Category: Market Action

The Bank of China has cut its GSE holdings by 25%, according to a Financial Times piece passed on by Naked Capitalism:

The sale by China’s fourth largest commercial bank, which reduced its holdings of so-called agency debt by $4.6bn, is a sign of nervousness among foreign buyers of Fannie and Freddie’s bonds and guaranteed securities.

However, MBS spreads have narrowed over the past month:

The difference between yields on Fannie Mae’s current-coupon 30-year fixed-rate bonds and 10-year government notes narrowed 10 basis points this week to 197 basis points, data compiled by Bloomberg show, reducing the cost of new home loans. The spread fell from 215 basis points on Aug. 18, the widest since March, when the gap set a 22-year high of 238 basis points.

The MCDX index (of credit default swaps on US Munis; briefly mentioned May 23; aspersions were cast May 7) is being circled by vultures. Accrued Interest suggests a spread trade against corporates, but:

I think at some point, arbitragers will put this trade on, and it will expose a lack of deep liquidity in the contract. Talking to various traders, it looks like much of the trading in the MCDX has been macro hedgers, not betting on munis in particular, but using municipals as a means of hedging against a disaster event.

I’m not entirely convinced of the goodness of this hedge. Sure, there’s a positive carry. But there’s a big size-mismatch, which can be thought of as an enormous – infinite, actually, until you actually put some capital into the deal – duration mismatch. And I must say, I’m rather surprised that Accrued Interest did not pass on, or take a stab at estimating, the basis for this trade (which is to say, the spread vs. cash bonds). In the corporate arena, the basis is negative as often as not; with all the auction rate failures I would not be in the least bit surprised to learn that the basis is bigger … but I won’t go too far out on that limb, because Munis are easier to margin (I think; based simply on their risk-weight for banks).

Anyway, why would I want to sell protection? Why wouldn’t I just buy cash bonds?

If I were a betting man, I’d bet that Accrued Interest has such a great long weekend planned that he listened, first idly, then more seriously to one of the salesmen cowboys and wrote the post to help organize his thoughts. I note that according to Bloomberg, 5-year Munis yield 2.87%, while 5-Year AAA Banking & Finance paper yields 4.91%. AI states that the MCDX contract trades at 86.25bp and CDX IG [Corporate Investment Grade] at 144bp. Hmm… I’m going to have to think about this over the weekend myself, and try to figure out what the tax effects are doing!

It is perhaps not coincidental that this opinion was published on the same day that Jefferson County managed to stave off default for another month.

And another US bank went bust:

Integrity Bank, with $1.1 billion in assets and $974 million in deposits, was shuttered by the Georgia Department of Banking and Finance and the Federal Deposit Insurance Corp. Regions Financial Corp., Alabama’s biggest bank, will assume all deposits from Integrity, which was run by Integrity Bancshares Inc. The failed bank’s five offices will open on Sept. 2 as branches of Regions, the FDIC said.
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Regions will buy about $34.4 million in assets and will pay the FDIC a premium of 1.01 percent to assume the failed bank’s deposits, the FDIC said. The FDIC estimates the cost of the Integrity failure to its deposit-insurance fund will be $250 million to $300 million.

And that’s another month done! Twenty trading days and PerpetualDiscounts were down on only four of them, returning a total of +3.91%. The total return index is now back to just below where it was on June 26 … but is still 4.90% below its May 30 level, which puts things in perspective a bit.

The weighted average pre-tax bid-YTW is 6.11%, equivalent to 8.55% interest at the standard 1.4x equivalency factor. Long Corporates were down on the month, with significant widening against Canadas; they now yield about 6.20%, so the pre-tax interest equivalent spread is now 235bp … still pretty wide!

The fund did quite well on the month. I have a back of an envelope calculation indicating that the portfolio’s gross return (before fees and expenses) was comfortably in excess of 5.50%, so I’m pretty happy about that. Turnover was a little in excess of 100% – take that, passive advocates! Commissions are significant, but market impact and spread costs can be … negative.

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

Nothing happened today.

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

Yesterday, Citigroup was reported to have advised that Fannie & Freddie aren’t dead yet. Today it was Merrill’s turn:

Merrill Lynch & Co. analysts said a bailout of the mortgage-finance companies is “premature” because losses won’t cause capital to deplete for several quarters.
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The market may be premature in expecting a rescue is imminent because the companies may not need to raise more capital to meet current requirements, the analysts said.

It’s not clear that Fannie and Freddie “need a capital injection,” [Kenneth] Bruce and [Cyrus] Lowe said in two separate reports. Still “policy makers may be forced by the controversy playing out in the market to consider various options to stabilize” the companies.
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The two mortgage-finance companies “will likely be plagued by poor visibility into the future of credit losses and the uncertainty surrounding the possible public policy actions that could jeopardize shareholders,” the analysts wrote. “Risks of further contraction in the mortgage market are as unpalatable as a high-profile bail-out.”

Both stocks are rated “underperform” at Merrill, the reports said.

Fannie & Freddie sold some more money market paper today:

Investors have been watching the debt sales for any “tell- tale” signs that Washington-based Fannie and McLean, Virginia- based Freddie can’t fund themselves, UBS AG analysts in New York including William O’Donnell wrote in a report. Today’s spreads were wide enough to attract demand, yet narrow enough to dim speculation that the government-sponsored enterprises will be forced to turn to Treasury Secretary Henry Paulson for support.
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Fannie sold $1 billion of three-month notes at a yield of 2.58 percent, the company said.
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Freddie raised $1 billion of one-month debt at a yield of 2.28 percent, or 66 basis points more than Treasuries and 18 basis points less than one-month Libor, separate data shows.
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Fannie also sold $1 billion of six-month debt today at a yield of 2.87 percent, about 93 basis points above Treasury bills

Geez, I wish that reporters would learn some of the jargon of the trade! I was all excited about the “short term notes” headline – indicating a 1-5 year term – only to find out it was money-market paper.

