Category: Market Action

I am feeling a bit shagged and fagged and fashed, it being a day of no small energy expenditure, O my brothers and only friends.

In other words – not much commentary today, folks! Just a pathetically small collection of links.

It’s not just housing any more … Econbrowser‘s James Hamilton took a look at Monday’s economic releases and didn’t like what he saw.

Monoline Death Watch … Naked Capitalism takes a few gratuitous shots at bond insurers. I am surprised to learn that there are still a few people in the world who consider Credit Default Swap spreads to be related, somehow, to Credit Default Risk. Besides all the other problems, forced unwinding (by, f’rinstance, Apex & Sitka of BMO fame) is elevating these spreads to hell ‘n’ gone.

Update 2008-3-6: I note the following:

The higher costs are an unintended consequence of securities that allow investors to speculate on corporate creditworthiness. So-called correlation models used to value them have become unreliable in the fallout from the U.S. subprime mortgage crisis. Last month some showed the odds of a default by an investment-grade company spreading to others exceeded 100 percent — a mathematical impossibility, according to UBS AG.“The credit-default swap market is completely distorting reality,” said Henner Boettcher, treasurer of HeidelbergCement in Heidelberg, Germany, the country’s biggest cement maker. “Given what these spreads imply about defaults, we should be in a deep depression, and we are not.”

— end of 2008-3-6 update

Ten Year Treasuries Fall … It will soon be fashionable again to call oneself a “bond vigilante”.

Rather a quiet day for prefs, on the whole … even the price moves are basically just reversals of the more egregious recent zig-zags.The market drifted up, but has not recovered the ground lost after the TD New Issue announcement.

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

Accrued Interest leads off with an interesting post on the US Municipal market:

What’s the result? Friday it was possible to buy 5-year pre-refunded municipals (which are backed by Treasury bonds held in escrow) at yields in the 3.50’s. In other words, around 80bps higher than Treasury rates. That is literally Treasury credit at a 80bps spread to Treasuries tax-exempt. Dozens of large new issue municipal deals came at significant spreads to Treasury rates.

There’s an interesting aside to this escrow issue which may be unfamiliar to Canadians – when the municipalities buy Treasuries to defease their issues, they don’t really care (too much) about the price. They have their list of things to buy which, while not carved in stone, is pretty inflexible: too much mismatch with their bond liabilities and the assets won’t pass muster. So they’ll go on the Street and sweep up whichever Treasuries they need.

Very often, they’ll buy more than is available, with the dealers shorting the issues to them. The end result is often that firstly the issue trades well off the yield curve AND goes special in the repo market (when you borrow bonds, you collateralize with cash. The bond lender pays interest on this cash at the “GC”, “General Collateral” rate. If the particular bond issue is scarce on the repo market, the bond lender can get away with paying less than the GC rate, which is referred to as going special).

This state of affairs affects off-the-run Treasuries in the under-three-year term. And the moral of the story is … don’t invent bond strategies that assume all short treasuries can be borrowed at the GC rate, because very often they can’t!

Related to the US Municipals story is MBIA – in the news again today with one investor placing a big bet:

Third Avenue Management LLC’s flagship mutual fund purchased 10.6 million of MBIA’s common shares at $12.15 each in February, Whitman said in a letter to shareholders released this week. New York-based Third Avenue, which Whitman founded in 1986, also bought $197 million of MBIA surplus notes.

This follows disclosure of long-term restructuring plans:

A plan to split MBIA’s structured-finance business from its municipal insurance operation in the next five years will make the Armonk, New York-based company more transparent, Chief Executive Officer Jay Brown said in an interview today on Bloomberg Television.

It’s an interesting story to watch!

Getting back to municipals for a moment, there is at least one indication that the market is – slowly – normalizing:

California, the largest borrower in the U.S. municipal market, sold $1.75 billion of bonds after attracting record demand from individuals amid the highest tax- exempt yields in more than three years.

The state got orders from more than 4,000 investors equal to over 72 percent of the bonds available, said Tom Dresslar, spokesman for California Treasurer Bill Lockyer. Officials, who were to complete the sale tomorrow, were able to wrap it up a day early after selling the rest of the debt to institutions.

… which just goes to show ya … ignore the headlines … behave sensibly … you’ll do fine.

On the other hand, though, there’s one market that’s getting sillier. Naked Capitalism brings to my attention the fact that real yields on 5-Year TIPS are negative:

Yields on five-year Treasury Inflation-Protected Securities fell below zero for a third day on investor speculation that inflation will quicken as the U.S. economy slows.

Yields on the securities, known as TIPS, dropped to minus 0.036 percent on Feb. 29, according to Barclays Capital Inc., the biggest dealer of the securities. It was the first foray below zero since five-year TIPS were first sold in 1997, according to the firm, one of the 20 primary dealers that trade directly with the Federal Reserve.

It brings to mind one of my favourite factoids …. at times during the Great Depression, T-Bills traded above par. This doesn’t make a lot of sense until you consider the alternatives … put your cash in the bank and the bank fails … keep your cash under your mattress and get robbed. I can’t find hard proof of this factoid, however … anybody who can help me will deserve my most earnest thanks. 

