Category: Market Action

Monolines, monolines! Accrued Interest muses on an Ambac breakup and concludes:

The challenges of making the split are numerous. There will likely be lawsuits by structured finance holders who logically want to keep the stronger muni business around to support their policies. So we’ll see how it plays out. Since government regulators seem keen on providing aide to the muni market pronto, Ambac may get some legal cover if they manage to push this plan forward.

If they don’t, then a New York imposed plan seems inevitable. I think its time for Ambac (and MBIA) shareholders to start thinking about how to make the best of a bad situation.

While William Ackman, long a gadfly to the monolines as noted on January 31, has proposed an actual structure for such a breakup:

Ackman’s plan has two separate boards of directors, one for the municipal insurer and the other for the structured finance unit. Each board would include policyholders. The municipal insurer would pay dividends to its structured-finance parent only when the board was satisfied the unit could remain AAA rated. The structured finance insurer would send dividends to the holding company only after its board determined the money wasn’t needed to cover claims.

KKR Financial (last mentioned on August 20) continues to experience financing difficulties:

KKR Financial Holdings LLC, Kohlberg Kravis Roberts & Co.’s only publicly traded fixed-income fund, delayed repaying debt a second time in six months after failing to find buyers for commercial paper backed by mortgages.

Lenders to the fund agreed to the delay as KKR Financial seeks to restructure, the San Francisco-based company said yesterday in a regulatory filing. KKR Financial, whose stock has fallen 50 percent in the past year, didn’t say how much debt is affected.

Assiduous Reader madequota has remarked on the disconnect between the (government) bond market and preferreds, which echoes the equity/credit disconnect remarked by Naked Capitalism quoting, inter alia, John Dizard of the Financial Times:

At the moment, the most striking “arbitrage” is between the valuation of risk in the credit markets and the equity markets. Credit markets are discounting the end of the world, while equity strategists whose e-mails I spend half the morning deleting are saying that we are forming a tradeable bottom, which sounds faintly obscene.

As far as prefs are concerned, I’m more surprised by the long corporate/perpetual discount disconnect … according to the DEX long term bond indices long corporate yields are now around 6.00%, up 40bp from their bottom in early January, while long governments are now at about 4.60%, up 20bp from January’s bottom. In sharp contrast to this, PerpetualDiscounts are now at their YTD bottom, yielding 5.39% (about 7.55% interest-equivalent). Currently, the long corporate/Perpetual-Discount-Interest-Equivalent (LC/PDIE) spread is about 155bp.

This may be compared to previous LC/PDIE spreads of 113bp at the end 2006, 109 bp at the beginning of May, 2007, and 210bp at the end of October 2007. So, using these three data points to determine value, in the best of all “Look Mummy I Got A Spreadsheet” tradition, we could say (if we were willing to place our reputation on such a thing) that the LC/PDIE spread is simply moving back to a normal level and we’ve still got about 45bp to go – which is about 6.3% price appreciation.

As I’ve noted before, the end is in sight for my preparation of historical HIMIPref™ Preferred Share indices and soon I will be an enthusiastic member of the “Look Mummy I Got A GREAT BIG Spreadsheet” school of securities analysis. Until then (and after then, as well, if you really want to know) I will proudly state that I don’t have a clue where overall prices are going. I just compare risk to expected return as best I can (of the asset classes, through a cycle) and try to outperform my benchmarks. It works for me.

New York’s Auction Rate Securities, regarding which I noted my lack of panic yesterday and which were in the vanguard of a spate of failed municipal auctions on February 13 have now found that headlines are helping:

Interest rates on $100 million of bonds issued by the Port Authority of New York and New Jersey were set at 8 percent in a weekly auction after surging to 20 percent on Feb. 12.

Rates had soared from 4.3 percent when too few buyers bid for the so-called auction-rate debt and Goldman Sachs Group Inc., which runs the auction, refused to put up its own capital to buy unwanted securities. That caused the yield to be set at a level predetermined in bond documents. Rates fell yesterday as the prospect of high yields enticed investors, according to data compiled by Bloomberg.

It isn’t over, any more than the Great Credit Crunch is over, but at least things are starting to normalize.

Another solidly strong day for the preferred market, but volume was light … and if it hadn’t been for Nesbitt, doing yeoman’s work with some crosses, it would have been even lighter. I just wish I understood the prices being paid for some of those operating retractible issues though … it would seem that some players, for one reason or another, are assigning virtually zero probability to pre-last-minute calls. All the negative YTWs really screw up calculation of averages for the index!

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

A number of continuing stories today …

Accrued Interest reviewed a recent batch of Auction Rate Municipal auctions:

There was absolutely no rhyme or reason to what failed vs. succeeded and what rates resulted. The City of New York (rated Aa3/AA) had three issues auctioned, all three of which were fully tax-exempt. The rates were 5%, 5.25%, and 6%. Energy Northwest, a municipal power provider in Washington State, which is rated Aaa/AA-, had their ARS fail, and got a rate of 6.23%. Meanwhile, at one healthcare institution with a Baa3 rating and Radian insurance had their auction succeed with a 4.67% yield.
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Meanwhile, I’ve received many e-mails from people interested in how one can play these ARS failures. One interesting idea is closed-end funds. Most closed-end bond funds are leveraged, usually in the 1.2-1.5x area, and they commonly use auction-rate preferred to create this leverage.
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And yet closed-end muni funds are getting hammered, with several falling more than 5% today. I looked at the worst performers on the day, all of which had leverage created with auction-rate preferreds with 7-day auctions. The highest reset number I found was 3.3%. Excuse me if I don’t panic.

In times like these, the baby tends to go out with the bathwater! Naked Capitalism pours scorn over the entire idea of Auction Rates and notes:

The Wall Street Journal reports that organizations facing big funding cost increases are quickly trying to raise money at the longer maturities they should have borrowed at in the first place:
Turmoil in an obscure corner of the credit markets is expected to lead to a wave of refinancing by institutions that are in danger of finding themselves paying abnormally high interest rates on their bonds.

One of the first to queue up is the University of Pittsburgh Medical Center, which yesterday announced plans to refinance as much as $430 million of bonds. The medical center offered to buy back $92 million of bonds after market rates on some of its existing auction-rate debt topped 17% last week — threatening the center with extra weekly interest costs of as much as $605,000.

In the comments, Naked Capitalism goes even further and brands the issuers of Auction Rate Securities as speculators:

Municipalities get approval from taxpayers (either directly by approving bond issues or indirectly via who they elect) to enter into certain projects deemed useful for the community. They weren’t authorized to speculate with the public’s money, which is what this sort of thing is.

I cannot agree with such absolutism. Diversification of funding sources for an issuer is just as important as diversification of investments for an investor. I would have enormous reservations if it were suggested that all funding took place via Auction Rates, but I have no problem with a small piece being done that way.

A good example is floating rate mortgages and HELOCs in Canada. Many people have them and I’ve been asked many times about whether floating rate or fixed rate is better. It has been shown – and sorry, I don’t remember the reference – that, usually, floating rate is cheaper. This only makes sense; when you go floating rate then, ceteris paribus you should save money on the term premium. The risk you run is that rates will rise.

The advice I have given people to to imagine that they go for floating rate and immediately the rate doubles on them. If this is going to wipe them out and cost them their home … stick to fixed rate! On the other hand, if they will simply mutter to themselves and say ‘Oh, shoot, this investment didn’t work out’ … then go for floating rate because the odds are with them.

It’s the same with issuers. It would be most interesting to compare the overall cost of the funding over, say, a twenty-year period, and I’ll bet there are all kinds of graphs and figures in the brochures the treasurers get from their underwriters. Naked Capitalism is being more than just a little simplistic in this instance.

This issue is being raised on Bloomberg:

State officials, who are reviewing the $4 billion of auction bonds sold by six different authorities as well as by the state in 2002-2004, said the debt was the least expensive type of debt in the two years ended Sept. 30, according to a Dec. 12 report. Since then, it has become the most expensive.

The auction-rate turmoil represents a reversal for state fiscal officials. As recently as Jan. 22, Louis Raffaele, a chief budget examiner who helps manage New York’s borrowing, said higher rates on auction bonds across the country could benefit the state. “Because of our high ratings and unblemished record,” he said, the state could attract investors fleeing lower-rated issues.

I suggest that Mr. Raffaele’s remarks of Jan. 22 will ultimately be supported by the marketplace … albeit not without a period of dislocation of unknown length.

Another story that has crept back into the headlines is Structured Investment Vehicles, or SIVs. Standard Chartered’s USD 7-billion vehicle is close to default, while there has been an announcement that Bank of Montreal is committing 12.7-billion to prop up Links Finance.