Assiduous Reader prefhound noted in yesterday’s comments:

You noted the other day that they needed to rollover about $120B of debt in the next 35 days. This looks to be about 7.5% of their combined debt of $1.6T, which seems an odd calendar concentration. Their recent tendency to go short term (in response to market conditions?) could make rollovers get bigger quite quickly.

Some long overdue poking around in Fannie Mae’s website uncovered their Monthly Summary Archive, which includes their Summary for July 2008. According to Table 7 of this summary, FNM has slightly under $273-billion in money market issuance outstanding and $573-billion in bonds, for a total of $846-billion. The ratio of Money-Market to Bonds outstanding has increased from 1:3.7 in July 2007 to 1:2.0 in July 2008, which is kind of interesting. It might be analytically important; it might be a cause for concern; it might not be. It is certainly something that should be understood before plunking money down on the table, however!

Anyway, if we say that one-quarter of the MM paper outstanding needs to be rolled every month (which assumes an average 4-month initial term; I have no idea how accurate this assumption might be), we arrive at required gross issuance of $68-billion monthly in MM paper simply to refinance the programme.

Bond issuance has totalled $190-billion year-to-date (compared to $194-billion for all of 2007!). If we assume that the YTD rate is representative, this comes to monthly gross issuance of $16-billion bonds.

The total comes to $84-billion to be financed monthly, which makes the figure of $120-billion in the five weeks to September 30 that I passed on in the August 25 report look at least halfway credible.

This level of dependence upon the wholesale market has been blamed for (among other things) the Northern Rock debacle; the Economist has dealt with the subject:

Start with liquidity, the obvious gap in the regulatory firewall. Liquidity risk is barely mentioned in the Basel 2 accord, largely because capital and liquidity were seen as separate (if entwined). The Basel rulemakers are due to issue an updated set of liquidity standards later this year, but devising a sensible regime is no easy task. “Liquidity risk is a kind of catastrophic risk—you either have it or you don’t,” says a senior regulator.

Authoritative references to the Northern Rock fiasco may be found in my post Earth to Regulators: Keep Out!.

Now, I don’t want anybody running out and shorting Fannie Mae because I’ve pointed out that they have an awful lot of short term financing to roll! I will simply point out that a rational investor will understand the nature and vulnerability of their funding mismatch – if any – prior to plunking money down on the table. I will stress yet again that I do not have a view on the investment merits of Fannie Mae preferreds; I’m simply pointing out the various considerations that never make it into the press due to the number of syllables in the words required to explain them.

Scared enough yet? Bloomberg reported a Moody’s press release on prime-Jumbo loans, inter alia:

The performance of mortgage pools in Jumbo transactions from 2006 and 2007 has also weakened relative to that of prior years. While the absolute level of delinquencies remains low in comparison to other RMBS segments, Jumbo delinquencies are building more quickly in recent months.

Moody’s had previously identified some recent-vintage Jumbo transactions that were at risk of downgrade based upon the performance data available at the beginning of 2008. Given the continued performance deterioration in the Jumbo sector, Moody’s is currently reviewing all Jumbo transactions that were originated in 2006 and 2007 .

Second lien pools, a much smaller proportion of RMBS issuance in comparison to first liens, have also experienced extreme poor performance. Moody’s expects 2005 vintage subprime closed-end second (CES) pools to lose 17% on average, 2006 vintage pools to lose 42% on average, and 2007 pools to lose 45% on average. However, given the wide range of deal characteristics and pool performance among transactions, Moody’s expectations for any given transactions can vary significantly.

Prime CES pools have experienced far lower losses than have subprime ones, although, like in every other RMBS sector, 2006 and 2007 vintage delinquencies and losses have been increasing. On average, Moody’s expects 2005 vintage prime CES pools to lose about 6% of their original balance, 2006 vintage pools to lose about 13%, and 2007 vintage pools to lose about 17%.

The performance of recent vintages of home equity line of credit (HELOC) pools has also weakened significantly. Moody’s projects that pool losses on 2005 vintage HELOC transactions will average about 9%, while 2006 vintage transactions will on average lose around 24% and 2007 vintage around 26%.

PerpetualDiscounts were off a bit today, with reasonable volume but a much higher than usual number of big blocks. The average YTW is 6.13%, equivalent to 8.58% interest at the standard conversion factor of 1.4x. Given that long corporates yield about 6.18%, this represents a spread of 240bp; still quite high by historical standards.

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

The Fannie & Freddie reporters highlighted what they believe to be startlingly new information today – sub-debt does not default with deferred dividends:

Buyers of credit-default swap contracts that protect against losses on Fannie Mae or Freddie Mac subordinated debt may not get paid immediately if the mortgage-finance companies were to defer interest payments as part of a government bailout, according to Bank of America Corp.

While a failure to make the payments permits credit-default swap buyers to cash in on their protection, Freddie and Fannie subordinated bond indentures allow interest to be deferred for as long as five years, or until maturity, if capital cushions breach certain thresholds, Bank of America strategist Glen Taksler in New York wrote in a note to clients yesterday.

Bank sub-debt has been discussed on PrefBlog before, as have Credit Default Swaps. The place of sub-debt in a bank’s capital structure has been mentioned in a review article.

But Citigroup says ‘calm down, people!’:

Fannie Mae and Freddie Mac can withstand losses through the end of the year and still keep a cushion above their minimum capital requirements, according to Citigroup Inc. analysts.

Freddie of McLean, Virginia, will have $12.7 billion of capital above the minimum requirement, according to slides provided by Citigroup for a conference call with investors. Washington-based Fannie will have $20.3 billion.
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The bank’s interest rate strategists led by Scott Peng in New York said last week that the beleaguered mortgage-finance companies don’t need to be nationalized and the U.S. should resist being “stampeded” into a bailout.

