Category: Market Action

Menzie Chinn at Econbrowser has reviewed credit and term spreads: 

He notes:

It might appear that the two phenomena are unrelated. But the DB article argues that while banks pursued off-balance sheet activities such as “rating transformation” (transmuting assets of one credit default risk category to another category by financial engineering), they moved away from reliance on maturity transformation and taking on credit risk. With the end of the structured credit market, and reorienting of banks’ operations, credit spreads and term spreads will reappear.

Interestingly, as Chart 6 illustrates, term and credit spreads are not back to where they were pre-2005. However, in terms of the latter, they’re close. And, as time on goes on, one might very well expect further curve steepening.

It would certainly be a pleasure to see some actual curve steepening! Preferably a bull steepening (in which the steepening is effected by a decline in shorter-term rates), just to wipe the smug smile off the faces of those who claim to be avoiding risk by shortening term! Bloomberg notes, however, that steepness and fear of inflation are intertwined.

In somewhat related news:

JPMorgan Chase & Co. CEO Jamie Dimon said SIVs, whose assets have dwindled by at least $75 billion since July, will “go the way of the dinosaur.”

“SIVs don’t have a business purpose,” Dimon, 51, said at the Merrill Lynch conference today.

I consider this “somewhat related” because of the term spread; a SIV is nothing more nor less than an unregulated “country bank”, seeking to make money from the term spread (financing long-term assets with short paper) and the credit spread (enhancing the credit quality of its debt by subordination of its senior tranches with equity tranches). What we are seeing now is the unravelling of the business model due to:

• General loss of confidence (equivalent to a bank run)
• Bad quality on their asset side

… which are the same things that will do in any bank.

While I agree that SIVs qua SIVs are dead, I’m not so sure that they served no business purpose; and feel entirely confident that other vehicles – probably better capitalized and not so aggressive with their financing models – will arise to take their place. People want to lend short and borrow long. In the aggregate, short-term money is available for the long term. Banks, SIVs and ABCP conduits all serve the same business purpose in this respect … so I’m not sure what Dimon meant.

I mentioned possible downgrades of bond insurers on November 9. Accrued Interest has continued his educational campaign by analyzing some scenarios for ABS default, insurance and recovery that sheds quite a bit of light on the matter.

The CDOs are tricksy things! Fitch Ratings indulged in a mass downgrade yesterday:

Derivative Fitch–New York–12 November 2007: Derivative Fitch has downgraded $37.2 billion (U.S. dollar and U.S. dollar equivalent) and affirmed $6.9 billion of structured finance collateralized debt obligations (SF CDOs) across 84 transactions. Fitch’s rating actions follow the completion of a review of 55 U.S. and European SF CDOs executed on a synthetic basis, and 29 U.S. and Asian SF CDOs executed on a cash/hybrid basis. Ratings on 66 U.S. cash and hybrid SF CDOs remain on Rating Watch Negative pending resolution on or before Nov. 21, 2007.

A downgrade:affirm ratio in excess of 5:1 is big news, especially since many of the downgrades are multi-level:

more than $14 billion worth of transactions falling from the highest-rated AAA perch to speculative-grade, or junk, status.

The implications can be as scary as you want them to be. Naked Capitalism provides excellent links to some informed discussion. Just to make things even more interesting – for those of you who are bored by mere multi-billion writeoffs – Naked Capitalism also reports on a now somewhat dated (two weeks) judgement refusing foreclosure to Deutsche Bank:

Judge Christopher A. Boyko of the Eastern Ohio United States District Court, on October 31, 2007 dismissed 14 Deutsche Bank-filed foreclosures in a ruling based on lack of standing for not owning/holding the mortgage loan at the time the lawsuits were filed.

Whether this was an isolated SNAFU by Deutsche, or indicative of lack of paper trail maintenance by the various intermediaries, is something regarding which I do not care to speculate at this time.

Naked Capitalism also takes issue with Countrywide funding its operations with Certificates of Deposit, but I can’t see any problem with that … provided that FDIC and Fed is supervising the bank properly and it’s solvent. Otherwise, of course, it would be a Bad Thing. I’m much more concerned about the back-door guarantees via the Federal Home Loan Banks, as I noted on October 30.

I noted yesterday that Legg Mason was bailing one of its MMFs out of SIV paper – now it appears that Sun Trust is doing the same thing along with Bank of America and at least two others. This is a very worrisome development for the investment industry as a whole … I am currently trying to finish an article on the topic, but there’s a lot going on in the market just now! In an overdue development:

The 10 largest managers of U.S. money funds have about $50 billion in short term debt of SIVs, some issued by vehicles such as Cheyne Finance Plc that defaulted as investors shunned the funds on concerns about losses from securities linked to subprime mortgages, according to reports from the companies.
…
BlackRock, the largest U.S. publicly traded asset manager, has been in contact with the Treasury, Fink said. BlackRock will raise “multibillion dollars” to invest in distressed securities that are resulting from the “chaos” in the market, Fink said, while declining to elaborate on fund details.