Speaking of interest rates, how about that Bank of Canada, eh? Scotia has announced prime of 5.25% effective 3/5; so has TD and National and CIBC and BMO. I don’t see anything for RBC yet, but it’s a pretty good bet! Oddly, each of the three Prime-Rate-Dependent HIMIPref™ indices was up on the day. Well, I find it odd, anyway! Were traders of these shares pricing in a bigger cut? Are they now looking forward to faster hikes sooner? Is it just random chaos? Somebody tell me, because I don’t know.

TD announced today that the new issue greenshoe was fully exercised, indicating that the underwriting did very well, even as the preferred market went down (which might indicate indigestion). Will other issuers find the situation encouraging or not? The Shadow knows!

The market was weak, but the volume was up … maybe the Technical Analysis guys will short whatever they can get on this news. That’s fine … I’ll sell em some liquidity!

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

All the problems with Municipal Auction Rate Securities lead one to the not terribly difficult conclusion that the issuers, where possible, will redeem them and replace them with fixed-rate debt … unfortunately, that highway looks gridlocked:

U.S. states and local governments may extend the worst slump in municipal bonds on record as they replace as much as $166 billion of auction-rate securities.

California, Boston’s biggest hospital and Duke Energy Corp. are converting their bonds to other types of tax-exempt debt after auction failures drove rates as high as 20 percent. The potential supply equals almost 40 percent of the municipal securities sold last year, overwhelming a market that tumbled 4.9 percent last month, according to indexes maintained by Merrill Lynch & Co., which began compiling market data in 1989.

This prompted Naked Capitalism to launch another vitriolic attack on the Credit Rating Agencies:

Now the New York Times piece, on page one, is no doubt intended for a broad audience, so it explains (without giving comparative default rates, which would have been useful), that rating agencies grade muni bonds more harshly than corporates:

At every rating, municipal bonds default less often than similarly rated corporate bonds, according to Moody’s. In fact, since 1970, A-rated municipal bonds have defaulted far less frequently than corporate bonds with top triple-A ratings. Furthermore, when municipalities do default, investors usually receive some — or even all — of their money back, unlike in most corporate bankruptcies….. Moody’s estimates that more than half of the market would be rated triple A or double A using the corporate scale. Triple-A securities are considered nearly as safe as Treasury bonds issued by the federal government.

However, the piece notes rather blandly the central conflict of interest: that rating agencies have good reason to have established and perpetuated this double standard. When less than AAA municipalities go to buy bond insurance, they are paid again to issue the second rating.

Naked Capitalism does not explain why all fault lies with the Credit Rating Agencies and not with the issuers and investors; nor does he speculate why Moody’s, for instance, would choose to publish explanations of their municipal rating scale if it’s such a big secret.

There’s a thread on Financial Webring Forum discussing long-term equity premia. It is clear that the long term equity premium will vary, moving marginally up and down in response to transient mispricing – this was discussed in a paper by Campbell, Diamond & Shoven, presented to the (American) Social Security Advisory Board in August 2001 (quoted with a different author for each paragraph):

The yield on long-term inflation-indexed Treasury securities (TIPS) is about 3.5%, while shortterm real interest rates have recently averaged about 3%. Thus 3% to 3.5% would be a reasonable guess for safe real interest rates in the future, implying a long-run average equity premium of 1.5% to 2.5% in geometric terms or about 3% to 4% in arithmetic terms.

In evaluating proposals for reforming Social Security that involve stock investments, the Office of the Chief Actuary (OCACT) has generally used a 7.0 percent real return for stocks. The 1994-96 Advisory Council specified that OCACT should use that return in making its 75-year projections of investment-based reform proposals. The assumed ultimate real return on Treasury bonds of 3.0 percent implies a long-run equity premium of 4.0 percent. There are two equitypremium concepts: the realized equity premium, which is measured by the actual rates of return; and the required equity premium, which investors expect to receive for being willing to hold available stocks and bonds. Over the past two centuries, the realized premium was 3.5 percent on average, but 5.2 percent for 1926 to 1998.

My own estimate for the long-run real return to equities looking forward is 6 to 6.5 percent. I come to that using roughly the parameters chosen above. If the P-E ratio fluctuates around 20, the cash payouts to shareholders should range from 3 to 3.5 percent. I am relatively optimistic about the possible steady-state growth rate of GDP and would choose 3 percent for that number.

Note that the paper was written near the height of the tech-bubble; the authors agreed that the market was over-valued at time of writing. 

However, there seems to be a belief by some that long-term GDP growth caps the equity premium, which is nonsense. Long-term GDP growth may well cap corporate revenue, but not equity returns. A corporation that has grown (at 10% p.a., say) until it has reached the limits to growth (revenue of some percentage of GDP) can then pay dividends comprised of the earnings it doesn’t need to retain. Alternatively but almost equivalently, it may choose to buy back stock – presumably, the choice would be made according to whether the market price of the stock was considered cheap or expensive on a long-term basis.

Corporations will pay dividends and buy back stock in order to maximize returns on equity while at the same time providing themselves with enough cushion to survive a downturn. Investors will demand a premium to compensate for the chance they’ll have to sell during one of those downturns. There is no mathematical limit to the size of the equity premium; the practical limit historically has been about 5%.

Taxation muddles matters, of course, but this debate has implications for preferred share investors, since the equity premium should set a cap on preferred spreads. How much of the equity premium can be captured, vs. how much equity risk is inherent in prefs? Now, me, I don’t think this is a topic doing a LOT of work on with respect to asset allocation, given standard market chaos, but is something to keep an eye on!