Speaking of Fannie, I am thrilled to announce that I have finally seen a definition of “wiped out”, as used in the phrase “Fannie Mae preferred shareholders may get wiped out!!!!!”. According to Dealbreaker:

There had been widespread fear that a government rescue of Freddie would wipe out the preferred shareholders, possibly by subordinating them to new government-owned preferred shares.

I fail to see how the simple fact of subordination to another series of prefs can be equated to a “wipe out”. They’re already subordinated to sub-debt and ordinary liabilities. Would the phrase “wipe out” continue to apply if it was simply more sub-debt being loaded on to the balance sheet? As I discussed on August 22, in the absence of (a credible threat of) liquidation or expropriation, any talk of a preferred share wipe-out at Fannie Mae is simply hysterical nonsense.

If you want to say that Fannie Mae will be liquidated with little or no value to the preferred shareholders, that’s one thing to argue. Or Treasury making an offer they can’t refuse with the threat of liquidation, that’s another. Or Treasury simply expropriating the preferred shares, that’s a third avenue of argument. But simple, straightforward subordination is not equivalent to wipe-out unless one of those arguments holds.

Freddie was downgraded by S&P today:

Standard & Poor’s Ratings Services said today that it affirmed its ‘AAA/A-1+’ senior unsecured debt rating on Freddie Mac with a stable outlook. At the same time, we lowered the risk-to-the-government stand-alone issuer credit rating to ‘A-‘ from ‘A’, the subordinated debt rating to ‘BBB+’, and the preferred stock rating to ‘BBB-‘ from ‘A-‘. The ratings that were lowered are all placed on CreditWatch Negative.
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It could be straightforward funding support through expansion of the Treasury line, buying Freddie Mac’s debt or its agency mortgage-backed securities, or it could consider an equity investment. The possibility of an equity investment is driving Freddie Mac’s equity price lower and the yield on its preferred stock higher. An equity investment by
Treasury could be accompanied by the consideration of nonpayment of existing preferred stock and common dividends.

The subordinated notes pose incremental risk to investors because of an interest deferral feature given certain trigger events tied to Freddie Mac’s regulatory capital levels. The subordinated debt covenant language also states that a deferral of the subordinated debt interest payment triggers the nonpayment of all preferred stock and common dividends, arguing for a close alignment of preferred stock and subordinated debt ratings. However, we now rate the preferred stock two notches below the subordinated debt to reflect the increased risk of nonpayment of dividends as a means of capital preservation. Furthermore, there are no covenants restricting the payment of interest on the subordinated debentures, while the preferred dividends are suspended.

The language is fairly similar in the release announcing the downgrade of Fannie Mae. I must say, a downgrade from A- to BBB- for the preferred stock given the potential for a suspension of the preferred dividend seems to me to be a far more appropriate response than hysterical screaming about wipe-outs.

But!

Wait a minute!

I just remembered!

S&P, in its role as Evil Credit Rating Agency, is paid by the issuer! Geez, that sounds terrible.

And there’s a somewhat related story that Lehman is trying to sell or spin-out-for-cash its Commercial Mortgage assets.

Accrued Interest has engaged in some blue-sky thinking about the GSEs; there’s much with which I disagree:

its looking more and more like a bailout isn’t imminent (meaning its a matter of weeks or months, not days). I expect an interim step, probably some kind of purchase of MBS, to come before any actual injection of cash.

I don’t think there will be any interim step; I think such action would be economically and idealogically indefensible.

A big part of the inherent problem in the GSEs’ current business model is that it requires substantial leverage to generate a reasonable return on equity. Think about it. They collect a relatively small fee in exchange for guaranteeing MBS. The de facto leverage created is huge, evidenced by the fact that foreclosure rates in Fannie and Freddie’s guarantee portfolio remain fairly low, and yet both GSEs are facing capital problems. There is just no way around the leverage issue if the current business model remains in tact.

Well … yes there is. The fee can become larger. And structural reforms in US mortgages are urgently needed:

Americans should also be taking a hard look at the ultimate consumer friendliness of their financial expectations. They take as a matter of course mortgages that are:

• 30 years in term
• refinancable at little or no charge (usually; this may apply only to GSE mortgages; I don’t know all the rules)
• non-recourse to borrower (there may be exceptions in some states)
• guaranteed by institutions that simply could not operate as a private enterprise without considerably more financing
• Added 2008-3-8: How could I forget? Tax Deductible

But Accrued Interest‘s main suggestion is:

Covered bonds have been advanced as a long-term solution for the mortgage market. But covered bonds, as currently conceived, would not be a good replacement for agency MBS. This is because covered bonds would not trade generically, meaning that a covered bond from smaller banks would trade as well as those from larger banks. We’d wind up with large banks dominating the mortgage market, which has its own systemic risk problems.

So what if in the future the GSEs provided some limited guarantee on covered bonds?
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This a plan combines the best parts of both the covered bond idea (alignment of incentives) and the original mission of the GSEs (lowering mortgage rates). It would also kick-start the emergence of a covered bond market, because it would give investors a known set of outcomes when buying the new bond sector.

It’s a very interesting idea … I’ll have to think about it a bit more. My first thought is that covered bonds are generally AAA anyway – how much could the GSEs charge for adding another layer of protection?

Covered bonds have been recently approved by the FDIC and were discussed on PrefBlog last fall.

When reviewing the 3Q08 BMO Financials, I noted that they were keeping assets constant while beefing up their capital – thus engaging in some gentle delevering. Bank borrowing is getting expensive:

Banks, securities firms and lenders have a record $871 billion of bonds maturing through 2009, according to JPMorgan Chase & Co., just as yields are at their most punitive compared with Treasuries. The increase in yields may cost them as much as $23 billion more in annual interest versus a year ago based on Merrill Lynch index data.