More happily, Naked Capitalism has toned down the hysteria regarding negative non-borrowed reserves and is now focussing concern where it belongs: on the concept of the TAF itself:

We’ve called the TAF a discount window without stigma (and in fact, the Fed implemented the TAF because banks weren’t using the discount window even when they should have). Banks can post a wide range of collateral, borrow on a non-disclosed basis, and can hold on to the cash for a while (by contrast, the discount window is overnight)
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But are things all that rosy? The Financial Times today raises some concerns, noting that banks are indeed using the TAF to use crappy collateral for borrowing,

And note that, with no announcement I can recall, the facility has been increased to $50 billion even though the year end crunch has passed. That too is not a good sign.

Naturally, we cannot let a day go by without a reference to the monolines! The Bank of America has forecast years of litigation if the monolines are split:

“Despite the regulatory interest in separating the exposures, the essential fact remains that all policy holders, whether municipal or structured finance, entered into contracts backed by the entire entity,” analysts led by Jeffrey Rosenberg in New York wrote in a note to investors dated Feb. 15. A breakup is “likely to lead to significant legal challenges holding up the resolution of the monoline issues for years.”…..

“The fact that one group of policy holders’ exposures has imperiled the policies of the other does not mean they should forfeit the value of their claims altogether,” the Bank of America analysts said.

Investors in credit-default swaps based on the bond insurers may also seek damages to compensate for losses, according to the research note.

 Accrued Interest has admitted to complete befuddlement over the question of what will happen to Credit Default Swaps on the pre-split companies. And again, Naked Capitalism provides a good round up of opinion (basically, everybody is saying that a monoline split will unleash the lawyers) and pours scorn on the idea:

Now, Ambac is seeking to raise money. It hopes to split up, but gee, we aren’t certain we can do that, and even if we can, we aren’t exactly sure yet how this will work.

Is any one with any sense going to invest in a proposition like that? You have absolutely no idea what you are getting into. This whole discussion of a breakup plan has increased uncertainty enormously and raised the specter of litigation risk. Those are not exactly comforting to investors.
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Microsoft has long used FUD, Fear, Uncertainty, and Doubt, to paralyze its competitors. This bunch has managed to introduce a ton of FUD into something they want to move forward. Good luck.

Frankly, I don’t see how one can begin to consider a split ethical prior to bankruptcy and complete wipeout of the monoline’s shareholders. After all, preferential treatment of investors is generally considered a naughtiness. Never-the-less, there are rumours that MBIA is discussing joining the happy throngs.

VoxEU has an interesting article by Levich and Pojarliev on currency trading and the value of active management:

In the last year, both Deutsche Bank and Citibank have introduced several indices that track returns from several well-defined trading strategies.

• Carry – To reflect the returns on the well-known strategy of borrowing a low interest rate currency and investing in a higher interest rate currency
• Trend following – To reflect the returns of strategies related to identifiable patterns in currency movements
• Value – To reflect the returns on taking short positions in overvalued currencies and using the proceeds for long positions in undervalued currencies

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While theoreticians may argue over whether currency risk, like equity risk, always deserves a risk-premium, as a practical matter, institutional investors willing to hold currency risk can do so using a variety of simple trading strategies. Many of these strategies have been profitable recently and exchange-traded funds built on those strategies have been launched for the retail market. It is questionable whether professional currency managers can continue to charge higher management and performance fees while delivering cheaper-to-obtain beta returns. However, our results show that even when evaluated against the higher standard, some currency managers show superior performance, and true alpha. How they achieve this may in part be due to superior market-timing ability, trading in emerging market currencies, or some other factors. Whatever their formula, their returns appear unrelated to some conventional simple trading strategies. These true “alpha generators” may deserve their fees after all.

The actual paper costs money and I’m not really that interested … but if anybody does buy the paper, I’d be very interested in learning how the authors corrected for survivor bias. I will also note the critical sentence of the authors’ conclusion:How they achieve this may in part be due to superior market-timing ability, trading in emerging market currencies, or some other factors. Until this question is resolved, any analysis is of the “Look, Mummy, I got a spreadsheet!” variety.

Assiduous Readers will be aware that Naked Capitalism‘s opinions often meet a severe reception on PrefBlog, but as a clipping service, it’s excellent! Northern Rock has been nationalized by the UK government, generating a lot of discussion.

However, the article that most caught my eye on the weekend was a long piece on the Credit Default Swaps market and the fact that it may, ultimately, be dragged down by operational inefficiency:

In a credit default swap, two parties enter a private contract in which the buyer of protection agrees to pay the seller premiums over a set period of time; the seller pays only if a particular credit crisis occurs, like a default. These instruments can be sold, on either end of the contract, by the insurer or the insured.

But during the credit market upheaval in August, 14 percent of trades in these contracts were unconfirmed, meaning one of the parties in the resale transaction was unidentified in trade documents and remained unknown 30 days later. In December, that number stood at 13 percent. Because these trades are unregulated, there is no requirement that all parties to a contract be told when it is sold.

As investors who have purchased such swaps try to cash them in, they may have trouble tracking down who is supposed to pay their claims.

“This is just a giant insurance industry that is underregulated and not very well reserved for and does not have very good standards as a result,” said Michael A. J. Farrell, chief executive of Annaly Capital Management in New York. “I think unregulated markets that overshadow, in terms of size, the regulated ones are a real question mark.”

I dispute the notion that the lack of attention to the most basic detail is due to under-regulation … I claim that it is due to the practice of putting know-nothings on the the trading desks; and, what’s worse, promoting these know-nothings to managerial roles. Lack of knowledgeable supervision can, I suspect, also be fingered as the cause of mark-to-market “errors”.

I mentioned on February 13 my distaste for a system in which traders in securities not only boasted of their ignorance of operations, but made such ignorance a condition of entry to the elect. These operational issues with CDSs illustrate the first logical consequence of such ignorance … and I will admit, there is a large part of me that wants to see a big House go bankrupt over these issues, throwing those effete cowboys on welfare where they belong!

BMO has announced another writedown involving preferred shares – I have updated the post regarding preferred performance in 2007. In another update to an old post, I’ve added some information to Seniority of Bankers’ Acceptances … which I find particularly interesting in view of concerns over the monoline business model. Finally, the most recent post re ABK.PR.C has been updated … everything is proceeding as anticipated.

As noted in the comments to Feb 15, bonds got nailed today:

Treasuries fell, pushing the 10-year note’s yield to the highest level in more than a month, on speculation accelerating inflation will prompt the Federal Reserve to be less aggressive in cutting borrowing costs.
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The yield on the benchmark 10-year note, more sensitive to inflation than shorter-term debt, was 1.84 percentage points higher than two-year rates. The spread was 1.93 percentage points on Feb. 14, the most since July 2004, reflecting a steepened yield curve.
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Consumer prices rose at an annual rate of 4.2 percent in the 12 months through January after a 4.1 percent pace through the previous month, according to the median forecast of 31 economists surveyed by Bloomberg News. Excluding food and energy, prices rose 2.4 percent in the year through January, economists forecast. The Labor Department will release the report tomorrow.

…  and the Fed Funds contract backed off its more dramatic predictions.

Fed funds futures on the Chicago Board of Trade indicated a 100 percent chance policy makers will cut the 3 percent target rate for overnight loans by a half-percentage point at the March 18 meeting, compared with 66 percent odds on Feb. 15. The chance of a three-quarter-point reduction was 34 percent on Feb. 15.

Another good, solid day for the preferred share market, although volume continued light.

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

I will admit to having felt a certain amount of schadenfreude when Accrued Interest brought to my attention what has to be one of the world’s worst bond funds. A loss of over 50% in a year in what was touted as a fund that would seek:

a high level of income by investing in intermediate maturity, investment grade bonds. The fund seeks capital growth as a secondary objective when consistent with the fund’s primary objective.

… must be something of a record. But this is the modern age! Faster, Stronger, Better! Citigroup’s Alternative Investments unit has brought new meaning to the word “Alternative”:

Falcon Plus Strategies, launched Sept. 30, lost 52 per cent in the fourth quarter, after betting on mortgage-backed and preferred securities and making trades based on the relative values of municipal bonds and U.S. Treasuries. Some collateralized debt obligations in the fund trade at 25 per cent of their original worth, the newspaper said.

OK, well, I think it’s funny! The WSJ had some more detail about the excellence of Citigroup’s risk-control procedures:

Mr. Pickett’s big order last June was for several hundred million dollars of leveraged loans that a group of banks was selling in a private auction on behalf of a German media company, according to people involved in the transaction. At the time, CSO had roughly $700 million in assets, meaning that Mr. Pickett wanted to commit more than half of the hedge fund’s assets.