The big preferred share news today was the long-anticipated (by me, anyway!) new issue – an issuer finally looked at the recent improvement in the market and decided to test the market. It was TD 5.60% perps – and I understand the offering of $200-million went very well.

This knocked the market down considerably, but volume was nothing special … the rest of the week will be interesting … will other issuers attempt to jam in their own issues while the window’s open? Regardless of whether they do or not, is today’s price action an automatic and transient response to a new issue, or a sign of saturation? Stay tuned!

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

Won’t be much today, folks! Besides month-end stuff, I was working on my “Auction Rate Securities : Hibernation Sickness – a review of this week’s Municipal Auction Rate Securities activity. Still sick, but on the rebound … and it appears that hedge funds are throwing in stink bids.

Sitka / Apex Update – BMO still in restructuring talks.

Naked Capitalism : Leveraged Funds Hurry to Sell $100-billion of Debt – there’s a lot of Medium Term Note issuance coming due this year … if they can’t roll it or otherwise refinance it, there’s going to be yet more Asset Backed paper desperately looking for a home.

Naked Capitalism : Did Mark-to-Market Accounting Create the Credit Bubble? … Well, it sure helped! And it’s definitely speeding the way down!

Perpetuals (of both flavours) ended the month on a down-beat, but PerpetualDiscounts were still up 3.03% on the month, which will do for now! Volume was OK.

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

Accrued Interest leads off today with a very good piece on credit ratings, concluding:

On Monday, the Dow rallied nearly 200 points, and credit spreads almost universally tightened. Why? Because a AAA rating for MBIA and Ambac means that banks won’t have to pledge more capital against downgraded ABS. This gives them more capital to lend into the economy. No matter what you think of S&P’s analysis, that’s the reality. If that reality bothers you, perhaps your derision should not be aimed at S&P or MBIA, but at the banking regulations that are so heavily reliant on ratings.

Indeed. For an investor, a credit rating is an opinion; for a bank, a credit rating is the law. It was the regulators who made this move – with a certain amount of sense; the credit ratings agencies have a better track record than most – and now the regulators are busy trying to make the agencies the villains. 

There are howls of outrage over reports that the agencies encouraged the monolines to diversify:

Insurance regulators did not stop the financial guarantors from expanding their busineses out of the muni market, a dynamic that one of the moderators suggested could nevertheless play out in future business cycles. In response, Dinallo said his understanding of the current crisis was the the bond insurers were encouraged to expand into the structured finance by the rating agencies, who asked them to expand their books of business.

“From what I have learned so far, the bond insurers were encouraged by the rating agencies to improve their returns on equity and seek diversification through doing this structured business,” Dinallo said.

And Naked Capitalism further indicates displeasure at bank-operated credit analysis :

That procedure allows them to tell the regulators how much equity they need to hold, putting the inmates in charge of the asylum.

The source document for that post urges three steps to improve internal credit analysis:

• Do a follow-up study using data from the Credit Crunch!
• Enforce a “raw leverage” maximum … no risk weights, no credit conversion factors, just a straight assets/equity thing.
• Make some amount of subordinated debt mandatory

All that’s reasonable enough (the second item is a standard feature of North American regulation); the uncertain desirability of mandatory sub-debt has been previously discussed.

Naked Capitalism also publicizes charges that the Auction Rate Securities market has always been manipulated:

DealBreaker does some serious reporting today, informing us that some traders have told them that the failed auction rate securities market was always dependent on stabilization by dealers.

But this raises the question of why the markets were faltering in the first place. In our earlier reporting, we revealed how accounting changes may have set some corporate buyers running for the exits from this market. More recent conversations with a broader array of bond traders and dealers points toward another possiblility—the market never had enough buyer demand to support itself and has been dependent on stabilization from the banks for a very long time.

I find it fascinating that there are some implications from accounting changes; if anybody can track down what that little snippet is all about, please let me know! But, as with taxation, accounting has become a complex system – a complex chaotic system – and seemingly small changes can lead to huge, unforseen and (practically speaking) unforseeable consequences. On the bright side, of course, it creates work for lawmakers, regulators, accountants and lawyers; while providing Portfolio Managers more credence for the “Well, gee, how was I supposed to know that?” defense of poor returns. All is for the best in this, the most perfect of all possible worlds.

From the what goes up must come down department comes story about dead cowboys:

Peloton Partners LLP, the London- based hedge-fund firm run by former Goldman Sachs Group Inc. partners, is liquidating its ABS Fund after “severe” losses on mortgage-backed debt and demands from banks to repay loans.

Peloton, founded by Ron Beller and Geoff Grant in 2005, is seeking buyers for the $1.8 billion fund’s assets, according to a letter sent today to investors. Firms including Citadel Investment Group LLC and GLG Partners Inc. have made bids, two people familiar with the situation said.

The fund’s demise after an 87 percent gain last year highlights the severity of the U.S. subprime-mortgage collapse, which has spread to AAA-rated securities and triggered bank margin calls.

Sitka & Apex Trusts, mentioned yesterday have basically defaulted, according to DBRS:

On February 27, 2008, DBRS confirmed the ratings as Under Review Negative following an agreement between Sitka Trust and a swap counterparty to Sitka Trust to extend the due date of a collateral call notice received by Sitka Trust to the close of business on February 27, 2008. That agreement has expired. Moreover, as of the date of this release, no restructuring proposal has been agreed to by the relevant transaction parties. DBRS stated in the press release of February 25, 2008, that failure to enter such an agreement would likely result in substantial rating action.

