The biggest bond dealers, including JPMorgan Chase & Co., and Citigroup Inc., aren’t committing as much cash to boost corporate-bond trading. That’s because they’re shoring up their capital after the collapse of the subprime-mortgage market spurred about $511.4 billion of writedowns and losses.

While corporate-bond trading is shrinking, average daily trading in government securities has risen to about $584 billion this year from $560 billion in the same period of 2007, Fed data show.

The decline in corporate-debt trading, known in market parlance as illiquidity, is prompting fund managers to demand higher compensation to buy new bonds, driving up borrowing costs for companies, including American Express Co. and Verizon Communications Inc., and reducing returns on existing securities.

PerpetualDiscounts moved solidly upward on a moderately busy day. Royal Bank issues took the spotlight, with high volume and strong performance.

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

In the wake of the Fannie & Freddie rescue comes the news that CDSs on Treasuries are rising:

Contracts on U.S. government debt increased 3.5 basis points to a record 18 basis points, up from 6 basis points in April, according to CMA Datavision prices for five-year credit-default swaps at 4 p.m. in London. Credit-default swaps on German government bonds cost 8 basis points and Japanese bonds 16.5 basis points.

I’m not sure what constitutes a “credit event” under these swaps.

The article makes another point that is being lost amidst the hand-wringing:

The U.S. budget deficit will grow next year to $438 billion, the Congressional Budget Office said today, making it harder for President George W. Bush’s successor to either cut taxes or increase spending.

The CBO Report states:

CBO expects the deficit to rise from 1.2 percent of GDP in 2007 to 2.9 percent this year (see Summary Table 1). The significant expansion in the deficit is the result of a substantial increase in spending and a halt in the growth of tax revenues. In 2008, CBO estimates, federal spending will be 8.3 percent higher than in 2007; at the same time, total revenues will probably be less than they were in 2007.

The CBO Report Web-Page has links to various tables and supporting/extracted data … and even to the CBO Director’s Blog! Geez, you know, my respect for American institutions has been monotonically increasing for the last twenty years, at least. They do things so well there! Too bad their politics is so … um … well, what with the deficit being up so much, maybe it’s time to cut taxes again!

Anyway … my point is: even if Poole’s estimate of $300-billion in Fannie/Freddie costs is correct, that’s still less than a bad year’s deficit. Armageddon is only one year closer. As I have said before, the US will eventually hit the wall on debt, just the way Canada hit the wall in 1994. Hitting the wall caused Canadians fiscal pain, but we got out from under the monster and are now pillars of fiscal rectitude – even with “What debt?” Harper in command. Old what-debt’s policies are indicative of a weakening of resolve, but I wouldn’t have expected 1994’s dose of reality to last more than 20 years anyway; but the point is that the US will eventually hit the wall, raise taxes, cut spending, get their house in order and move on.

I was pleased when Treasury took my advice regarding the structuring of the GSE rescue, but they didn’t follow my instructions of September 5:

I continue to feel that nothing should happen until the GSEs either fall below their regulatory minimum capital (a la IndyMac), or become unable to finance themselves in a normal commercial manner (a la Bear Stearns).
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Any GSE bail-out will be politically divisive enough; to take action before the last minute will simply exacerbate the attention paid to side issues while increasing the potential for future moral hazard without providing a solution that is necessarily any more effective.

Instead, they went ahead when it was still possible to argue the companies could survive on a stand-alone basis. So now the squabbling over side issues has started:

Senator Jim Bunning said Treasury Secretary Henry Paulson, by rescuing Fannie Mae and Freddie Mac, is acting like China’s finance minister and both Paulson and Federal Reserve Chairman Ben S. Bernanke should step down.
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“We no longer have a free market in the United States, we have a government controlled free market,” Bunning said in an interview. Paulson, a former chief executive officer of Goldman Sachs Group Inc., “is acting like the minister of finance in China.”

So now we’re headed for twenty years’ worth of idealogical bickering, instead of concentrating on what constitutes – or should constitute – 90% of government business: What’s gonna work best?