Well, whether Superconduit = Vulture or not, there’s at least one major player stepping up!

If today’s news has been too cheery for you: consider deadly bird flu!

Good volume, poor returns in the preferred share market today.

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

A quiet day, with bond markets closed for Rememberance Day.

There is speculation the Fed will move to explicit inflation targetting … but the WSJ can’t make up its mind. At a Bank of Canada conference in 2006, Alan Blinder, a former Fed Vice Chairman, commented on evolution of Bernanke’s thinking on the subject to that date.

There are some heavy-weight predictions of a US slowdown floating around, linked by both Naked Capitalism and WSJ. Willem Buiter points out that the banks are feeling some strain:

At the end of October 2007, the net worth of commercial banks in the US (as reported by the Fed) stood at just under $ 1.1 trillion (against assets of $10.7 trillion). Tier 1 capital stood approximately at $964 bn. While quite a significant share of the mortgage-related losses will be born by financial institutions other than commercial banks, such as investment banks, commercial banks’ capital will take a significant hit.
…
The combination of losses and unintended asset accumulation may depress the banks’ capital ratios to the point that dividends and share repurchases are threatened and even rights issues may have to be contemplated. All that does not do much for their willingness to engage in new lending, including to the real economy.
…
The single best thing that could happen would be for the true magnitude of the losses suffered by banks and other exposed parties to be revealed and put in the P&L. Until what happens, fear of getting stuck with the hot potato makes banks unnaturally unwilling to extend credit against the kind of collateral that they would not have thought about twice accepting at the beginning of the year.

Noriel Roubini, while acknowledging the banks’ problems, considers the wealth effect and increased difficulty of Home Equity Withdrawal to be more important.

Naked Capitalism points out that there is mass confusion over Super-Conduit, what it is supposed to be doing and whether there is economic reason to expect it to work … but quite frankly, I can’t be bothered to discuss the situation much any more. There’s no information – merely rumours. I’ll talk about it when there’s something to talk about.

But there is some related news illustrating the problem. Readers with exceptional memories may remember Ottimo Funding, briefly mentioned here on August 21:

Mortgage companies without any sub-prime on their books, such as Ottimo Funding LLC, are experiencing financing difficulties.

Well, it’s gone bust:

Ottimo Funding Ltd., whose name is Italian for “excellent,” started selling its $2.8 billion of mortgage bonds this week after being unable to raise debt financing in the commercial paper market, according to three people with knowledge of the sale.

The securities being auctioned are rated AAA and backed by Alt-A mortgages, a credit class above subprime, according to Standard & Poor’s. The sale probably won’t generate enough cash to fully repay investors who bought short-term debt from the fund, the ratings firm said last week.

As far as I can make out from S&P ratings reports, Ottimo was one of several Extendible asset-backed commercial paper (ABCP) conduits with no or partial third-party liquidity support – in other words, it was like a Canadian ABCP issuer, relying on credit enhancement and extendability to avoid liquidity squeezes.

In a fascinating report, the Asset Management firm Legg Mason has disclosed it is bailing one of its MMFs out of ABCP trouble:

Legg Mason Inc. invested $100 million in one of its money-market funds and arranged $238 million in credit for two others as a cushion against potential losses on commercial paper linked to subprime mortgages.

In related problems, E-Trade is in trouble:

Chief Executive Officer Mitchell Caplan’s strategy of building E*Trade’s bank by tripling loans outstanding backfired as borrowers fell behind on payments and U.S. home prices declined.
…
Bhatia estimated that E*Trade will post a loss in the fourth quarter after setting aside $500 million in extra money for bad loans and writedowns. Clients in the company’s brokerage unit may shift their accounts to rivals, while deposits at the bank could erode, said Bhatia, who cut his rating on the stock to “sell” from “hold.”

Citigroup is downgrading E*Trade “based on the higher probability of a run on the bank,” Bhatia said.

But let’s keep things in perspective. While there is lots of pain, while some people are losing their jobs, others their houses and an overall slowdown in forecast by some … Wall Street is still on track for a great year. They take risks and when it works against them the numbers are huge … but when they work out – as, by and large, they did in the first half of the year – the numbers are even bigger.

At least one Wallaby Street player is doing pretty well too:

Macquarie Group Ltd., Australia’s biggest securities firm, said first-half profit climbed 45 percent to a record on higher trading income and increased fees from mergers and acquisitions.