Some investors in the fund contend that executives at Citigroup didn’t supervise Mr. Pickett closely enough. “I don’t understand…how it would have been possible for him to take on a position that was disproportionately large,” says one investor in CSO.

Citigroup defends its handling of the situation. Spokesman Jon Diat said CSO and similar funds “are subject to comprehensive internal fiduciary risk oversight, risk management practices and senior-level management supervision.”

The mention of collateralized debt obligations continues to resonate, since UBS says there’s a good chance of huge write-downs to come:

Writedowns for collateralized debt obligations and subprime related losses already total $150 billion, [UBS analyst Philip] Finch estimated. That could rise by a further $120 billion for CDOs, $50 billion for structured investment vehicles, $18 billion for commercial mortgage-backed securities and $15 billion for leveraged buyouts, UBS said. “Risks are rising and spreading and liquidity conditions are still far from normal,” the note said…..

And you’ve got to figure … a UBS analyst would know!

Monolines, monolines … Elliot Spitzer, best known for his efforts in singlehandedly saving the world from the horrors of a NY state governor who was not Elliot Spitzer, has made a bald threat to take over the monolines (well … MBIA, anyway) and split them:

During a recess, Mr. Spitzer told reporters that splitting the bond insurers’ businesses was a last resort. “The clear preference is a recapitalization of the companies,” he said. “Even if the deals don’t close, the sort of market comfort that would be needed to stabilize the marketplace could get there pretty quickly. We just have to wait and see what happens.”….

Turning up the heat yesterday on the banks’ discussions, he said in an interview that there are “some mechanisms” in the law that allow regulators to “force [the bond insurers] into what’s called ‘rehabilitation.'” During his testimony before the panel, he asked Congress for a $10 billion line of credit for the bond insurers, which he said could encourage banks to contribute capital.

There are claims that FGIC wants to be split up:

FGIC Corp., the bond insurer stripped of its Aaa rating by Moody’s Investors Service, asked to be split in two to protect the municipal bonds it covers, according to the New York Insurance Department.

FGIC, owned by Blackstone Group LP and PMI Group Inc., applied for a new license so it can separate its municipal insurance unit from its guarantees on subprime-mortgages, David Neustadt, a department spokesman, said in a telephone interview.

And was the regulator holding a gun to FGIC’s head at the time, or what? What’s the whole story? 

How can this possibly be legal? More to the point, how can it possibly be ethical? Those who purchased credit protection on sub-prime did so based on the strength of the whole company, not simply the post hoc selection of bad bits. Accrued Interest speculates that the so-called crisis might simply be political embarrassment:

But the refinancing won’t erase the embarrassment of having an auction failure. Governmental agencies, including the Port Authority, will start putting increasing pressure on the New York insurance regulators to resolve this matter once and for all.
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But the combination of heavy political pressure and a viable private sector solution will be too difficult to ignore. A deal will be worked out to insulate the municipal bond market.

Perhaps more to the point, there is at least a little concern that the so-called crisis in Auction Rate Municipals is largely self-inflicted:

Banks including Goldman Sachs Group Inc. and Citigroup Inc. allowed hundreds of auctions to fail this week after they were unable to attract bidders and decided to stop buying unwanted securities. A failed auction nearly doubled seven-day borrowing costs on $15 million of bonds sold by Harrisburg International Airport in Pennsylvania to 14 percent while a $100 million Port Authority of New York & New Jersey bond reset at 20 percent, up from 4.3 percent a week earlier.

“The problem with most auction bonds isn’t the bonds’ credit quality or default risk,” said Joseph Fichera, chief executive at Saber Partners, a New York-based financial adviser to local governments. “The problem is that there isn’t enough demand for the bonds because some issuers gave monopolies on the distribution to a few banks.”

Just to think … there are still some people in the world who believe that increased political involvement via regulation will save the world!

There has been an amusing twist to the increase in the allowed size of GSE mortgages, which was discussed on January 29. The effective infusion of new money into the jumbo mortgage sector will, in the absence of other factors, affect prices of existing securities:

If larger loans can be packaged into guaranteed securities that can trade in the TBA market, the difference between their rates and those on other prime mortgages would probably fall to between 4 basis points and 19 basis points, from more than 80 basis points today, New York-based Credit Suisse analysts Mukul Chhabra, Chandrajit Bhattacharya, and Mahesh Swaminathan wrote in a report last week. The rates offered on other prime mortgages would climb by a similar amount, they said.

So the trade association that regulates such matters is not allowing the GSE-jumbos to trade normally:

The larger home loans that Fannie Mae and Freddie Mac will temporarily be allowed to guarantee won’t be accepted into the main market for mortgage bonds, the Securities Industry and Financial Markets Association said.

The revised guidelines for the so-called To Be Announced market cover mortgages of more than $417,000 that the government- chartered companies are permitted to buy or guarantee under the $168 billion economic stimulus package signed into law this week, according to a statement today from the trade group in New York.

The exclusion of the larger loans should reduce the size of drops in jumbo mortgage rates that will result from the new law, according to analysts at Credit Suisse Group and Citigroup Inc. Including the loans would have hurt bondholders because their securities would have dropped in value.

A quiet day in the market – not much volume or price movement, probably due to intensive preparations for Bozo Day. With markets at current levels, and now that that $430-million in bank issuance seems to have been well-digested … it wouldn’t surprise me much to see a new issue first thing Tuesday morning, or sometime next week, anyway. Maybe one of the insurers will want some capital so they can go after AIG’s business in its weakened state? Who knows? I wouldn’t bet a dime on it, but I’d go so far as to put a nickel on a new Pfd-1 issue next week at 5.50%.

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

The bond insurance story is just getting bigger and bigger!

Accrued Interest points out:

According to data from Thomson Financial, only about 28% of municipal bonds issued in January carried insurance from a monoline insurer. That’s down from 46% in 2007. Meanwhile, according to Merrill Lynch, new insurance was dominated by FSA and to a lesser extent, Assured Guaranty. FSA insured $3.8 billion of new issues, about 70% of all new issue munis which carried insurance. Assured picked up most of the remainder ($1.3 billion or 23% of new insured issuers).
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The fact is that confidence in insurance has never been lower, and yet buyers continue to demand insurance at all tells you something. MBIA and Ambac may never be able to regain AAA levels of confidence, but municipal bond insurance as a concept will survive.

Yesterday‘s rumours that the New York insurance regulator would pursue a Good Insurer/Bad Insurer solution to the problem have been confirmed:

One part would operate the profitable municipal bond insurance business, while the other would handle so-called structured finance products, according to testimony prepared for Eric Dinallo, the New York State insurance superintendent. Dinallo is scheduled to address a U.S. congressional committee today.

“Our first priority will be to protect the municipal bondholders and issuers,” according to Dinallo’s testimony. “We cannot allow the millions of individual Americans who invested in what was a low-risk investment lose money because of subprime excesses. Nor should subprime problems cause taxpayers to unnecessarily pay more to borrow for essential capital projects.”

Naked Capitalism observes:

the priorities have been turned on their head. Before, the reason for a rescue was to prevent carnage on Wall Street. That objective has now been shunted aside as municipalities are hit by the seize-up in the auction rate securities market.

And yes, the Auction Rate Municipals market is getting worse by the day:

UBS AG won’t buy auction-rate securities that fail to attract enough bidders, joining a growing number of dealers stepping back from the $300 billion market, said a person with direct knowledge of the situation.
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As much as $20 billion of auctions didn’t attract enough buyers yesterday, an 80 percent failure rate, based on estimates from Bank of America Corp. and JPMorgan Chase & Co.

Merrill Lynch is also cutting back its support. Auction Rate Municipals were introduced to PrefBlog readers on February 6. From esoteric trivia to world crisis in eight days! I feel certain that, like the Canadian ABCP market, this is all the fault of the credit rating agencies. Did you know they get paid by the issuers?

There’s another interesting piece of trivia about the insurers … apparently many brokerages considered them such stellar credits that they didn’t have to put up collateral on their CDS exposure:

Goldman Sachs has made plenty of canny decisions in relation to the credit crunch. One of the smartest might have been its treatment of MBIA, the world’s biggest bond insurer.

While many rivals have in recent years been cheerfully using bond insurers to hedge their structured credit bets, Goldmans has refused to do so due to concern about counterparty risk.
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In taking $2bn and $3.1bn writedowns in hedges with insurers whose ability to honour those commitments is in doubt, CIBC and Merrill Lynch respectively have become the face of Wall Street’s nightmares.