In addition to the failure of Sitka Trust to fulfill its obligations to fund a collateral call by the close of business on February 27, 2008, DBRS was informed after close of business on February 27, 2008, by BMO Nesbitt Burns Inc., as Securitization Agent and Sub-Agent of Apex Trust and Sitka Trust respectively, that on February 27, 2008, Apex Trust failed to roll over all of its Series A, Class A Notes which came due on that date. As a result, pursuant to the terms of the Apex Trust indenture, the failure to pay the principal of or interest on the Series A Notes when due is considered to be a trust default if it continues for a period of two business days after a notice in writing has been given by the Indenture Trustee to the Trust. Due to the nature of certain agreements between the Trusts, a default of Apex Trust would result in a default of all of the Notes of Sitka Trust.

It’s interesting. My guess is that the default is real and will be confirmed in two days … but the two day grace period does leave open the possibility that BMO is engaged in high stakes brinksmanship with the swap counterparty. You never get to hear the good parts about these stories!

A Globe story about the situation noted:

The bank now has just two days to make a tough call. It can support the trusts by meeting the collateral calls, which means putting more capital at risk in what may be a vain bet on a recovery in capital markets, or Bank of Montreal can cut its losses by writing off $495-million of exposure to the trusts and letting them wind down.
…
The costs likely wouldn’t end there, though, because the bank is the biggest player in Canada’s securitization market with a business that generated about $296-million in revenue last year. That business would be in jeopardy if Bank of Montreal let Apex and Sitka fail, analysts said.

“Now the question is how committed BMO is to the securitization business in Canada because letting these trusts go down would decimate them in the eyes of customers,” said industry consultant Daryl Ching, managing partner of Clarity Financial. “The problem for BMO is if they meet these collateral calls they could easily be faced with more in a month if credit markets continue to worsen.”

The $296-million figure is from 2007 Annual Report; it is not even completely clear whether Sitka/Apex feed into this number at all; over half the amount is derived from selling credit card loans to existing vehicles. Whether or not letting Sitka/Apex go down would jeopordize the revenue is a matter of opinion … my opinion is “not”.

Meanwhile, the Alt-A RMBS market is looking pretty sick:

Typical 6 percent securities rated AAA and backed by 30-year fixed-rate Alt A loans of more than $417,000 on Feb. 22 fell to 12 cents less per dollar of principal than similar “agency” securities guaranteed by government-linked entities such as Fannie Mae, according to a report this week by JPMorgan Chase & Co. That was up from 5.5 cents on Jan. 25.

AAA bonds with 6 percent coupons backed by 30-year, fixed- rate “jumbo” prime loans of more than $417,000 probably traded for 2.5 cents per dollar less than similar agency securities, the report said, compared with 2.25 cents last month.

… and this has caused yet another good sized hedge fund to call it a day …

Peloton Partners LLP, the London- based hedge-fund firm run by former Goldman Sachs Group Inc. partners, is liquidating its ABS Fund after “severe” losses on mortgage-backed debt and demands from banks to repay loans.

Peloton, founded by Ron Beller and Geoff Grant in 2005, is seeking buyers for the $1.8 billion fund’s assets, according to a letter sent today to investors. Firms including Citadel Investment Group LLC and GLG Partners Inc. have looked at the portfolio, two people familiar with the situation said.

The fund’s demise after an 87 percent gain last year highlights the severity of the U.S. subprime-mortgage collapse, which has spread to AAA rated securities backed by safer loans and triggered bank margin calls.

Volume picked up today and, the market was steady. Of interest was a plunge in price of NTL.PR.F and NTL.PR.G: there are lots of headlines. Whether the plunge reflects a genuine reevaluation of the prospects for default, or whether just being in the headlines was sufficient reason … is something we’ll never know.

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

Accrued Interest has a very good post today regarding S&P’s views on the monolines:

S&P and Moody’s have now both affirmed MBIA. S&P also more or less said they would affirm Ambac as well if the reported $3 billion capital infusion is completed. MBIA’s infamous 14% surplus note is now trading comfortably above par ($101 bid, $104 offer last night). So are we out of the woods with the monolines?

Well let’s start by looking at S&P’s methodology. In short, S&P will bestow a AAA rating if they believe an insurer can survive their “stressed” scenario. Here are their assumptions for various types of mortgage-related securities.
…

…
So all in all, I’d say that’s a pretty stressful scenario.

S&P, with its customary eagerness to become a credit rating agency that charges both the issuers and the subscribers, does not make the full report freely available. But Moody’s has published some notes:

Although losses on the 2006 mortgages are still low – mainly because the loans are still relatively unseasoned and the foreclosure process is taking longer than in previous years – Moody’s expects that they will rise considerably in the next few years. The most significant components of the uncertainty regarding the ultimate loss outcomes are (1) the extent to which loans will be modified and these modifications are successful in preventing defaults, (2) the impact of interest rate resets in 2008 and (3) the strength of the US economy in 2008 and beyond.