Naked Capitalism reprints an opinion piece by Ken Rogoff:

If central banks are faced with a massive hit to their balance sheets, it will not necessarily be the end of the world. It has happened before – for example, during the financial crises of the 1990s. But history suggests that fixing a central bank’s balance sheet is never pleasant. Faced with credit losses, a central bank can either dig its way out through inflation or await recapitalisation by taxpayers. Both solutions are extremely traumatic.

Raging inflation causes all kinds of distortions and inefficiencies. (And don’t think central banks have ruled out the inflation tax. In fact, inflation has spiked during the past year, conveniently facilitating a necessary correction in the real price of houses.) Taxpayer bailouts, on the other hand, are seldom smooth and inevitably compromise central bank independence.

Well, there is one other solution, technically. If you want to spend money you can:

• Tax it
• Print it
• Borrow it

After a period of massive expansion during which the financial services sector nearly doubled in size, some retrenchment is natural and normal. The sub-prime mortgage loan problem triggered a drop in some financial institutions’ key lines of business, particularly their opaque but extremely profitable derivatives businesses. Some shrinkage of the industry is inevitable. Central banks have to start fostering consolidation, rather than indiscriminately extending credit.

Quite true – as was first stated by Bagehot. As the turmoil decreases, the central banks should be tightening the screws, with the “penalty rate” on discount-window (including the new menagerie of special facilities) becoming more penalizing. I don’t think we’re there yet … but I suggest that bank investors should be keeping a sharp eye on their ratios and favouring banks that have, or a building up, large war chests for acquisitions in the coming buyers’ market.

As it is, shareholders are being punished in the usual fashion – huge dilution, unrealized capital losses, lower dividend expectations – and it’s only a matter of degree. It seems to me that Lehmann shareholders aren’t exchanging high-fives about putting one over the authorities:

Lehman Brothers Holdings Inc. fell as much as 43 percent in New York trading after talks about a capital infusion from Korea Development Bank ended. The Wall Street firm is continuing to negotiate with other potential investors, a person briefed on the matter said.
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The lack of a deal “is depressing shareholders and infuriating insiders,” said Richard Bove, an analyst at Ladenburg Thalmann & Co., in a report today. The bank “refuses to take what it believes are fire-sale prices for its key assets,” he said.

In the Everything Bad Always Happens at the Worst Time Department, we have issuer-side damage estimates from the Auction Rate Securities mess:

The collapse of the market for auction-rate bonds put New York state in the same position as millions of homeowners whose adjustable-rate mortgages reset: It wanted to refinance.

The state had $4 billion in debt with interest rates, set in periodic auctions, that soared as high as 14.2 percent after bidders vanished in February. That was more than triple the January average. The cost to taxpayers rose even more when the state’s first option, replacing auction-rate debt with variable- rate bonds, wasn’t available for the full amount.

Taxpayers and not-for-profit institutions across the U.S. are on the hook for the same kinds of fees and added interest as New York. The bill for replacing the $166 billion in auction- rate debt may top $7 billion, not counting extra interest, based on New York’s expenses. Most of that money is going to the same banks that created and controlled the auction market.

“It’s unfortunate that borrowing costs will rise at the very time the state plans to increase bond sales and the budget is under stress,” said Elizabeth Lynam, deputy research director at the Citizens Budget Commission in New York, a business-funded group that monitors state and city fiscal issues.

PerpetualDiscounts were down a tad on the day, but nobody noticed since Energy & Materials equities got slaughtered. The fund is doing quite well, solidly positive on the month to date and handsomely outperforming CPD … which I use as a handy external benchmark.

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

Assiduous Readers will remember that on September 5 I noted a paper regarding foreign exchange rate prediction – there is another paper on VoxEU today titled Where are commodity prices headed next? Look at exchange rates by Chen, Rogoff & Rossi:

Figure 2 shows the rate of growth of the IMF global commodity price index (the US dollar price index of over 40 exchange-traded primary commodities, weighted according to world export earnings) since 1994. It has indeed been highly positive in the past 5 years, resulting in the high price levels shown in Figure 1. Our forecast based on the exchange rates, labelled “Model Forecast”, is strikingly close to the actual realisation. Indeed, we find that such forecasts of future commodity prices are significantly better than forecasts that rely on traditional statistical models, such as an auto-regression or a random walk.
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This forecasting success of commodity currencies is no deus ex machina but has a sound and intuitive economic basis. It follows naturally from the fact that exchange rates are asset prices that embody expectations of future movements in macroeconomic fundamentals, specifically ones that will directly affect the exchange rates. For commodity currencies, global commodity prices matter to their exchange rate values.