It’s always the same thing, eh? Times are good and leverage increases, which only deepens the downturn when it finally arrives. Not just leverage, but also sector concentration of cowboys’ portfolios, witting or unwitting. The importance of correlation has been discussed before: briefly, for example, a husband and wife might each be in jobs that have a 10% chance of disappearing in any given year. A naive analysis (zero correlation) will assign a 1% chance to them both losing their jobs in a year … but if they both work for General Motors at a SUV plant, the chance of them both losing their jobs could be as high as the 10% risk they face individually.

Aleablog has noted in a post picked up and expanded by FT Alphaville that was linked by Naked Capitalism a story by Reuters [I love the Internet] that states:

Correlation on the five-year investment-grade Markit iTraxx Europe index — a measure of investor fears of a system-wide crash — reached new highs of 45 percent on Tuesday. Analysts said the figure had room to go higher still, but some said investors who are now trading based on high correlation could get burned if companies start to default.
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Over the past six months, the credit crisis and a low corporate default rate have pushed correlation up, which means the equity tranche has gained relative to the triple-A tranches.Analysts at UBS, in a recent note to investors, said one reason was that banks and financial entities such as conduits, which accumulated billions of dollars of triple-A tranches of CDOs, have needed to unwind or hedge against those tranches.
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“Now in a world where leverage has to come down, the pressure is on the piece that is the most leveraged, and that’s the super-senior tranches,” Charpin said.
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UBS analysts said the latest rise in correlation may have come also from hedge funds’ needs to raise cash. “If you are a cash-strained hedge fund, that may be a cheap trick to get quickly money back in your pocket,” the analysts wrote. “This is all the more relevant in the last weeks as prime brokers are clamping down on hedge funds’ funding.”

This is where smart analysis is worth money. A mechanism is at work that is pushing up the price of one analytical variable (correlation) without [necessarily] having anything to do with the the actual value of that variable. Therefore, a thorough analysis might show that shorting that variable is a smart thing to do – subject, of course, to a host of risk-control measures. In the preferred share market, for example, I might determine (with the use of HIMIPref™ that convexity is cheap. I might not be able to buy convexity directly, but the valuations of each investible instrument will be adjusted to reflect that view. And, perhaps, a portfolio with an increased convexity might then become cheap enough to the current portfolio that a trade is signalled. And … sometimes it works!

Monoline woes are also spreading into the LBO market, as noted yesterday and on February 11. It seems that formerly reliable Negative Basis Trades are turning positive:

Banks’ exposures through bond insurers, or monolines, is far from limited to mortgage-related MBS and muni bonds. There’s a third big exposure – to leveraged buyout loans – that banks will have to deal with if monolines hit the rocks.

Negative basis trades have been around for a while. A bank buys a bond – say it’s AAA – and then it takes out a CDS against that bond with a monoline. Since spreads in the CDS market for such tranches have been typically much lower than in the cash market, the bank pockets the difference.

But as well as banks’ much-dissected CDO exposures, there have been two other big markets for that kind of trade: on infrastructure bonds and – most interestingly – in structured finance, on CLOs (collateralised loan obligations) – CLOs being the vehicle of choice in which to park massive buyout loans.

Monolines, of course, are no longer in a position to be writing new contracts for banks to use as one half of their negative basis trades. The consequence of that has been that banks have stopped buying AAA tranches of CLOs. Unable to sell those, CLOs have faltered and banks in turn, have found themselves with lots of big buyout loans stuck on their books. No new financing is available for private equity deals.

The monoline FGIC was downgraded by Moodys today, which won’t help things much. The last sentence of the quoted analysis might be of interest to BCE speculators! 

Meanwhile, with a continue plunge in US real-estate values, there are desperate pleas for a government bail-out:

One proposal, advanced by officials at Credit Suisse Group, would expand the scope of loans guaranteed by the Federal Housing Administration. The proposal would let the FHA guarantee mortgage refinancings by some delinquent borrowers….

The risk: If delinquent borrowers default on their refinanced loans, the federal government would have to absorb the loss…

*Yawn*. Speaking of bail-outs, the German government bailout of IKB was mentioned yesterday. Willem Buiter is not happy:

If ever a bank was sufficiently systemically insignificant and small enough to fail by any metric except for the political embarrassment metric, it is surely IKB, the German small and medium enterprise lending bank that got itself exposed fatally to the US subprime crisis through a conduit (wholly owned off-balance sheet entity) devoted to speculative ventures involving instruments it did not understand.
…
I can think of no better way of encouraging more appropriate future behaviour towards risk by German banks than letting IKB go into insolvency now. The institution gambled recklessly and irresponsibly. It lost. Liquidation and sale of its assets would be the market-conform reward for its failures.

Light-ish trading again today, but holy smokes, this market is on FIRE! PerpetualDiscounts are up 2.84% month-to-date; I noticed yesterday that the S&P/TSX Preferred Share Index (as proxied by CPD) had erased its post-new-issue losses to return to the level immediately prior to the BNS new issue announcement. And more today. So there.

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

MGIC, the US Mortgage Insurer, announced a huge loss today and is seeking capital:

MGIC Investment Corp., the largest U.S. mortgage insurer, fell the most in a month after posting a record quarterly loss of $1.47 billion and said it hired an adviser to raise capital.

MGIC’s fourth-quarter net loss was $18.17 a share, compared with a profit of $122 million, or $1.47, a year earlier, the Milwaukee-based company said in a statement today. Excluding investment losses, the insurer lost $18.09 a share, worse than the $8.13 average loss estimate of seven analysts compiled by Bloomberg.

They’ll have to pay up for capital in this environment!

Buffet’s municipal bond re-insurance offer, mentioned yesterday, attracted some comment at Naked Capitalism amid rumours that it is merely a stalking horse for regulatory action:

This seems to be a misguided application of the “good bank-bad bank” approach used in the saving & loan workouts.

But consider the differences: the dead S&L’s landed in the FDIC’s lap. They had to figure out what to do with them, and they wanted to make a recovery on the payments they made in deposit insurance. So the Resolution Trust Corporation was set up. Note that a big issue was that the Federal government had to continue to fund the S&L’s working capital and also pay to keep some staffing going. That cost was considerable and controversial, and led the RTC to sell assets faster than it would have if it had wanted to maximize value.

The reason for segregating assets was simple: there were two different types of investors who might want to acquire them: banks that hadn’t been too badly damaged were interested in the “good bank” assets; distressed players and wealthy individuals went after the “bad bank” assets. The bad bank assets were going sufficiently on the cheap that even parties that had never dabbled in that sort of deal like Ron Perlman made acquisitions and did very well.

But what does a segregation achieve here? No one but an AAA rated party would make sense as a buyer/reinsurer of the muni portfolio. Buffett already having decided to enter the business on a de novo basis means the only interest another insurer is likely to have is reinsurance.
…
And who would buy the rest? The parties who best understand the CDO/CDS exposures and have reason to do a deal are already at the table. You aren’t going to have new parties materialize out of the blue. Private equity investors like TPG and Bain Capital predictably said no thank you, we don’t understand this stuff.
…
So a simple runoff of the portfolios would make the most sense. Any other activity appears to be for the benefit of lawyers and Perella Weinberg, not the policyholders.

As corporate spreads widen, there are fears that Fed cuts are pushing on a rope:

Companies are paying more to borrow now than before the Fed reduced its benchmark rate by 1.25 percentage point over nine days in January, based on data compiled by Merrill Lynch & Co. Rates on so-called jumbo mortgages, those above $417,000, have increased in the past month, making it tougher to sell properties and risking further price declines.

“It’s the clogging up of the credit markets that worries me most,” Harvard University economist Martin Feldstein said in an interview in New York. “The Fed has done a lot of cutting, the question is whether it’s going to get the traction that it did in the past.”