Higher refinancing expenses will restrict the ability of banks to borrow in the capital markets and lend, further cutting off credit to consumers and businesses and curbing what is already the slowest growing economy since 2001. Standard & Poor’s said last week that it had a “negative” outlook on almost half of the 50 highest-rated financial institutions in the U.S. as of June 30, the highest proportion in 15 years.

PerpetualDiscounts eased off a bit today, on reasonably average volume. What should I say? According to “Investment Punditry for Dummies”, I could say “profit taking”, “concern about this week’s bank earnings announcements”, “making room for a new BNS issue” … there’s lots of choices! I think I’ll just say “I have no idea. Ask a priest!” and leave it at that.

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

Freddie Mac had a gushing review on Bloomberg today:

Freddie Mac rose 17 percent in New York trading after a $2 billion sale of short-term debt stoked confidence the second-largest U.S. mortgage-finance company can still attract investors.
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Freddie Mac sold $1 billion of three-month notes at a yield of 2.58 percent, the company said today. That translates to about 90 basis points more than similar-maturity U.S. Treasuries and 23 basis points less than the three-month London interbank offered rate. The spreads from last week’s sale were 61 basis points over Treasuries and 32 basis points below Libor, according to Stone & McCarthy Research Associates.

The company also sold $1 billion of six-month debt at a yield of 2.858 percent, a spread of about 92 basis points above Treasuries and 25.5 basis points below Libor; compared with 80 basis points and 32 basis points last week. A basis point is 0.01 percentage point.

Well … it’s nice that they were able to finance through LIBOR, but let’s not get carried away! Let’s see how well they can finance the next month’s needs:

Fannie has about $120 billion of debt maturing through Sept. 30, while Freddie has $103 billion, according to figures provided by the companies and data compiled by Bloomberg.

… on the bond market, rather than the Money-Market, before breaking out the champagne. Unless my trusty calculator has let me down, $2-billion is less than half their daily quota until September 30 … each.

Fortunately for oenophiles, there is an excuse for some bubbly. PerpetualDiscounts were up 21bp today, bringing the total return index back to slightly above its June 30 levels … OK now it’s time to start working on June (a really, really lousy month).

The perpetualDiscount index now has a weighted average mean yield to maturity of 6.11%, equivalent to 8.55% interest at the standard 1.4x equivalency factor. Long corporates now yield in the 6.15-6.20% range, so the pre-tax interest-equivalent spread is now about 235bp.

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

Update: Dealbreaker passes on a rumour that Fed Pressures Treasury Not To Wipe Out Fannie Mae Preferreds:

The Federal Reserve has been quietly pressuring the Treasury Department not to adopt a rescue plan for Fannie Mae and Freddie Mac that would wipe out the value of their preferred shares, according to a source familiar with the matter. The Fed fears that any move that hurt the preferred could worsen the crisis in regional banks that is already under way.
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The situation is complicated, however, by the large share of preferred stock held by regional banks, many of which are viewed as possible candidates for failure in these credit crunched times. As the Financial Times reported over the weekened regional banks and US insurers hold the majority of Fannie and Freddie’soutstanding preferred stock. The Fed has begun advocating against wiping out these shares, saying the threat to stability of the banks is greater than the ‘moral hazard’ argument, a source familiar with the matter says.

As usual, it’s not clear what is meant by “wiping out”.

An Assiduous Reader sent me an article from Barrons today The Endgame Nears for Fannie and Freddie:

Should the agencies fail to raise fresh capital, the administration is likely to mount its own recapitalization, with Treasury infusing taxpayer money into the enterprises, according to our source. The infusion would take the form of a preferred stock with such seniority, dividend preference and convertibility rights that Fannie’s and Freddie’s existing common shares effectively would be wiped out, and their preferred shares left bereft of dividends. Then again, the administration might show minimal kindness to preferred shareholders; local and regional bankers have been lobbying the Bushies not to wipe out the preferred since the bankers own a lot of that paper and rely on the bank preferred-stock market for much of their own equity capital.

This is similar to the scary-scenario-base-case I outlined yesterday … but the airy assertion that the result would be “preferred shares left bereft of dividends” is more than just a little vague. Left bereft for how long? That’s the key.

As with all investing, it’s important to look behind the headlines and put actual numbers together … to date, I’ve seen no actual analysis that goes beyond “The sky is falling!”.

As an illustration – a very rough one! – of what I mean, let’s work out the value of FNMPRG under the scenario above – and let’s say that the dividend is halted for five years. Given the uncertainty in the market, we’ll say we want a yield of 10%.

FNMPRG pays a dividend of $2.29 annually; we’ll assume that this is in one payment, due exactly one year from now. At ten percent, this would imply a value of $22.90 for these prefs, before accounting for five years of missed dividends.

The five years of missed dividends, discounted at 10%, have a present value of $8.44. Subtracting this from the $22.90 that the perpetual annuity is worth, we arrive at a fair value of $14.46 for the prefs, compared to their market value of $9.76. Under this scenario, the prefs are a bargain.

This, at least, represents an attempt to put numbers on the table. Is the scenario too harsh? Too lax? Change it. Put some percentage chances on it and stick it in a pot with all your other scenarios, come up with a range of values and – if it turns out to be an attractive speculation – put a little bit of money into it, with all the other little bets in your portfolio. And, if you’ve done your homework properly, and you have kept all your bets sufficiently small that a run of bad luck or bad analysis won’t hurt you – you’ll do fine.

Naturally, if you do your homework and decide that …

• Dividends will be stopped immediately, probability 100%
• There will be no recovery, ever, probability 100%

… then your analysis will result in a fair value estimate of the prefs of $0 and you will consider them expensive. But at least you will have done your homework and put your assumptions and scenarios on the table where you can look at them.

You can let the yumps who cry Oh, the dividend might be stopped and everything is worthless boo-hoo-hoo run along home to play with their dollies.