In this article, we provide projections of the lifetime average cumulative losses for each of 2006’s quarterly vintages, given each transaction’s current level of losses and delinquencies, and assumptions regarding the “roll rates” into default from various categories of delinquent loans and the severity of losses on loans that default.
…
Moody’s projection for mortgage losses on the 2006 vintage is in the 14-18% range

The Buiter/Sibert column on Barack Obama’s “Patriot Employer Act”, mentioned yesterday,  has drawn a lot of comment. Tanta at Calculated Risk has a very entertaining and devastating commentary about Lost Note Affidavits with respect to foreclosures, prompted by a story about legal maneuvering that caught my eye at the time, but went unremarked here. I’ve added some updates to the Crony Capitalism post and have made a little progress on Seniority of Bankers Acceptances.

The rather surprising level of lending by the Federal Home Loan Banks (FHLB) mentioned here on November 26 was attacked by Nouriel Roubini yesterday, as noted by the WSJ. I found his views on the monolines more interesting:

Similarly, the concern about the writedowns that will follow a downgrade of the monolines is well taken. However, desperate attempt to avoid a rating downgrade of monolines that do not deserve such AAA rating are highly inappropriate as the insurance by these monolines of toxic ABS was reckless in the first place. If public concerns about access to financing by state and local governments during a recession period are warranted it is better to split the monoline insured assets between muni bonds and structured finance vehicle, ring fence the muni component and let the rest be downgraded and accept the necessary writedowns on the structured finance assets. If these necessary writedowns will then hurt financial institutions that hold this “insured” toxic waste so be it as these assets should have never been insured in the first place. The ensuing fallout from the necessary writedown – such as the need to avoid fire sales in illiquid markets – should then be addressed with other policy actions.

I can’t agree with this at all. You can’t just split up a company’s committments – effectively, expropriating the rights of whoever’s guaranteed by the “bad” side – just on the basis of which set of guaranteed counterparties are nicer people. Should the monolines fail – and they’re not close to that yet, they’re merely close to losing their AAA ratings – and need to be recapitalized, then company splits can make sense. But not until their equity has gone to zero!

The hills are alive with the word that Apex & Sitka trusts might fail, costing the Bank of Montreal something like $495-million. DBRS explained in a Feb. 25 press release:

The Trusts were organized to enter into collateralized debt obligation (CDO) transactions, including CDO transactions that employ leverage. As of the date of this press release, 100% of the transactions entered into by the Trusts are LSS transactions. A LSS transaction is a type of transaction where a credit protection seller (such as a Canadian asset-backed commercial paper (ABCP) issuer (Conduit) that issues ABCP, extendible commercial paper or floating rate notes) writes credit protection on a tranche of a CDO transaction which is less than 100% collateralized and that will incur its first dollar of loss above the AAA attachment point. Losses to LSS transactions are considered a remote credit risk; however, these transactions exhibit funding risk. LSS transactions include leverage in that the collateral held by the Swap Counterparty will be smaller than the potential maximum exposure under the credit default swap. As such, the credit protection seller may be required to post additional collateral if its exposure under the swap increases.

Well, I’m not going to take a strong view on this. I don’t know how profitable the business was for BMO or how carefully they measured their risk. On the surface, it sounds like just another failed CDPO (“Whoopsy! Long term returns can be interupted by margin calls!”) … but again, I don’t know what risk controls BMO had in place (and leverage of loans is what banks do, right? The difference is that most loans don’t have to be marked-to-panicky-market every day … the bankers exercise judgement, good or bad, as to whether there is permanent impairment). What I do know is: Show me somebody who’s never failed, and I’ll show you somebody who’s never tried.

Another quiet day, with PerpetualDiscounts easing down.

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

Nobody must ever get hurt in the field of finance! This has been confirmed by all the political attention paid to states and municipalities now that their auction rate securities are paying high yields:

Gregoire, Corzine and Spitzer joined other governors Feb. 24 in forming a group that will “produce something that gets us out of the problem, but most importantly produce something for Congress” to deter a future borrowing squeeze, Gregoire, a Democrat, said during a National Governors Association meeting in Washington yesterday…

“A lot of governors really hadn’t anticipated that,” Gregoire told reporters in Washington. The group, which plans to meet soon, hasn’t discussed specific solutions, she said

Some people may also be upset that the Fed has no direct power over mortgage rates:

When Bernanke faces Congress tomorrow and Feb. 28, he will be questioned about why long-term bond yields are moving in the opposite direction to the Fed funds rate, said Credit Suisse Group Chief Economist Neal Soss. Lower fixed mortgage rates would avert foreclosures and give consumers more money to spend, said Diane Swonk, chief economist of Mesirow Financial Inc. in Chicago.

“Chairman Bernanke is caught in a tug-of-war between growth and inflation,” said Swonk, who is a member of the Congressional Budget Office’s panel of economic advisers. “Inflation is still a threat and that influences the mortgage-bond investors who ultimately set the fixed rates.”

All the above is probably just political grand-standing in an election year, but boy! Does this kind of thing ever irritate me!