One example of this is the recent spate of Auction Rate Municipal auction failure. These auctions were last discussed – and explained! – on February 6. Another example is the market for Leveraged Buy-Out loans. Naked Capitalism provides an update to the commentary that was discussed February 11. Incidentally, there’s a new issue of CLO being touted:

Goldman Sachs Group Inc. and Carlyle Group plan to sell a 2 billion-euro ($2.9 billion) collateralized loan obligation and invest their own funds in the riskiest portion, according to a person with direct knowledge.
…
The CLO will mostly hold loans used to finance European leveraged buyouts, purchasing directly from the managers of the transactions as well as loans traded in the market, the person said. Goldman is handling the CLO sale and Carlyle will manage the investments.
…
CELF Partnership Loan Funding 2008-1

Class Size Rating Reinvestment Initial terms

(euros) (M/SP)** Period (years)

A 1.47 bln Aaa/AAA 2 150 bp* B 85 mln Aa2/AA 2 350 bp* C 90 mln A3/A- 2 525 bp* D 70 mln Baa3/BBB- 2 750 bp* E 50 mln Ba3/BB- 2 1100 bp* F 80 mln B3/B- 2 1500 bp* Pref 55 mln 20 percent Sub 100 mln

* in basis points over Euribor ** Ratings are Moody’s Investors Service and Standard & Poor’s

However, when I look at two Fed H.15 releases, for Feb. 11, 2008, and Feb. 12, 2007, I see that 30-year interest rate swaps are now at 4.83% to receive 3.20% LIBOR, vs. the year ago figures of 5.42% to receive 5.36% LIBOR. In Canada, long corporates hit 5.8%+ around the end of September and have been relatively stable since … and when we make a selection from the Fed’s easily accessible data, we see that the October 1 rates were 5.42% to receive 5.30% LIBOR. Note that Swaps were discussed briefly on PrefBlog in the context of synthesizing floating rate preferreds.

So maybe things are being transmitted quite as quickly as some might hope, but it certainly appears to me that there has been a bull steepening … at least as far as the swaps market is concerned! To the extent that arbitrage still exists – and friction has increased a lot in the last six months! – that should filter through to the cash bond market in the course of time.

It should also be noted that in Canada, long corporates and long Canadas are down (in price) roughly the same amount Year-to-Date, so all this fancy-pants Swap-Rate stuff should be taken with a grain of salt – at least as far as Canadian prospects are concerned.

Meanwhile, Treasury Secretary Paulson, fresh from his successes with the Hope Now Alliance and Super-SIV/MLEC is proposing new rules for securitization.

U.S. financial regulators will propose changes in the rules for packaging loans into bonds in the aftermath of the subprime credit collapse.

Paulson said it will be “a number of months” before the Presidential Working Group on Financial Markets announces its recommendations and that easing credit strains is the first “priority.”

In not entirely unrelated news, Moody’s has requested comment on the question “Should Moody’s Consider Differentiating Structured Finance and Corporate Ratings?”. There’s a survey! Log in RIGHT NOW and tell them that cosmetic differences are relevant solely to cosmeticians and bullshit artists!

The German government has bailed out IKB:

Germany will provide 1 billion euros in capital to the Dusseldorf-based lender, government officials told reporters in Berlin today. The country’s banks should help pay for the rest and talks on how to raise the remaining 500 million euros are continuing, the officials said.
…
An agreement on the bailout was necessary because IKB needed 500 million euros immediately to have sufficient capital to fulfill demands by German financial regulator BaFin to avoid insolvency, Scheel said. BaFin President Jochen Sanio threatened to close the bank last week if it didn’t quickly receive new capital, Handelsblatt newspaper reported.

I have been extremely annoyed about the emphasis on SocGen scapegoat Kerviel’s background as a back-office employee, most recently on January 30. My fears of a decline in career mobility appear to be justified:

Kerviel’s unauthorized trading at Societe Generale SA ruined the chances of French bank clerks getting promoted to the trading floor, headhunters say.

Kerviel, 31, became a trader at Societe Generale in 2005 after spending five years in the compliance and control section of the bank’s so-called middle office. Last month, the Paris- based bank blamed him for trading losses of 4.9 billion euros ($7.2 billion).

“The middle office won’t be a springboard to become a trader anymore,” said Gael de Roquefeuil, an adviser for financial industry headhunting at Korn/Ferry International in Paris. “Career bridges were already difficult and at least for the short term they are completely over.”

Great. So, especially in France, one of the primary qualifications in gaining promotion to a management position in trading is not having a clue about operations; such clues are gained only through experience. Expect more blow-ups over the next twenty years as competence and knowledge becomes even further divorced from authority than is already the case in financial services. Not to mention reduced profits even in the absence of problems if the major dealers wilfully reduce the size of their talent pool.

A very strong day for preferreds, with returns well-distributed within each asset class.

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

The Street was alive today with news that Warren Buffet, out of the kindness of his heart, is willing to fix the monoline crisis:

Billionaire investor Warren Buffett said he offered to assume responsibility for $800 billion of municipal bonds guaranteed by MBIA Inc., Ambac Financial Group Inc. and FGIC Corp.
…
“The Buffett plan basically cherry picks out the only worthwhile parts of the portfolio,” said David Havens, a credit analyst at UBS AG in Stamford, Connecticut. “It leaves them with a terrible mix of business.”

Berkshire would put up $5 billion as capital for the plan and is offering to insure the municipal debt for 1.5 times the premium charged by the bond insurers to take on the guarantee. The insurers could accept the offer and back out within 30 days for a fee, Buffett said.

The secret of Buffet’s success? Do business only with those who are stupid and desperate.

AIG’s woes with Credit Default Swaps, which were mentioned yesterday, continued to attract attention today. AIG issued a press release:

AIG continues to believe that the mark-to-market unrealized losses on the super senior credit default swap portfolio of AIG Financial Products Corp. (AIGFP) are not indicative of the losses AIGFP may realize over time. Based upon its most current analyses, AIG believes that any losses AIGFP may realize over time as a result of meeting its obligations under these derivatives will not be material to AIG.

… and so did Fitch:

Fitch Ratings has placed American International Group, Inc.’s (NYSE: AIG) Issuer Default Rating (IDR), holding company ratings and subsidiary debt ratings including International Lease Finance and American General Finance on Rating Watch Negative.
…
AIG has relatively large exposure to the current U.S. residential mortgage crisis. Fitch believes the area of AIG most exposed to further deterioration in this market is the credit derivative portfolio within AIG FP, with its large net notional exposure of $505 billion at Sep. 30, 2007. Included in this total is $62.4 billion of collateralized debt obligations backed by structured finance (SF CDOs) collateral, mainly subprime U.S. residential mortgage-backed securities (RMBS).

Fitch has stated that it believes AIG will not be immune to potential losses from U.S. residential mortgage crisis, although at the present time the agency believes these losses should be absorbed by the existing capital base and future earnings stream. Today’s announcement brings additional uncertainty to the potential impact on the financial statements.

The actual SEC Filing states:

As disclosed in AIG’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007 (the “Form 10-Q”), AIGFP values its super senior credit default swaps using internal methodologies that utilize available market observable information and incorporate management estimates and judgments when information is not available. In doing so, it employs a modified Binomial Expansion Technique (“BET”) model that currently utilizes, among other data inputs, market prices obtained from independent sources, from which it derives credit spreads for the securities constituting the collateral pools underlying the related CDOs. The modified BET model derives default probabilities and expected losses from market prices, not credit ratings. The initial implementation of the BET model did not adequately quantify, and thus did not give effect to, the benefit of certain structural mitigants, such as triggers that accelerate amortization of the more senior CDO tranches.

As disclosed in the Form 10-Q, AIG did not give effect to these structural mitigants (“cash flow diversion features”) in determining the fair value of AIGFP’s super senior credit default swap portfolio for the three months ended September 30, 2007. Similarly, these features were not taken into account in the estimate of the decline in fair value of the super senior credit default swap portfolio through October 31, 2007 that was also included in the Form 10-Q because AIG was not able to reliably estimate the value of these features at that time. Subsequent to the filing of the Form 10-Q, through development and use of a second implementation of the BET model using Monte Carlo simulation, AIGFP was able to reliably estimate the value of these features. Therefore, AIG gave effect to the benefit of these features in determining the cumulative decline in the fair value of AIGFP’s super senior credit default swap portfolio for the period from September 30, 2007 to November 30, 2007 that was disclosed in AIG’s Current Report on Form 8-K/A, dated December 5, 2007 (the “Form 8-K/A”) filed after AIG’s December 5, 2007 Investor Conference.

In addition, during AIG’s December 5 Investor Conference, representatives of AIGFP indicated that the estimate of the decline in fair value of AIGFP’s super senior credit default swap portfolio during November was then being determined on the basis of cash bond prices for securities in the underlying collateral pools, with valuation adjustments made not only for the cash flow diversion features referred to above but also for “negative basis”, to reflect the amount attributable to the difference (the “spread differential”) between spreads implied from cash CDO prices and credit spreads implied from the pricing of credit default swaps on the CDOs.

So … as far as I can make out, this is more of a mark-to-market problem than an actual credit problem, but I’d have to do a lot more work before I bet a nickel on that scenario. The trouble is that AIG has shareholders equity of $104-billion and notional exposure of $505-billion. So just on this notional bond portfolio – of credit quality that I’m not looking at right now – they’ve levered up the company 5:1, on top of whatever leverage is implicit in their regular insurance operations.