I am hesitant to criticize anything by Rogoff (for whom I have great respect) in the field of FX (his speciality) … but as stated in this very brief article, the mechanism sounds a little circular. ‘We can’t predict FX rates, but we can use them to predict commodity prices, because they’re moved by predictions of commodity prices which predict FX rates’.

The best stab I can make – as a complete non-specialist, understand, and looking at no actual numbers whatsoever – is that FX rates might be driven by foreign takeovers of producers by other producers (a mechanism often seen in Canada over the past few years) who might have a better handle on balance of risks (impending shortages and lengthy order books) than might the general public. But this mechanism is not investigated in the paper.

Top credit market story of the day was, of course, the fallout from the Fannie/Freddie takeover. Mortgage Backed Securities gapped in big-time which generated a lot of duration buying, which caused Treasuries to rally.

Fixed-Reset issues celebrated their ascension to respectability (by which I mean, of course, incorporation into the HIMIPref™ database) by losing money. PerpetualDiscounts had a good day.

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

James Hamilton of Econbrowser passes on a debunking of Shadowstats … I confess, I have not examined the issues raised very closely, but this is the sort of thing I like to see. The internet has offered looney-tunes a pulpit, which is generally a bad thing; on the other hand, it makes this kind of thinking more visible and susceptible to criticism.

You can tell where my sympathies lie, despite my professed ignorance regarding this particular issue! Assiduous Readers will remember the forecast of the end of the world last February, narrowly averted when it was shown that Armageddonists can’t read balance sheets or do arithmetic.

Accrued Interest reviews the GSE situation and sets up a straw-man proposal:

What if the Treasury agreed to guaranty the principal (not the interest) on a preferred stock offering.
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The preferreds would be callable after 5 years, with the call becoming automatic if the GSEs share price reaches some milestone. The idea would be that if the GSEs are able to issue common equity, then they would be forced to call the tax-payer backed preferred and issue their own securities of some variety.

The Treasury could charge some fee in exchange for the guaranty.
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Here are the advantages of such a plan. First, it could be implemented right away, allowing for stability in the mortgage market and likely a decline in mortgage lending rates. Second, its probably a cheaper plan for tax payers when compared with other options.
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Unfortunately, this kind of solution has a number of problems. First, it creates all kinds of moral hazard, as common equity holders wind up benefiting from the tax payers risk.
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Second, this plan doesn’t move us any closer to a more permanent solution to the problem of macro risk and the GSEs.

Well, I don’t like the plan either! I continue to feel that nothing should happen until the GSEs either fall below their regulatory minimum capital (a la IndyMac), or become unable to finance themselves in a normal commercial manner (a la Bear Stearns). Then Treasury steps in and backstops a rights issue of senior preferred shares convertible into common at a dollar, possibly with a provision that no dividend be paid on the existing and suddenly junior preferreds until some specified capital ratios are met.

Any GSE bail-out will be politically divisive enough; to take action before the last minute will simply exacerbate the attention paid to side issues while increasing the potential for future moral hazard without providing a solution that is necessarily any more effective.

And what to do now? Start drafting legislation that turns the GSEs into regular banks. And start weaning the American mortgage market off fully open mortgages with a 30-year term. That’s the root of the problem.

But stay tuned! After the markets closed, the WSJ said Treasury is Close to Finalizing Plan to Backstop Fannie, Freddie. There are no details, but speculation is rampant on, for instance, Accrued Interest, Bloomberg and Dealbreaker.