The always reliable Willem Buiter, with Anne Sibert, highlights an interesting plank in Barack Obama’s presidential platform:

on 2 Aug 2007, along with Senators Dick Durbin and Sherrod Brown and Representative Jan Schakowsky, Obama introduced the yet unpassed Patriot Employer Act. On 13 February 2008, he stopped in Janesville, Wisconsin to give a speech extolling this accomplishment.
…
The legislation would provide a tax credit equal to one percent of taxable income to employers who fulfill the following conditions:

• First, employers must not decrease their ratio of full-time workers in the United States to full-time workers outside the United States and they must maintain corporate headquarters in the United States if the company has ever been headquartered there. 
• Second, they must pay a minimum hourly wage sufficient to keep a family of three out of poverty: at least $7.80 per hour. 
• Third, they must provide a defined benefit retirement plan or a defined contribution retirement plan that fully matches at least five percent of each worker’s contribution. 
• Fourth, they must pay at least sixty percent of each worker’s health care premiums. 
• Fifth, they must pay the difference between a worker’s regular salary and military salary and continue the health insurance for all National Guard and Reserve employees who are called for active duty. 
• Sixth, they must maintain neutrality in employee organising campaigns. 

…
Sen. Barack Obama’s proposal is reactionary, populist, xenophobic and just plain silly. It is time for him to stop pandering and to show the world that hope and reason are not mutually exclusive. 

There was some interesting news on the regulatory front today, with respect to hedge funds front-running PIPEs:

Since October, judges in three cases rejected the U.S. Securities and Exchange Commission’s argument that closing out short positions with shares bought in private offerings is illegal. The SEC sued hedge-fund managers that engaged in the transactions.
…
PIPEs offer a chance to make a guaranteed profit because the stock is sold for less than market prices. The average discount was 12 percent last year, according to PlacementTracker.

In a typical scenario the SEC has targeted, a hedge-fund manager learned of a PIPE through a placement agent and shorted the company’s stock before the offer was announced. The fund bought the equity at a discount in the private sale to cover the short position.

The SEC lost its argument that the entire transaction was completed when the short position was created. The insider- trading claim is based on the SEC’s accusation that the hedge funds used confidential information to trade before the PIPE was disclosed.

The accused managers argue in part they didn’t have nonpublic information or agree to forgo trading before the PIPEs were announced.
…
Robert A. Berlacher, 53, on Feb. 15 asked a judge in Philadelphia to dismiss the insider-trading accusations in a case involving buying and selling Radyne Comstream Inc., now Radyne Corp., in 2004. Berlacher’s lawyer, Perrie M. Weiner of DLA Piper in Los Angeles, said knowledge of a PIPE isn’t the “material nonpublic information” required to show insider trading.

My sympathies are entirely with the SEC on this matter. It may possibly be that the hedge fund managers are taking advantage of a loophole and should not be punished … but in such a case, the loophole must be plugged. If I’m considering placing an order to buy XYZ Corp. at $50.00, then I consider XYZ’s plans to issue more shares – and dilute my holdings – at $45.00 to be material.

I can see that with such private placements, the company may have a legitimate interest in keeping the plans quiet … but sizes and prices should not be negotiated with other players unless those players have entered a short-term stand-still and confidentiality agreement.

I’m uncomfortable with this method of financing, anyway. Let’s see more exchange offerings and rights issues!

Yields on the Fed’s Term Auction Facility increased in the current auction to 3.08%. This auction was for $30-billion in term loans, from Feb 28 – March 27. It replaces funds awarded in the January 28 auction, which went for 3.123%. The Fed Funds contract for March is now trading at about 2.77%; as of Feb 25, both the target and the effective Fed Funds Rates were 3.00%. It would appear that a term premium has now crept into the auctions … I note that one month LIBOR is at 3.12%. So … I think the result, together with an entirely reasonable FDIC report, is pretty good sign. If the sky really were falling, then insolvent banks, shut out of the uncollateralized interbank market, would bid the TAF rate to the sky as they attempted to foist their worthless collateral on the dumb old Fed.

Reliable data is hard to come by, but preliminary indications are that the new Federal Budget is dividend hostile – not good news for prefs, but (based on historical experience with the trend in the other direction) probably not that bad, either. Fresh from flapping his yap about the need for efficiency (except in egg and dairy products), Our Glorious Finance Minister introduced yet another tax-assisted savings plan, which will be of interest to the few Canadians who have maxed out their RRSPs (which is to say: those who don’t need any specially targetted help anyway). It is not clear whether the line item for this deduction has been efficiently placed above or below the line where you claim your public transit fare deduction. There are things, Assiduous Readers, which man was not meant to know.

On the plus side, the government’s desire to spend every cent coming in and to bloat the size of the Income Tax Act makes deficits much more likely. This will increase the supply of government bonds and hence act to decrease Preferred/Government yield spreads.

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

Today’s post may be foreshortened, due to the time I spent on crony capitalism. Well, anyway, here goes…

Naked Capitalism leads off with a piece suggesting that there’s not much worth saving in the monolines taking great exception to the idea that the proposed recapitalization of Ambac will be via a rights offering. I don’t see anything wrong with a rights offering myself … it allows existing shareholders to avoid dilution and, perhaps, get in on the opportunity to increase their position at a discounted price. And if they don’t want to increase their position, they can sell their rights to take their money off the table. Such procedures are much more fair to extant shareholders than private placements; I don’t understand why there aren’t more of them.

Naked Capitalism suggests that even the Good Insurer part of potential splits might be not all that good, citing a third party’s mention of the City of Vallejo, CA’s current problems:

Vallejo is a municipality. Presumably its debt would be considered AAA. Yet its civic leaders are talking about filing for bankruptcy. You wonder why local government and public works-related auction bonds are failing left, right and centre? US state and municipal finances are in dire shape – just as you would expect when the housing market is in deep depression and the economy is in recession.