There is a rather amusing section in their most recent 10Q:

As of October 31, 2007, AIG is aware that estimates made by certain AIGFP counterparties with respect to the fair value of certain AIGFP super senior credit default swaps and the collateral required in connection with such instruments differ significantly from AIGFP’s estimates.

Yeah, I’ll just bet!

Quite frankly, I don’t understand their investment strategy … or, I should say, I don’t understand how it makes sense. Why would an operating company seek to make money simply by levering up to hell-and-gone? I can certainly see them having a trading portfolio, and I can certainly see them having a greater value of tradeable instruments on the books than the value of their capital … but these CDSs were not – and, importantly, are not – tradeable … not in the same way regular bonds are tradeable, anyway, since you’ve got counterparty risk in there that cannot – usually – be transferred. CDSs are not fungible.

I am all in favour of big financial institutions providing liquidity – as dealer normally do, by keeping positions on their books for as long as it take to find somebody who wants to take the other side – but AIG was not, strictly speaking, providing liquidity except in the most general and useless sense.

Well, it’s easy to be wise after the event! But given the oppobrium in which large brokerage houses (and their stock prices) are now held, it will be most interesting to see whether any of the big-big-big public ones go private in the near future in a reversal of recent trends:

The private partnerships that once dominated Wall Street guarded their capital, used less leverage and limited their risk to trading blocks of stock for clients and shares of companies in mergers, said Roy Smith, a finance professor at New York University’s Stern School of Business and a former partner at Goldman Sachs Group Inc. Since raising money from the public, many of the biggest firms have abandoned that caution.

There was TAF auction today, which at least one news source thinks is new money. In fact, this auction, which resulted in a stop-out rate of 3.01%, simply rolls over the loans from the January 14 auction. It is interesting to compare this with the Fed Funds Rate of 3.00% … the next FOMC meeting is March 18, which is after the maturity of these loans. It would appear that:

• No intra-meeting activity is anticipated
• there is no term premium being paid on this money

Pedants may wish to point out that this is not necessarily the case, since these two effects might be equal and opposite; I will apply sophisticated quantitative analysis in my rejoinder: So’s your old man! Ray Stone of Stone & McCarthy Research Associates notes:

“The TAF program was an ingenious approach to solving a serious problem” of strained money markets, Mr. Stone says in a note to clients. “That said, it is not clear that the TAF program should be employed except in the extraordinary circumstances that have prevailed in recent months.” The TAF credit weakens the Fed’s balance sheet because the collateral offered at auction is inferior to the Fed’s other holdings, he says. And the result of the two January auctions — with interest rates below the federal funds target — “raises a philosophical issue as to whether the Fed’s provision of reserves at a rate below the target debases the role of the FOMC,” he says.

Note, however, that Bernanke has stated:

Based on our initial experience, it appears that the TAF may have overcome the two drawbacks of the discount window, in that there appears to have been little if any stigma associated with participation in the auction, and–because the Fed was able to set the amounts to be auctioned in advance–the open market desk faced minimal uncertainty about the effects of the operation on bank reserves. The TAF may thus become a useful permanent addition to the Fed’s toolbox.* TAF auctions will continue as long as necessary to address elevated pressures in short-term funding markets, and we will continue to work closely and cooperatively with other central banks to address market strains that could hamper the achievement of our broader economic objectives.
…
*With the footnote: “Before making the TAF permanent, however, we would seek public comment on its design and utility.”

The Fed Funds Futures are projecting a massive easing at the March meeting, to hit 2.5% in April before bouncing back (although the later contracts are low-volume). You know something? This is all very strange.

Not the most interesting of days. Volume was light and there wasn’t much price movement.

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

I mentioned the increasing nervousness of the Treasury market on February 8 and now Accrued Interest has opined:

Treasury yields at current levels can only be supported if the Fed holds interest rates low for an extended period of time and inflation doesn’t become a problem. Traders know this is a very fine line to walk, and confidence in Bernanke’s ability to walk that line is, well, not as strong as it could be. It will probably take a pretty stiff recession to keep inflation low despite highly accomodative monetary policy. Tuesday’s ISM report supported the idea that we are already in a recession, and therefore supported rates at their current levels. But if it turns out we aren’t in a recession, the Fed will have to make a rapid reversal of policy to combat inflation. If so, long rates will be the big loser.

Place yer bets, gents, place yer bets! Never mind Bernanke, I have serious doubts about anyone’s ability to walk the line demanded by current long rates.

In news that may be of interest to BCE Takeover Speculators, Naked Capitalism has exerpted articles regarding the current weakness of the Collateralized Loan Obligation (CLO) market:

Investment banks are sitting on sizable unsold inventories that are declining in value, thus sure to lead to further writedowns. And ironically, the Fed’s interest rate cuts are only making matters worse. These instruments are floating-rate, priced off the short end of the yield curve, so rate cuts lower their interest payments, making them less attractive to investors.

The Journal article adds some useful information: UBS and Wachovia are set to auction $700 million of loans believed to underlie some collateralized loan obligations (instruments made from pools of leveraged loans) adding to further pressure to the market.
…

Readers who have become heartily sick of seeing the word “monoline” in this blog will be gratified to learn that a multi-line insurer has now gotten in trouble over a CDS portfolio:

American International Group Inc., the world’s largest insurer by assets, fell the most in 20 years in New York trading after auditors found faulty accounting may have understated losses on some holdings.

So-called credit-default swaps issued by AIG lost $4.88 billion in value in October and November, four times more than previously disclosed, the company said today in a filing with the U.S. Securities and Exchange Commission. AIG’s auditors found “material weakness” in its accounting for the contracts, according to the filing. The insurer said it has no yearend price estimate for the obligations.

Similarly, SocGen is looking for €5.5-billion. Meanwhile, a group of US banks is seeking to avoid foreclosures:

Bank of America Corp., Citigroup Inc. and four other lenders will announce new steps tomorrow to help borrowers in danger of default stay in their homes, according to three people familiar with the plans.

The banks will start “Project Lifeline,” offering, on a case-by-case basis, a 30-day freeze on foreclosures while loan modifications are considered, two people said on condition of anonymity. The companies met with Treasury officials over the past week to discuss ways to encourage homeowners to get in touch with their mortgage servicers, one person familiar with the deliberations said.

Translation (courtesy of PrefBlogs Spin/English dictionary [patent pending]): “Please don’t make us buy all these damn houses.”

On February 6 I noted some news reports about Auction Rate Municipals auctions failing … now they have been joined by some Student Loan securities:

College Loan Corp., a San Diego- based lender, said some bonds it issued with rates determined through periodic auctions failed to attract enough bids.

The company wouldn’t say which specific issues failed or identify the banks that managed the auctions.

Demand for bonds in the $360 billion auction-rate securities market is waning on investor concern that dealers who collect fees for managing the bidding on the bonds won’t commit their own capital to prevent failures. Reduced appetite for auction-rate debt in the municipal market also reflects expectations that the credit strength of insurers backing the securities may deteriorate.

A quiet day, of overall good performance. To my regret, I am unable to update the indices at this time. I regret this because it proves I’m an idiot. Never mind the story … you don’t want to know.

Bill Gross of PIMCO (whose forecast of FedFunds at 3.50% was mentioned here on October 29) has called for rough justice for the monolines:

As long as the illusion lasted, however, it is clear that monoline guarantees fostered an expansion of our modern shadow banking system and therefore an extension of US and even global economic prosperity.
…
…authorities through both official and backdoor channels now endorse a rescue effort. What is good for Ambac, they reason, is good for the country – and by extension the world.
…
As stock markets rise on optimistic workout developments, it is clear that it is – in the short run. But like General Motors a half century back, the sense of stability imparted to an oligopolistic industry with visible flaws is not likely to last, nor may the hope for a return to economic growth of recent years. The modern US financed-based economy has a striking resemblance to Barney Fife, guaranteeing global prosperity without the productive industrial-based firepower to back it up. Neither ultra-low interest rates or tax rebates, nor investor-led and authority-based monoline bailouts are likely to change that significantly during the next few years.

I’m inclined to agree with him … as far as I can tell – without specializing in such matters – the monolines are better characterized as hedge funds than anything else. Let them fail!

Treasury trading is showing increasing nervousness:

Traders drove two-year note yields to 172 basis points below 10-year rates, the widest gap since September 2004. The spread signals increasing demand for shorter-maturity debt in anticipation that interest rates will fall. Longer-dated securities are more vulnerable to speculation that rate cuts will revive the economy, spurring inflation and eroding the bonds’ fixed payments.