Amidst all this, I will stress again that I am not taking a view, one way or another, on the investment merits of the GSE prefs. I haven’t done my homework. All I’ve done is try to find an actual reference to actual analysis in the press reports and been disappointed.

Accrued Interest has passed on some GSE speculation from Merrill.

Moody’s downgraded Fannie’s prefs today:

The preferred stock ratings and BFSRs remain on review for possible further downgrade. Fannie Mae’s and Freddie Mac’s Aaa senior long-term debt and Prime-1 short-term debt ratings were affirmed with stable outlooks. The firms’ Aa2 subordinated debt ratings were affirmed, but the outlook was changed to negative from stable.
…
Moody’s believes these firms currently have limited access to common and preferred equity capital at economically attractive terms.
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The downgrade and continued review for further downgrade of the preferred stock ratings reflects a greater risk of dividend omission on the preferred stock.
…
Should a capital injection result in the subordination of the existing preferred stock, or should it result in any missed preferred dividends, then the preferred stock rating would be lowered further.

I will point out that the Moody’s downgrade still leaves the prefs at investment grade, although not by much; I will further point out that the rating is an opinion on the probability of the prefs not deferring any dividends at all – in which case, the yield will be about 25%, not the 10% net that I demanded in my scenario.

All this is reminiscent of my musings on the proper analysis of FTU.PR.A; there is some doubt as to whether this will be able to pay all its dividends and 100% of principal, so its credit rating has suffered; but it’s so cheap right now that that particular scenario results in a phenomenal return. Formally, the asset coverage is only about 1.2:1, as of August 15 according to the company – but that asset coverage figure is based on the par value of $10 and the unit value of $12. Based on the current market price of the preferreds of about $7.50, asset coverage is 1.6:1 of the amount invested, a much nicer number! Even if the underlying US Financials do terribly over the next few years and the prefs eventually recover only the current price of $7.50 (which counts as a default), interim dividends (if actually received, of course) of $0.525 p.a. will have resulted in a yield of 7%, which some might consider to be rather good. There are other scenarios, which result in returns being “extremely good” … and yet other scenarios, which result in returns ranging from “lousy” to “disastrous”. Do yer homework, gents, and place yer bets! Small ones!

Oh! And I like to keep abreast of the Thornburg Mortgage situation, since that’s been the most spectacular flame-out so far into the current crunch or preferreds in North America. Investing Thoughts brings to my attention a press release on the story so far:

As of 5:00 p.m., New York City time, on August 19, 2008, holders of Preferred Stock had tendered approximately (i) 88.7% (5,786,035 shares) of the Series C Preferred Stock; (ii) 83.5% (3,340,873 shares) of the Series D Preferred Stock; (iii) 91.7% (2,900,546 shares) of the Series E Preferred Stock and (iv) 96.2% (29,161,031 shares) of the Series F Preferred Stock.

Shareholders who participate in the Exchange Offer will receive $5.00 in cash and 3.5 shares of the company’s common stock for each share of Preferred Stock validly tendered and accepted. Holders of the Preferred Stock who have previously tendered their shares of Preferred Stock continue to have the right to revoke such tenders at any time prior to the new expiration date by complying with the revocation procedures set forth in the Offering Circular relating to the Exchange Offer.

Total book value of all series of Thornburg’s preferreds was around $832-million as of Dec. 31/07.

I suppose that every now and then I should mention something about the Canadian preferred market, seeing as that’s what this blog is supposed to be about … although the market has rationalized itself somewhat over the past month, there’s still plenty of craziness left. For instance, good old BAM.PR.O, which had a very poorly received underwriting in June and performed poorly in the last half of July. Credit concerns, possibly? Well, riddle me this: Why does it yield more than the perps? It is bid at 22.90 to yield 7.33% until optionCertainty 2013-6-30, while the perpetuals BAM.PR.M and BAM.PR.N are both bid at 16.90 to yield 7.17%.

An extremely quiet day on the preferred share market today, but PerpetualDiscounts did creep up and have almost repaired July’s damage.

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

More excitement and speculation regarding Fannie and Freddie today, with some rather vague television commentary:

The companies’ preferred securities are typically held by insurance companies, mutual funds and banks, analysts said. That may cause Paulson to stop short of eliminating their holdings in any government intervention.

“The common shareholders will probably be completely wiped out,” Paul Miller, an analyst at FBR Capital Markets, said in a Bloomberg Television interview. “Preferred will also see a lot of pain. But that is up in the air because a lot of banks own the preferred. You put a lot of banks in trouble if you just wipe out the preferred also.”

The mechanism for wiping out preferreds was not specified – even the gloomiest commentary Naked Capitalism could dig up did not make Fannie’s net worth significantly negative. Forced sales of inventory could make things worse, of course – but would any responsible receiver or creditor’s committee do this?

Freddie Mac is in a much worse position, according to a somewhat more credible commentator:

Chances are increasing that the U.S. may need to bail out Fannie Mae and the smaller Freddie Mac, former St. Louis Federal Reserve President William Poole said in an interview. Freddie Mac owed $5.2 billion more than its assets were worth in the first quarter, making it insolvent under fair value accounting rules, he said. The fair value of Fannie Mae’s assets fell 66 percent to $12.2 billion, data provided by the Washington-based company show, and may be negative next quarter, Poole said.

It should be noted that all this kerfuffle isn’t just of interest to bloated plutocrats: the troubles are being passed through to retail mortgage rates:

Rates on average 30-year fixed mortgages rose to 6.37 percent this week, about the highest in six years, as yields on bonds guaranteed by Fannie Mae and Freddie Mac increased to almost the highest since 1986 relative to Treasuries. More than 70 percent of new home loans are bought or guaranteed by the government-chartered companies, known as “prime” mortgages.

I will note, yet again, that I am not taking a view on the merits or lack thereof of the Fannie and Freddie prefs – but the matter holds some general interest, at the very least, for preferred share investors because it’s an example of a situation in which the common dividend of a financial corporation has been cut and the prefs have plummetted. And I won’t say that the resolution of the problem will set a precedent … but to some extent, it will set a benchmark.