And if you think Vallejo is a one off, consider California itself (isn’t it something like the tenth largest economy in the world in its own right?). Remember, US states are constitutionally bound to run a balanced budget. California is now faced with a US$16bn deficit (see here). Some legislators are calling for unilateral tax INCREASES (where’s your $170bn stimulus package now Mr Bush?) as well as spending CUTS. The US is in deep, deep trouble and it isn’t coming out of it for years.

So I looked a little into press reports about Vallejo:

Vallejo may run out of cash as early as March, council member Stephanie Gomes said.

“Not only that, but now we have 20 police and fire employees retiring because they are afraid of not getting their payouts,” Gomes said. “That means we have another few million dollars in payouts that we had not expected. So the situation is quite dire.”
…
The city currently has a $135 million liability for the present value of retiree benefits already earned by active and retired employees and an additional $6 million a year as employees continue to vest and earn this future benefit, [City Manager] Tanner said.

“The problem is basically bloated union contracts,” [Council Member] Shively said.

… and, with a bit more detail:

[Council Member] Gomes said salaries and benefits for public safety workers account for 80 percent of Vallejo’s general operating budget. “The city cannot support this anymore,” she said.

Gomes said that last year, 98 firefighters made more than $100,000 and 10 made more than $200,000 including overtime. It is overtime that some firefighters say they would just as soon not have to work.

This is happening in a city with a population of about 120,000. Quick! Somebody call David Miller! We’ve finally found a city that’s run worse than Toronto!

Vallejo was recently downgraded by Moody’s (enormous spreadsheet) to A3 (Watch Negative) from Aaa (Watch Negative), as a result of the downgrade of FGIC.

The monolines did catch a break today! S&P affirmed MBIA as AAA though it remained on Watch Negative. Ambac is still under review.

Naked Capitalism also reprints a report on the collateral accepted by the TAF. The Fed claims it lends only to sound banks, irrespective of collateral; NC says he doubts it. I’ll go with the Fed.

In what BCE shareholders will hope is not a foreshadowing of things to come, Wachovia has sued Providence Equity Partners (part of the BCE acquisition group) to get out of a financing:

Wachovia, the fourth-largest U.S. bank, said Providence officials changed the terms of the accord without consent from the Charlotte, North Carolina-based bank and voided the agreement, according to a lawsuit filed in state court in North Carolina Feb. 22. Providence and two of its investment banks, Goldman Sachs Group Inc. and UBS AG, agreed over the weekend to drop the price from $1.2 billion for the Clear Channel unit, a person briefed on the negotiations said.

Well! They drop the price and Wachovia jumps at the opportunity to call foul! This is an interesting development.

Rather a dull day for prefs, although the fact that this is only the third trading day this month that PerpetualDiscounts were down gave it some interest. Not much price action and the volume was rather lame as well.

Still no sign of new issues, much to my chagrin!

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

Not much today! I did, however, post about RS’s attitude towards icebergs and Inflation Expectations … you guys will just have to make do with that.

I see there are rumours of an Ambac rescue:

Banks may invest about $3 billion in the company, said the person, who declined to be named because no details have been set. The New York-based company rose 16 percent in New York Stock Exchange trading today after CNBC Television said Ambac and its banks were preparing to announce a deal.
…
A rescue that enabled Ambac to retain its AAA rating for the municipal and asset-backed securities guaranty units would help banks and municipal debt investors avoid losses on securities it guarantees. Banks stood to lose as much as $70 billion if the top-rated bond insurers, which include MBIA Inc. and FGIC Corp., lose their credit ratings, Oppenheimer & Co. analysts estimated.

Let me see if I have this straight … the banks are looking at a mark-to-market loss of $70-billion, which they can avoid with an investment of … oh, call it $10-billion, if Ambac gets three. How can anybody talk about market efficiency with a straight face?

Volume picked up today and performance was good … nothing earthshattering, but given that down days are currently rare, monny a mickle maks a muckle. As they say.

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

Naked Capitalism reprints a WSJ editorial that concludes:

A financial system runs on trust, and the credit crisis is continuing in part because there is so much mistrust about the magnitude of potential losses and where those losses reside. By encouraging bond insurers to unilaterally rewrite their contracts, Messrs. Spitzer and Dinallo are only creating more mistrust and uncertainty. We assume the banks that bought the bond insurance and signed the contracts will take their insurers to court.

Holy smokes, if this thing doesn’t get reasonably resolved, things are going to get messy! I can only assume that Dinallo is simply engaging in brinksmanship, with the actual object being a recapitalization of the monolines. The trouble with brinksmanship, of course, is that if it doesn’t work, things have become worse.

MBIA has announced:

it withdrew from its trade association because of differences over the direction of the industry.

“We believe that the industry must over time separate its business of insuring municipal bonds from the often riskier business of guaranteeing other types of securities,” MBIA’s new Chairman and Chief Executive Officer Jay Brown said in a statement today. The company also disagrees with the Association of Financial Guaranty Insurers’ “positions on the appropriateness of monoline financial guarantors insuring credit default swaps.”

The press release on the MBIA site states:

For one thing, we believe that the industry must over time separate its business of insuring municipal bonds from the often riskier business of guaranteeing other types of securities, such as those linked to mortgages. Additionally, we disagree with AFGI’s positions on the appropriateness of monoline financial guarantors insuring credit default swaps and the ability of U.S. financial guarantors to reinsure U.S. domestic financial guarantee insurance transactions with foreign affiliates without paying U.S. corporate tax rates.