Two-year notes are poised for the longest stretch of weekly gains since October 1998, while 10-year notes are headed for their biggest weekly loss in almost two months. Thirty-year yields have risen this week by the most in nine weeks.

I am fearful of US inflation, but it takes two to make a market! Janet Yellen, president of the Federal Reserve Bank of San Francisco, takes the other view:

I expect core inflation to moderate over the next few years, edging down to around 1¾ percent under appropriate monetary policy. Such an outcome is broadly consistent with my interpretation of the Fed’s price stability mandate. Moreover, I believe the risks on the upside and downside are roughly balanced. First, it appears that core inflation has been pushed up somewhat by the pass-through of higher energy and food prices and by the drop in the dollar. However, recently, energy prices have turned down in response to concerns that a slowdown in the U.S. will weaken economic growth around the world, and thereby lower the demand for energy.… Another factor that could restrain inflationary pressures is the slowdown in the U.S. economy. This can be expected to create more slack in labor and goods markets, a development that typically has been associated with reduced inflation in the past.

We shall see! 

I’ve added another blog to the blogroll … Across the Curve. As with Accrued Interest, I don’t know the guy (John Jansen) and haven’t verified any of his claimed credentials … but I’ve read his posts and yes, he’s been a player.

I discussed the effect of the TAF on bank reserves – and hysterical reactions thereof – on January 29. Naked Capitalism is now republishing a UBS research note that, frankly, I don’t understand at all:

What if the Fed’s rate cuts aren’t motivated by the desire to stave off recession, rather they’re to prevent a major banking crisis. Not one of escalating subprime losses or monoline downgrades, but actually a sheer lack of cash. The Fed’s not telling anyone what it’s up to because it doesn’t want to cause panic, but the evidence is actually there in its own data…

Ok, so things might not be quite as bad as that, but the situation isn’t far off. That’s because of the TAF. ….a savvy bank can put down lesser quality paper that it can’t generally do very much with (and certainly no one else really wants it), raise funds through the TAF, then use those funds to put down as reserves, and then conveniently gets paid a modest rate of interest against those reserves (which acts as a partial offset against the TAF). While there’s a small net cost to the banks, the real loser here is the Fed, what it gets stuck with is an ever growing pile of collateral.

Now consider this – that collateral is actually what’s backing the entire US banking system by way of its conversion to dollars and then the flow of those same dollars back to the Fed….

All this changes the complex of the US banking system somewhat. From the gold standard to the subprime standard perhaps?

In the first place, there is no interest paid on reserve balances. In the second place, the monetary effect of the TAF was neutralized by the Fed’s sale of T-Bills. I note Caroline Baum’s column and say: one may take a view on the advisability of the TAF, one may take a view on capital adequacy, and one may take a view on inter-bank lending; but any hullaballoo over “negative non-borrowed reserves” is hysterical nonsense:

The writer of the e-mail directs his readers to the most recent H.3 report, which shows total reserves ($41.6 billion) less TAF credit ($50 billion) less discount window borrowings ($390 million) equals non-borrowed reserves (minus $8.8 billion). The negative number is really an accounting quirk: If banks borrow more than they need, non-borrowed reserves are a negative number.

This gentleman is overlooking the fact that the Fed is “a monopoly provider of reserves,” said Jim Glassman, senior U.S. economist at JPMorgan Chase & Co. “This is a non-starter. There is no such thing as a banking system short of reserves. The Fed has absolute control over the supply.”

[Update: See also Felix Salmon at Why Non-borrowed Reserves Don’t Matter] 

On the Better-Living-Through-More-Rules front, SEC Chairman Christopher Cox made a speech today:

Among the proposals that the Commission may consider in the spring are rules that would require credit rating agencies to make disclosures surrounding past ratings in a format that would improve the comparability of track records and promote competitive assessments of the accuracy of past ratings. In addition, the Division may propose rules aimed at enhancing investor understanding of important differences between ratings for municipal and corporate debt and for structured debt instruments.

I have also asked the Division to present proposed rules to the Commission that begin to address the significant shortcomings that we’ve identified in the municipal market. The recent financial stress on monoline insurers has heightened the importance of timely and rigorous disclosure that investors can understand. We have had ample illustration already of what happens when investors fail to look past an AAA rating to do independent analysis themselves — a problem that was exacerbated when important information was not supplied to the market in real time.

Well, I don’t have any problems with the transition analyses that the agencies currently publish, but I suppose if a standard format for these is defined it’s not horrible. I fail to see the point of the other stuff, though: “may propose rules aimed at enhancing investor understanding”; “what happens when investors fail to look past an AAA rating to do independent analysis themselves”. Seems to me these are due diligence issues, to be addressed at the SEC/Advisor level; with performance issues to be Client/Advisor.

I love the way that Mr. Cox assumes that advisors at fault in the sub-prime debacle will actually read additional information if it is available. All the rules in the world won’t make a genius out of a bad advisor.

It was a very quiet day for prefs. PerpetualDiscounts had their first down day since January 28 – they have gained 3.1% since then.

In the continuing saga of the credit rating agencies, S&P has announced the creation of an ombudsman position, together with other reforms:

Among the changes set to be announced today, S&P will rotate lead rating analysts after five years of following the same company, government bond issuer, or structured-finance arranger. The new practice, which will be phased in, should prevent professional or personal relationships from affecting ratings, company officials said.

Analysts who leave S&P to work at a bond issuer will have some deals they previously rated reviewed to make sure their objectivity wasn’t compromised by the prospect of the new job.

Hey! That makes all kinds of sense, doesn’t it? Perhaps, now that I’ve been offering advice on preferred shares for over five years, the regulators should insist that I be rotated to, say, junior oil equity. Naked Capitalism isn’t much impressed:

The real problem that the agencies are paid by the very organizations they rate, and as long as this conflict remains, all other measures are mere window-dressing. The creation of an ombudsman role is an inadequate, unrealistic remedy for a problematic payment structure.

Well, last I heard, this was still a reasonably free country. Anybody who doesn’t want to take S&P’s advice is (as far as I know) welcome to listen to somebody else. But nothing, particularly not logic, will dampen expectations for certainty and a risk-free investment environment … portfolio managers should, if anything, welcome the provision of bad advice (if we may make the assumption, for the moment, that S&P’s advice is bad), since this will lead to market mispricing that may be exploited.

Andrew Cuomo, well known for his uncanny expertise at fixed income credit analysis, isn’t much impressed either:

New York Attorney General Andrew Cuomo said “supposed reforms” by Standard & Poor’s and Moody’s Investors Service, which gave high ratings to subprime debt that later plummeted, are “too little, too late.”
…
“Both S&P and Moody’s are attempting to make piece-meal changes that seem more like public relations window dressing than systemic reform,” Cuomo said in the statement.

In more interesting news, it appears that Credit Default Swaps may have increased the corellation in the mononlines sector:

Separately, the Financial Times reports on yet another largely unrecognized hole in the bond insurers’ balance sheets. Wall Street was apparently fond of a so-called negative basis trades. If they bought a bond, hedged it with credit default swaps, then hedged the risk of the guarantor defaulting (generally a monoline) with a different guarantor (generally a different monoline), they could accelerate the expected profits over the life of the deal into the current period. The result is that the bond insurers have an unknown (to the outside world) but potentially significant number of guarantees written on each other.

There is at least one player trying to whip up the panic:

Deutsche Bank AG Chief Executive Officer Josef Ackermann said rating downgrades for bond insurers pose risks that could match the U.S. subprime market collapse.

“It could be a tsunami-like event comparable to subprime,” Ackermann said in a Bloomberg Television interview in Frankfurt today. Deutsche Bank, Germany’s biggest bank, is “well positioned” on its risk from bond insurers, he said

But there is another player – one not trying to sell a specific product – who has an opinion. Bernanke is concerned that monoline problems could cause banks’s balance sheets to gross-up. And Moody’s has downgraded SCA:

Security Capital Assurance Ltd.’s bond insurance units, hobbled by a decline in subprime mortgage securities, lost their Aaa credit rating at Moody’s Investors Service.

XL Capital Assurance Inc. and XL Financial Assurance Ltd. were cut six levels to A3, New York-based Moody’s said today in a statement. The outlook for both is negative, Moody’s said.

And MBIA, desperate to avoid such a fate, has embarrassed itself even more than it did yesterday by selling even more equity at an even lower price:

MBIA Inc., the world’s biggest bond insurer, raised $1 billion by selling shares at $12.15 each in an effort to protect its AAA insurance rating.