Jian Wang of the Dallas Fed writes an interesting review on VoxEU: Understanding exchange rates as asset prices and comes to a conclusion that is consistent with my understanding of the FX markets and markets in general:

In a seminal paper, Richard Meese and Kenneth Rogoff (1983) found that economic fundamentals – such as the money supply, trade balance and national income – were of little use in forecasting exchange rates, at least over short to medium time horizons. They compared existing models to an alternative in which fundamentals are excluded and any exchange rate changes are purely random. They found the “random walk” model to be just as good.
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We argue that exchange rate movements may be driven by both a permanent long-term trend and some transitory noise. These noisy terms can drive exchange rates away from their long-run levels in the short run. As time passes, exchange rates gradually move back to their long-run levels, exhibiting long-horizon predictability. In several models, such as the monetary model and the Taylor rule model in Engel and West (2005), the short-term noise is related to a fundamental that isn’t observable – the risk premium for holding a currency, for example.

Not much price action today, on reasonable volume. All eyes were on the stock market!

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

I posted a little while ago about Central Banks and the Eligibility Premium … today there was a dramatic illustration (maybe!) about the suddenly enormous importance of access to central bank lending facilities in a Bloomberg story on European bank risk:

The Frankfurt-based central bank will cut 12 percent from the value of asset-backed securities it accepts as collateral, ECB President Jean-Claude Trichet said at a press conference today, an increase from as little as 2 percent previously. Hard- to-value assets will have an additional premium of 5 percent, Trichet said. Unsecured bank bonds will have a 5 percent haircut. The new rules apply from Feb. 1, 2009.
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Credit-default swaps on the Markit iTraxx Financial index of subordinated debt of 25 European banks and insurers climbed 9 basis points to 174, the highest since April 1, according to JPMorgan Chase & Co. prices at 3:02 p.m. in London.

I am by no means convinced that this is direct cause and effect; and I am by no means convinced that the CDS market has any connection with reality; but both possibilities are subject to discussion!

Moody’s has discovered another CPDO programming error:

Moody’s Investors Service said it may cut the ratings of 854 million euros ($1.2 billion) of constant proportion debt obligations after disclosing a second error in the way it assesses the securities.

Moody’s review was “prompted by the identification of a coding error in a model used for monitoring CPDOs,” the New York-based firm said in a statement today. Moody’s will probably downgrade the affected CPDOs by one or two levels, it said.

Their last whoopsee was discussed on PrefBlog on May 21. CPDOs in general have been introduced to Assiduous Readers in connection with disputes over credit quality.

Pity poor Lehman! I confess I haven’t been following the story very closely as it twists in the wind, but given that its Price/Book Ratio is reported as 0.49 with an Enterprise Value of NEGATIVE 210-billion [a misprint?], my suspicion is that it has a lot of highly illiquid assets that investors are assigning a value far below the value management thinks they’re worth. So … they’re going to try to spin them off:

Lehman Brothers Holdings Inc. may shift about $32 billion of commercial mortgages and real estate to a new company that will be spun off in a move similar to the good-bank-bad-bank model used in the 1980s banking crisis, two people briefed on the discussions said.

The bad bank, nicknamed Spinco for now, would have about $8 billion of equity coming from Lehman, the people said, speaking on condition of anonymity because the plan is one of several under consideration. Spinco would borrow the remaining $24 billion from Lehman or outside investors.
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Korea Development Bank has been in discussions to buy a 25 percent stake in Lehman for $6 billion, according to the people familiar with the talks. That would replace most of the capital Lehman would put into the bad bank.

The OSC has a survey on product suitability (hat tip: Financial Webring Forum). Assiduous Readers now have their long desired chance to tell the regulators that investments should be sold to the public only if they go up. The committee has indicated that anonymous submissions will not only be read, but actually be taken seriously.

Sadly, there is no corresponding survey regarding Advisor Suitability. Force publication of composite performance – publish it on the regulatory website, disk storage of all that data is cheap enough – and most problems disappear instantly.

On a happier note, I’ve decided I like commodity crashes better than financial crises:

The Standard & Poor’s/TSX Composite Index fell 2.5 percent to 12,814.14 in Toronto. Canada’s equity benchmark, which derives about two-thirds of its value from energy, materials and financial stocks, has fallen 7 percent in three days and is 15 percent below its June 18 record.