The AFGI has posted a review of the industry dated November 2007 and the website FAQ includes asset backed securities as a field of future growth for monolines. I don’t see anything specific about Credit Default Swaps.

There was a further indication that the CDS market is strange:

Credit markets were thrown into fresh turmoil on Wednesday as the cost of protecting the debt of US and European companies against default surged to all-time highs.

The sharp jump, which rivalled the sell-off at the height of last summer’s credit market turmoil, came as traders rushed to unwind highly leveraged positions in complex structured products.

The sell-off was triggered partly by fears of more unwinding to come as investors rushed to exit before conditions worsen. As losses have snowballed, further unwinding has been triggered.
…
The cost of insuring the debt of the 125 investment-grade companies in the benchmark iTraxx Europe rose more than 20 per cent to as high as 136.9 basis points, before closing at 126.5bp. That compares with a level of about 51bp at the start of the year, according to data from Markit Group.

In contrast to this, let’s take a quick glance at some recent BoC research into CDS Pricing:

The paper examines three equity-based structural models to study the nonlinear relationship between equity and credit default swap (CDS) prices. These models differ in the specification of the default barrier. With cross-firm CDS premia and equity information, we are able to estimate and compare the three models. We find that the stochastic barrier model performs better than the constant and uncertain barrier models in terms of both in-sample fit and out-of-sample forecasting of CDS premia. In addition, we demonstrate a linkage between the default barrier, jump intensity, and barrier volatility estimated from our models and firm-specific variables related to default risk, such as credit ratings, equity volatility, and leverage ratios.

At best, this study represents a good try – the data for determining the value of a CDS through a cycle simply does not exist. Despite my interest in the asset class, I’m not convinced that the CDS market is ready for prime time. If their main attraction is the ability to lever up a portfolio significantly, then a huge degree of uncertainty is introduced into pricing, in addition to the uncertainty introduced by debt decoupling. I continue to wrestle with the idea, but these twin, undiversifiable uncertainties probably introduce a required risk premium that makes inclusion of these instruments, long or short, in a fixed income portfolio uneconomic.

It’s all very complicated and I’m a simple kind of guy! The complexity was noted in a Financial Times article by Aline Van Duyn and Gillian Tett excerpted by Naked Capitalism:

The fundamental problem is that this decade’s wave of banking innovation has created a financial system that is not just highly complex but also tightly interlinked in ways that policymakers and investors sometimes struggle to understand.
…
This could result in the businesses of companies such as Ambac, MBIA and FGIC being split into two, to ensure that bond insurers can ringfence the riskier assets (such as mortgages) from the municipal guarantee business.

But although such a split currently seems attractive in political terms – most notably because it would enable policymakers to protect the municipal bond market in an election year – it will not necessarilly prevent further turmoil on Wall Street. On the contrary, as Jeffrey Rosenberg, analyst at Bank of America, says: “A split may limit losses in the municipal market, but it would likely exacerbate losses to structured finance… To the extent that those losses further constrain financial institutions’ balance sheets, broader credit constaint may follow.”

Cowboys, cowboys! Playing with things they don’t really understand, and sometimes doing quite well for several years. I think they’re wonderful … selling them liquidity is a very profitable endeavor.

As I suggested when the news first came out on January 24, Kerviel’s status as a “rogue trader” must forever be preceded by the qualifier “so-called”. A SocGen report on the loss has reported:

“Controls in place were conducted without triggering a strong or persistent enough alert to enable the identification of the fraud,” the e-mailed report said.
…
It did say that compliance officers rarely went beyond established routine checks.

They “don’t have the reflex to inform their superiors or the front office of anomalies, even if they concern large amounts,” the report said.

There weren’t any follow-up checks on cancelled or modified transactions, and no limits on nominal positions, just on net positions, it found.

While procedures were respected and questions were asked, “no initiative was taken to check JK’s assertions and corrections he suggested, even when they lacked plausibility,” the report said. “When the hierarchy was alerted, it didn’t react.”

The committee said there were 75 red flags between June, 2006, and the beginning of 2008 that should have alerted managers to Mr. Kerviel’s unauthorized trades. The warning signs included a trade with a maturity date on a Saturday, bets with “pending” counterparties and missing broker names, the report said.

The actual SocGen report contains a marvellous graph of reported vs. actual P&L for Kerviel’s positions (page 11 of the PDF). 

In other words, SocGen risk management is a complete joke. And in response, of course, SocGen and many other firms are requiring complete ignorance of operations, rather than simply preferring it. This will also serve to emphasize to the traders that operations personnel are low-life scum, who may be ingored, lied to and sworn at with impunity. Brace yourselves for more blow-ups!

A very quiet day today, but the market continued strong. PerpetualDiscounts are now up 3.34% on the month-to-date and 3.76% on the year-to-date. They have had exactly two down days this month (so far!), both less than a beep’s worth.

To my astonishment, there have been no new issue announcements this week, in defiance of my February 15 prediction. Well, perhaps tomorrow will salvage my reputation …

I’m of two minds whether or not to write another post devoted to the BNA issues … the BNA.PR.A closed with a ludicrously strong bid, and the yield on BNA.PR.C is now lower than the equal-credit-shorter-term BNA.PR.B.

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