The 82.3 million shares were sold at a 14 percent discount to Armonk, New York-based MBIA’s $14.20 closing price today, according to data compiled by Bloomberg.

MBIA increased the sale from a planned $750 million, though accepted a lower price than it had anticipated. The sale matches the price private-equity firm Warburg Pincus LLC had agreed to pay to backstop the transaction in case no buyers could be found.

Speaking of downgrades, Loblaws was downgraded today, which has implications for Weston. I’ve updated the post about Weston’s credit. 

The Cleveland Fed has updated its estimate of inflation expectations from TIPS … very interesting indeed. The breakeven rate is increasing slightly, but the analytical rate – which attempts to incorporate adjustments for the inflation-risk-premium and liquidity-premium – is skyrocketting. This epsiode will be very useful in determining the validity of these adjustments!

I have opined many times in the past that the Fed’s easing may well rebound in an unfavourable manner vis-a-vis inflation – scarcely the most original of views, but I do what I can. In this context, it was interesting to read the following report on the Treasury Bond auction:

U.S. 30-year Treasuries fell the most since June as demand was weaker than expected at the government’s $9 billion auction of the securities.

Ten- and 30-year securities declined a second straight day as investors balked at buying at this week’s auctions, with yields at record lows. Investors are also betting that the Federal Reserve’s five interest-rate cuts since September will revive economic growth and cause inflation to accelerate, reducing the value of Treasuries’ fixed payments.

“The auction went as poorly as one could imagine,” said Andrew Brenner, co-head of structured products in New York at MF Global Ltd., the world’s largest broker of exchange-traded futures and options contracts. “There isn’t a lot of demand for bonds at these levels.”

These fears are finding support at high levels:

Federal Reserve Bank of Dallas President Richard Fisher, who voted against cutting interest rates last week, warned that aggressive reductions in response to a weak economy may “juice up” inflation.
…
“Given that I had yet to see a mitigation in inflation and inflationary expectations from their current high levels, and that I believed the steps we had already taken would be helpful in mitigating the downside risk to growth once they took full effect, I simply did not feel it was the proper time” for more rate cuts, Fisher said.

Another good day! PerpetualDiscounts continued to improve and volume remained above the recent average.

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

Willem Buiter was last mentioned in PrefBlog on January 25 in connection with inflation concerns. He’s back again today, preaching not just the likelihood, but the necessity of a US recession:

Therefore, to restore a sustainable external balance and to accumulate the financial assets that will support a greying US population in the style it would like to and hopes and expects to be accustomed to, the US private and public sectors must save more. To get to a higher saving and wealth trajectory, the US economy will first have to pass through the valley of the shadow of deficient effective demand, rising excess capacity and growing unemployment. Postponing the necessary adjustment will just make the pain of the eventual unavoidable correction that much greater.

The trouble with such a prescription is that it runs headlong into the American “can do” attitude. This attitude is admirable and has served them well … but sometimes it comes a cropper. “Reduce taxes and the deficit while increasing services? Can do!” “Bring Western Democracy to regions where even those who understand it don’t want it? Can do!”.

The failure of a few auctions for American Auction Rate Municipals has attracted some notice lately. Accrued Interest explains the situation … it all comes down to the monolines!

The bank was only willing to provide liquidity if there was some additional credit support. No problem, thought the municipal bond bankers! We’ll bring in a monoline insurer! The bank would therefore agree to provide liquidity so long as the bond insurer was rated at some minimal credit rating level. What that level is depends on the deal. Might be AA, might be A. I haven’t seen any that were actually AAA but they could be out there.

But what happens if the unthinkable happens? A monoline insurer gets downgraded? Well, the bank’s liquidity agreement becomes null and void. Where does that leave bond holders? It leaves them with no credit support at all. Only the issuer itself would remain.

Auction rate securities are a recurring niche in the markets – I remember (a long, long time ago) there were some Hees (remember Hees?) MAPS – Monthly Auction Preferred Shares. It’s really just another mechanism whereby issuers can finance long at short rates and investors can pretend they’re money-market superstars by outperforming the 3-month benchmark with 100-year paper … for a while.

And the mention of monolines reminds me of a funny story … remember MBIA’s line in the sand, discussed on January 31? Well, the tide’s come in:

MBIA Inc., the world’s biggest bond insurer, plans to raise an additional $750 million by selling about 50.3 million common shares, bolstering capital in an attempt to retain its AAA credit rating.

Investment firm Warburg Pincus will backstop the offering by purchasing as much as $750 million of convertible participating preferred stock, the Armonk, New York-based company said in a statement today. MBIA, which has already raised at least $1.5 billion since November, said it would contribute most of the proceeds to its MBIA Insurance Corp. unit.

Another article highlighted by Naked Capitalism delivers a rather vague exhortation for increased bank regulation while one particular example purporting to show the need concerns some recent problems with Wachovia:

AmeriNet was a “payment processor,” a company that creates unsigned checks on behalf of telemarketers to withdraw funds automatically from customer accounts. Such checks, once widely used by businesses collecting monthly fees, are legal if customers approve the transactions.
…
In 2006, an executive at Citizens Bank wrote via e-mail that thieves were routing unauthorized checks through Wachovia that stole from Citizens account holders.

“We have spoken to many of our customers who have been victimized by this scam,” wrote the Citizens executive, according to court documents. “We would appreciate it if you would shut down accounts of any customers of yours that may be engaging in improper activity.”

But Wachovia kept that account open until it was frozen by a federal court a few weeks later, as part of a government lawsuit against the client.

This is just more nonsense from the “Everything will be better with just a few more rules” camp. It is very tempting to believe that a few more rules will bring the new millennium, but those who argue in favour of this have never seen what happens in real life. Rules such as this – shutting down accounts due to suspicions of fraud – are not investigated by dispassionate keen-eyed investigators who have the evidence weighed by judicious descendents of Solomon. It is, in fact, a virtually random process in which facts become secondary to ass-covering.

In the quoted text above, the Citizens Bank executive should not have been contacting Wachovia – if they became involved at all, I suggest that police are generally considered the proper authorities for investigation of impropriety.

A bank clerk is not a cop I trust. A branch manager is not a judge I trust. And wishing won’t make it so.

But, that’s what happens when stuff hits the headlines – everybody’s an expert:

Regulators may restrict Moody’s Investors Service and Standard & Poor’s from advising banks on structured debt securities after criticism the firms failed to downgrade subprime-related debt as investor losses mounted.

Ratings firms may face a new code of conduct that limits their business and requires “reasonable steps” to ensure “a credible rating,” the International Organization of Securities Commissions in Madrid said in a statement today. IOSCO is the main forum for regulators, covering more than 100 countries from the U.S. to Japan.

I sure wish there was a code of conduct for regulators forcing them to take reasonable steps to ensure credible regulation!

An IMF research group has summarized a paper on VoxEU arguing that the subprime crisis is not unusual:

The subprime experience demonstrates that even highly-developed financial markets are not immune to problems associated with credit booms.

What can be done to curb bad credit booms? Historically, the effectiveness of macroeconomic polices in reducing credit growth has varied (see, for example, Enoch and Ötker-Robe, 2007). While monetary tightening can reduce both the demand and supply of bank loans, its effectiveness is often limited by capital account openness. This is especially the case in small open economies and in countries with more advanced financial sectors, where banks have easy access to foreign credit, including from parent institutions. Monetary tightening may also lead to significant substitution between domestic and foreign-denominated credit, especially in countries with (perceived) rigid exchange rate regimes. Fiscal tightening may also help reduce the expansionary pressures associated with credit booms, though this is often not politically feasible.

Fiscal tightening didn’t have much chance under a Republican administration! When in doubt, assume the best, right? It is very interesting to speculate as to what might have happened under Prof. Taylor’s counterfactual scenario of Fed tightening during the boom. We are certainly seeing that sub-prime sucked in a lot of money from Europe even with the relatively loose Fed policy during that time.

A very good day for the preferred share market, although I don’t see how the S&P/TSX Index was able to improve by 0.55% … half that, sure, two-thirds, maybe, but I suspect that this is an artefact of calculation caused either by low closes yesterday or high closes today.

Be that as it may, it was a strong day, with volume picking up and good strength throughout the entire PerpetualDiscount index. This index now has an interest-equivalent yield of 7.62% (at a conversion factor of 1.4), which is Canadas +350bp, Long Corporates +180bp. This latter (and probably more meaningful) figure has narrowed in about 30bp since last reviewed October 30, but still has a long way to go before reaching last spring’s levels of Long Corporates + ~110bp.

Hmmmm …. 70bp x 14years duration = … I’ll take it!

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