Besides, it annoys me to read stuff like: “Preferred will also see a lot of pain. But that is up in the air because a lot of banks own the preferred. You put a lot of banks in trouble if you just wipe out the preferred also.” without any indication of the mechanism or rationale underlying “wipe out” and “lot of pain”. Just once, it would be nice to see some actual analysis!

In further fallout from the unwinding of irrational exuberance, CMBS spreads are widening:

Yields on commercial real estate securities relative to benchmarks rose to near record highs on concern that Riverton Apartments, a high-rise complex in Manhattan’s Harlem neighborhood, will default on a loan.

AAA rated commercial mortgage-backed bonds widened about 37 basis points to 305.57 basis points more than 10-year swap rates during the week ended yesterday according to data from Bank of America Corp. A basis point is 0.01 percentage point.

The gap, or spread, jumped after a trustee report showed payments wouldn’t be made in September on a $225 million loan on the 1,230-unit Riverton.
…
Almost 93 percent of the New York property’s units were rent stabilized when the loan was originated, according to a JPMorgan report on Aug. 15 from analysts led by Todd. The owners intended to deregulate 53 percent of all the apartments by 2011, more than doubling the average monthly rent on those units from $894 to $2,261.

Only 10 percent of the units in the 12 buildings were converted to fair-market rents as of July, according to the Aug. 13 report from trustee LaSalle Global Trust Services Ltd. in Chicago.

Maybe the investors can run crying to mommy.

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

Update: A bit more speculation on the Fannie/Freddie prefs was reported by Bloomberg:

Small, regional banks may have the most to lose from the stumbles in Fannie and Freddie, and Paulson may risk bank failures unless he protects preferred stockholders, said Ira Jersey, an interest-rate strategist at Credit Suisse Group AG in New York. The impact on the preferred holders “may be an important driver” in Paulson’s decisions, Jersey said.

“Any wipeout of the preferreds could have implications for the capital of the greater financial system and these regional banks that might have reasonably precarious capital situations,” Jersey said. “You don’t want to make that worse if you’re the government.”

This nuance was noted by Accrued Interest in a post last Monday. Back to Bloomberg…

Treasury probably will get preferred shares as part of any bailout, eliminating the value of the common shares and causing “a lot of pain” for preferred shareholders, who will rank behind the government in payments and may have their dividend cut, according to Friedman Billings Ramsey & Co. analyst Paul Miller in Arlington, Virginia. CreditSights Inc. analyst Richard Hofmann in New York said holders should “brace” for a deferral of dividends.

The Treasury may wait until Fannie and Freddie’s capital is so eroded that regulators can put them into a receivership, said Andrew Laperriere, managing director at International Strategy & Investment Group, a money management and research firm in Washington.
…
Paulson must also weigh whether hurting preferred shareholders would cripple the $350 billion market that banks across the country also rely on for financing, said CreditSights’ Hoffman. Banks sold $76 billion of preferreds this year to bolster capital after more than $500 billion of credit losses and writedowns

Well … at least there’s been a bit of discussion of the possibilities! The trigger could be an inability to roll debt:

If either company has trouble selling bonds to finance maturing debt, Paulson’s hand may be pressed. They have about $20 billion of unsecured debt due on average every week, with more than $220 billion maturing by the end of next month.

A takeover could also be triggered if either company fails to meet its regulatory capital standards, to be released by the Federal Housing Finance Agency next month.

It should be noted that a failure to meet regulatory capital guidelines – which, as has been noted repeatedly – are pretty lax to begin with, is not the same thing as insolvency. Even Naked Capitalism was able to get that one right:

Mere solvency is not an appropriate standard for the GSEs. In their role of providing/guaranteeing mortgages, they have to be able to fund at the very best rates. That means they need to be an AAA credit, or at worst, a very strong AA. Mere solvency is BBB, perhaps even BB or B. Simply being solvent doesn’t cut it.

But … mere solvency does pay off the preferreds.

So … here’s my take on the most likely scary scenario:

• GSE can’t roll debt on terms that allow them to make a profit
• Treasury buys senior prefs, convertible into common in X years at $1
• GSE cuts dividend on junior prefs, for an indefinite period

With respect to the “indefinite period” part … it would be in the company’s best interests for the highly dilutive conversion to take place as soon as possible, since this would – presumably – reduce the dividend outflow. But it may also be assumed that no holder in his right mind will convert for as long as he gets a fat dividend while retaining convertability. Treasury might – possibly – account for this and

• Keep the conversion period short
• Step up the conversion price within the conversion period

In any event, it may be assumed that dividends to the junior prefs would resume very shortly after conversion of the senior prefs.

Have a look at the books, make up your own minds! I am not taking a view on the investment merits of the GSE prefs – but I will observe that the market can usually be counted upon to grossly overreact to adverse news; and (provided one does one’s homework, makes only bets that are favorable according to fundamentals, and KEEPS THOSE BETS SMALL AND DIVERSIFIED) … taking an informed contrary opinion (as opposed to an opinion that is simply contrary) can often be rather profitable.

Excitement over the Fannie and Freddie preferreds continues, with Accrued Interest noting in a late post that they showed good strength in the last hour of trading yesterday.

Amidst all this talk about how the preferred shareholders could be hurt by a bail-out, I think it’s time to take a better look at the mechanics of how they could be hurt. What can be done to them?

It’s easy to figure out how to hurt the common shareholders. Their dividend has already been slashed, the companies could just walk to the end of that road and cut it completely. After that, they could be diluted all to hell – for instance, the Treasury could backstop an issue of senior preferreds, convertable into common at $1. Presto! Permanent impairment for the common holders.