Even after today’s slight loss, PerpetualDiscounts are up 25bp on the month-to-date, a lack of correlation much more to my tastes than was the case during the dark days of July.

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

The Bank of Canada held the overnight rate steady at 3.00%:

Global inflationary pressures remain elevated, with potential implications for import prices and the dynamics of inflation in Canada. While total CPI inflation has moved above 3 per cent, core inflation has stayed at 1.5 per cent as expected. The temporary factors affecting both of these measures should dissipate over the coming quarters, and the Bank continues to expect that total and core inflation will converge on 2 per cent in the second half of 2009. However, the recent decline in both spot and futures prices for energy means that the spike in total CPI inflation expected between now and the first quarter of 2009 will be lower than projected in July.

Although an argument can be made for a rate cut, it is not clear and compelling. Most of the world’s central banks are tightening or are thinking about it – just today, there are updates on the Fed, the BoE and Indonesia); I don’t think the BoC will swim against the tide without a clear and compelling reason.

The collapse of Ospraie’s flagship hedge fund was mentioned yesterday; there are some rumours that natural gas brought it down while others finger copper.

The Clear Channel LBO debt might be clearing:

Banks led by Deutsche Bank AG are seeking to sell $980 million of Clear Channel Communications Inc. bonds in the biggest sale of leveraged buyout debt since March.

The 10.75 percent, eight-year notes are scheduled to price early next week, said a person familiar with the transaction, who declined to be identified because terms aren’t set. The debt helped to finance the radio-station operator’s buyout by Bain Capital Partners LLC and Thomas H. Lee Partners LP.

… and, perhaps not entirely coincidentally, Blackrock is setting up another vulture fund:

BlackRock Inc., the biggest publicly traded U.S. asset manager, is seeking as much as $3 billion for a fund to buy loans that banks are selling for losses, said two investors with knowledge of the matter.

BlackRock Credit Investors II will invest in leveraged- buyout loans that banks are trying to unload after the collapse of the subprime-mortgage market drove investors away from all but the safest securities, the investors said. Last year, New York- based BlackRock raised $3 billion for its first such fund.

As all Assiduous Readers know, one of my macro-economic fears is that regulators will make all but the most plain-vanilla securities too risky to sell to the usual recipients of their back-dated largesse. This may be happening with municipalities and interest rate swaps:

JPMorgan Chase & Co., under investigation in a federal antitrust probe of derivative sales in the $2.6 trillion municipal bond market, will stop marketing products such as interest-rate swaps to municipalities, a spokeswoman said.

The bank will still arrange derivatives for non-profit organizations and sell commodity derivatives to municipalities, said JPMorgan spokeswoman Kristin Lemkau. Derivatives are contracts whose value is derived from tradeable securities, or linked to future changes in lending costs.

Geez, when the rules change on a backdated basis, people don’t want to play anymore, eh?

Another solid up-day for the PerpetualDiscounts.

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

The most interesting news items of the day got their own posts (TD Capital to Issue Asset-Backed Tier 1 Paper, Swiss Bank Regulator to Impose Assets-to-Capital Multiple Cap, New Issue: TD Fixed-Reset 5.00%+196bp) so there ain’t much left to report!

Ambac got permission to set up a new bond insurer. After all, you can’t just let Buffet get his own way all the time!

PrefBlog’s “Whoopsee!” Department reminds me to link to a Bloomberg story about a hedge fund:

Ospraie Management LLC, the investment firm run by Dwight Anderson, will close its biggest hedge fund after it fell 38.6 percent this year because of losing wagers on commodity stocks, according to a letter to investors.

The Ospraie Fund lost 26.7 percent in August, after a “substantial sell-off in a number of our energy, mining and resource equity holdings,” Anderson, 41, wrote in the letter today.

I don’t know, particularly, why so many of these things are called “Hedge” funds … most of the ones I’ve seen are really “highly leveraged macro-bet” funds. But perhaps I’m just bitter, what with not being able to find funding for my own idea … a hedge fund, really hedge, trading preferred shares could, I am quite confident, make good money for non-taxable investors.

PerpetualDiscounts performed well on a slow day.

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