But pain by dilution is not a worry for the preferred shareholders. They have a claim for $X annual dividend and $Y liquidation value on the company, and that claim is not affected by how many prefs are outstanding. The enforcibility of that claim is affected – there’s the potential, for instance, for a liquidation to pay less than 100% – but (a) the claim is unchanged and (b) the company needs to be liquidated for this to happen. Liquidation is the ultimate step and will be a political decision – I don’t consider it too likely, frankly, but make up your own minds.

Another possibility is an offer they can’t refuse – as happened with the Thornberg prefs reported on PrefBlog on July 22. They were given the opportunity to exchange into a new series at twenty cents on the dollar, and all sorts of horrible outcomes were threatened if they didn’t accept. They had to accept; in liquidation they almost certainly would have gotten less, while there was an offer on the table to recapitalize the company provided they allowed impairment of their claim.

Is this scenario a valid fear for the Fannie and Freddie prefs? Well, make up your own minds – there’s plenty of people willing to state pseudonymously on the internet that everything is worthless. I’m not convinced. If such an offer were to be made to the Fannie and Freddie prefholders, I think that they could very well win a staring contest.

The most likely scary scenario that their dividends get cut off. This is basically the only action the company can unilaterally take – but it means no dividends to the common shareholders, either. Not a single penny until the preferred dividends re-start; and there may be other remedies in the prospectuses that I haven’t read. Such an action will make the common a little difficult to sell, eh? Even at $1.

And finally, Treasury could simply expropriate their rights – re-write the law and do whatever they like. Frankly, I don’t consider this a credible outcome; not when the base-case scenario of issuing senior, convertable preferred accomplishes the policy objective of wiping out the common shareholders and recapitalizing the company. If Treasury wants to punish the preferred shareholders, they might insist that dividends get suspended for ‘the duration of the crisis’; interested readers may work out for themselves what the yields are when dividends are suspended for a variety of periods. Sadly, all series of FNM prefs are non-cumulative – I haven’t done much investigation of the particulars, but I did check that!

Note that this is not intended to be an endorsement of the Fannie and Freddie prefs – I haven’t looked at the financials for myself and I haven’t parsed all of the political statements for myself. I am merely trying to point out that the common shareholders’ pain will not necessarily be transmitted 100% to the preferred shareholders.

However, Accrued Interest posted his latest thinking on the issue today – interestingly, his plan is very pref-favourable, and involves recapitalizing the GSEs to bank levels, although he does not explicitly support my desired outcome of turning them into banks, plain and simple. He notes:

Today both Fannie Mae and Freddie Mac management are meeting with Treasury officials. My take is that Treasury is setting a deadline for them to raise new capital before the Treasury acts.

As far as the common goes … well, the short interest is something fierce!

Marco Onado of Boccini University, Milan, writes a good review article in VoxEU regarding Bank Losses and Capital. He makes the points:

• Total assets grew much faster than the risk-weighted assets against which banks must hold capital – in other words, there is a good indication that European investment banks were “gaming the system”, by concentrating on assets with a low risk weight as defined by the Basel accords. At the same time, the Assets to Capital multiple of these players increased dramatically.
• The tangible component of equity decreased, which means that a part of the capital cushion was largely made of intangible assets deriving from the merger process within the banking system.
• new capital trails write-downs (i.e. the emergence of unexpected losses) by some $ 100 billion (See the IMF July Update to the Global Financial Stability Report)
• Much of the capital has been replaced with hybrid instruments (e.g., preferred shares and Innovative Tier 1 Capital), which has a lower equity content than the 100% equity content of the losses

Basically, he wants more regulation in future:

But regulators must face the hard truth, as Merrill Lynch did: “the credit crisis has destroyed the idea that unregulated financial markets always efficiently channel savings to the most promising investment projects”. This means that regulation must be thoroughly revised and capital adequacy rules must be strengthened

I must point out that his interpretation is logically fallacious. The failure of capital markets to achieve 100% efficiency does not imply that their level of efficiency can be increased by central planning. It could be – I’m willing to grant that much – I’ll listen to arguments! But it’s a non-sequiter.

PerpetualDiscounts had their second straight down-day on light volume.

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

Fannie and Freddie continue to be the focus of attention; Accrued Interest reminds us of an important point:

FRE and FNM preferreds are down another 20% or so today, threatening the $10 area on FRE Z. One trader told me he’s started to see bottom fishing here, which seems incredibly stupid to me. Bottom fishing can work as a strategy, but no one can put odds on whether the impending GSE nationalization will make preferred shareholders whole or not. This isn’t about financial analysis anymore.

Lacker just wants the damn things privatized:

Richmond Federal Reserve Bank President Jeffrey Lacker called for “demonstrably” privatizing Fannie Mae and Freddie Mac, becoming the first Fed official to publicly clash with the Bush administration’s strategy of keeping them as federally backed firms.

“I would prefer to see them credibly and demonstrably privatized,” Lacker said today in an interview with Bloomberg Television. He agreed with former Fed Chairman Alan Greenspan’s view that the two largest U.S. mortgage finance firms ought to be nationalized, then split up and sold off.

Amidst all this, there is speculation that Lehman will write off $4-billion this quarter and Naked Capitalism passes on reports that the Lehman delevering process continues:

From the New York Times

There has been widespread speculation that Lehman was contemplating a sale of Neuberger Berman, whose value is estimated by analysts to vary from less than $7 billion to as high as $13 billion (Lehman’s entire market capitalization is about $10.5 billion).

And here’s a report from the front lines:

“I’ve been at National City for 30 years and a month and for 29 of those we’ve seen nothing like it,” Thomas Richlovsky, National City’s 57-year-old treasurer, said in a telephone interview. “In past cycles certainly lending, or credit, has gotten more difficult. The cost of credit would go up. In this particular phenomenon of the last year it’s not like you can borrow money and the price went up. No, the market’s closed.”

National City on July 24 reported a $1.76 billion second- quarter loss and increased its 2008 forecast for uncollectible debt to as much as $2.9 billion. The Cleveland-based bank raised $7 billion of capital in April, which Richlovsky said is more than enough to weather the seizure in the credit markets.

The stock sale wasn’t enough to stop National City’s bonds from tumbling. Its $700 million of 6.875 percent notes due in 2019 traded last week at 61 cents on the dollar, down from 77.5 cents in June and 99 cents at the beginning of the year, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

The Ontario judgement on non-bank ABCP will be challenged by Ivanhoe, perhaps with others.

Amidst all this certainty, we can be glad that one thing in life is constant – there’s a lot of regulatory posturing on the US Auction rate market:

U.S. Securities and Exchange Commission Chairman Christopher Cox said investigations into the collapse of the auction-rate bond market extend beyond the banks that created the debt and settled with regulators to include brokerages that sold the investments.

“Nobody is getting a pass,” Cox said at a news conference in Washington today.
…
Regulators should force Wall Street banks to buy back all the auction-rate securities they created instead of investigating brokers that sold the debt, the Washington-based Regional Bond Dealers Association said in a letter to the SEC and other regulators last week.
…
Regulators focused first on the biggest underwriters, claiming they pitched securities as safe alternatives to money- market investments, even as the risk grew that the market would freeze.

Safe? What does “safe” mean? Are they talking about credit risk, liquidity risk, term risk, taxation risk, inflation risk, or one of the other million things that can go wrong? My view is that it should be treated in the same way as Canadian non-Bank ABCP should have been treated: brokers should be held liable for recommending overexposure to the asset class, but not for reasonable exposure. The credit was fine – and, as far as I know, remains fine (there are two exceptions to this generalization, I think). Liquidity … not so good.

However, consideration of more than one kind of risk – and genuine acceptance of the fact that black swans happen and all you can hope for is loss limitation by diversification – will make news reports longer than 500 words and involve a little judgement, so it won’t happen.

Amazingly, PerpetualDiscounts were weak today, losing 0.14% in their second down-day since July 16. From the close July 16 to the close today, they’ve gained 8.60%, with yields dropping from 6.63% to 6.13%. So … er … let me see … one month at 6.63% is about 0.55%, call it, so capital gain is 8.60-0.55 = call it 8% on a yield drop of 0.5% … the effective modified duration was about 16 years. Give or take. Remember, HIMIPref™ under-calculates modified duration (which is precisely 1/YTM) as a matter of computational and reporting convenience.

Today’s closing yield of 6.13% is equivalent to 8.58% interest at the standard conversion factor of 1.4x. Long Corporates currently yield a little under 6.1% … I think we can say the spread is maintaining itself around 250bp without anybody fussing too much. That used to be a long-term record!

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

Rumours swirled around Fannie and Freddie today, after a gloomy story in Barrons:

It is growing increasingly likely that the Treasury will recapitalize Fannie and Freddie in the months ahead on the taxpayer’s dime, availing itself of powers granted it under the new housing bill signed into law last month. Such a move almost certainly would wipe out existing holders of the agencies’ common stock, with preferred shareholders and even holders of the two entities’ $19 billion of subordinated debt also suffering losses.

Bloomberg’s rumours are more detailed:

Both Fannie and Freddie slid as much as 12 percent after Barron’s said government officials anticipate the companies will fail to raise the equity capital they need, prompting the U.S. Treasury to step in. Fannie is down 82 percent this year. Freddie has fallen 85 percent.
…
A rescue would include preferred stock with a seniority, dividend preference and convertibility right that would wipe out common stockholders, Barron’s reported, citing an unidentified source in the Bush administration. Treasury Secretary Henry Paulson, who received the authority he requested from Congress to help the companies, has said a bailout won’t be needed.
…
Standard & Poor’s cut Fannie and Freddie’s preferred stock and subordinated debt ratings by three levels last week to A- from AA-. S&P affirmed the companies’ AAA senior debt rating, reflecting perceived government support.

At the close, Accrued Interest made some good observations:

GSE securities of all types getting hit hard today. Interestingly, both the common and preferred shares are down ~20%. Sub debt some 200bps wider with poor liquidity.
…
The ultimate problem here is best described by Merrill Lynch’s Ken Bruce. You can dive into Freddie Mac or Fannie Mae’s balance sheet and make a good case that they don’t need new capital, at least under current forecasts for housing. You’d therefore conclude that if they were a truly private company, they’d best serve shareholders by trying to stick it out. But they aren’t a truly private company. As the perception of their capital strength wanes, policy makers are going to conclude that we are better off nationalizing the GSEs.
…
As for wiping out preferred shareholders… Remember that the big preferred shareholders are smaller banks. I don’t think it would make sense for the Administration to bolster one part of the banking system (Fannie and Freddie) at the expense of another part of the banking system (regional banks). And besides, I don’t think its necessary to protect tax-payers interests.
…
The trade is to be long senior Agency debt. There is just no way the Treasury allows anything to happen to senior debt holders. I don’t know who is playing in sub notes or preferred shares in here. No amount of investment analysis is going to help you figure what the Treasury’s next move is.

There was some discussion of the Fannie and Freddie prefs on August 8.

There was a great graph published by the Cleveland Fed in a discussion of the Student Loans Market:

Note: The spread is the three-month LIBOR rate minus the three-month financial commercial paper rate.
Sources: The Board of Governors of the Federal Reserve System; Financial Times.

The enormous volatility seems much more illustrative to me of the credit crunch than the more usual graphs of enormous spread increases:

Sunlife issues did very well today – it would appear that nobody noticed they went ex-Dividend today. PerpetualDiscounts had yet another up-day today, but the total return index is still a fraction under the June 30 value of 877.24. The fact that there has been a gain of almost exactly 8.75% since the July 16 nadir – with only one down-day in that period – should really rub it in about just how bad the first half of July was!

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