Net income rose to a record A$1.06 billion ($931 million), or A$4.02 a share, in the six months to Sept. 30, from A$730 million, or A$3.01 a share, a year earlier, the Sydney-based bank said in statement today. That beat the $1.03 billion median estimate of four analysts surveyed by Bloomberg.

It was a quiet day for prefs with relatively light volume … not only were the bond markets closed, but all eyes were on stocks and currencies! It was good to see BAM.PR.N among the volume leaders … but a continuing puzzle to see it among the loss leaders as well!

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

Well, there’s a day and a half!

US T-Bill yields plunged again and Fed Funds futures are now showing certainty of a cut to 4.25% in January, down from the current 4.5%. In what may be assumed to be related news, the Bank of Canada intervened to boost the overnight rate – presumably, there’s a lot of cash-equivalent money looking for a home.

There are alarming reports of gloomy consumers, but the direct catalyst is, as usual, more bad news from the banks. CIBC, ‘bank most likely to walk into a sharp object’, is taking a $463-million CDO/RMBS writedown, which offsets their gains from the VISA restructuring (TD has managed to hang on to its profit). Rumours that Barclays is looking at a big write-off triggered a temporary collapse of their share price, but they staggered back to more usual levels by the end of London’s trading day – Barclays’ CEO has stated “his refusal to comment on subprime writedowns indicates there is no truth to speculation about losses that wiped 29 percent off the bank’s market value in the past month”. Wachovia has disclosed $1.7-billion mark-to-market losses in October alone. Nouriel Roubini somewhat gleefully forecasts a total of $500-billion on a mark-to-market basis.

It’s almost a relief to see news of the first CDO liquidation:

Carina is the first CDO to begin unwinding after a slump in the credit worthiness of the underlying assets, S&P said. Thirteen others have informed S&P of an event of default, a precursor to liquidation. A widespread fire sale by CDOs, which package asset-backed securities and resell them in pieces, may further exacerbate declines in subprime-mortgage securities.

As these structures unwind it will become easier to sort out the winners from the losers … and easier for investors to price the assets!

On November 7 I made the comment:

Even worse, Citigroup has increased its exposure to CDO-issued CP, which has had the effect of ballooning the amount of Level 3 ‘Mark-to-Make-Believe’ assets. Citigroup’s cost of borrowing, as proxied through Credit Default Swaps, is skyrocketting.

I should make this more clear; banking & investment strategy is sometimes a little more complicated than can be summarized in a couple of casual sentences – particularly when discussing an institution that has more capital in the business than the Canadian Big Five-and-a-Half put together. It is not necessarily a Bad Thing for Citigroup to accumulate CDO paper and Level 3 assets. Panic has hit the markets and panics are the perfect time for an organization that has already done its homework to make an absolute killing taking unwanted assets off other people’s hands.

However, there are knock-on effects. If this same panic causes their borrowing costs (as proxied by CDS levels) to increase beyond the expected winnings, then the strategy becomes defunct. No matter how stupid the market is being in increasing the funding costs of such an investor. Blind fear in the marketplace can paralyze even a well-prepared investor.

What’s needed is for “real money” investors (those who will be perfectly happy holding on to the paper until maturity, like pension funds, retail investors and such, since they’re not completely at the mercy of mark-to-market; as opposed to “hot money” investors who want to flip it next week) to step up and buy the stuff. I suspect, however, that any pension fund manager who suggests such a plan at this stage of the game to an ordinary, unsophisticated pension board will get a blank stare and a chuckle instead of a mandate.

But at least one major player has gone bottom-fishing in the bond-insurers market:

MGIC Investment Corp. and PMI Group Inc., the two largest U.S. mortgage insurers, rose in New York trading after insurer Old Republic International Corp. disclosed it became the biggest investor in each company.

More news on the bond insurers’ front, as well. Fitch is reviewing the bond insurance industry, which may need to raise capital at one of the worst possible times to do so (typical!). Josef Ackerman, CEO of Deutsche, warns of a very strong impact on financial assets if a downgrade comes to pass, as has been previously stated by Accrued Interest. Naked Capitalism passes on the report that Fitch is outraged by the Financial Times misuse of technical terms in reporting the concerns … in times like this, when a misplaced comma in a Bernanke speech could cost billions, the technical guys want precision above all else! Two major municipal refinancings have been delayed due to market instability.

Naked Capitalism has a very good piece about Cuomo’s investigation of WaMu regarding possibly deliberately inflated appraisals of properties. I didn’t discuss it at the time, thinking it was just minor league grandstanding, but it seems more serious – especially since it appears Cuomo knows little about the business – or is disingenuously overstating his case. Lockhart’s letter, linked by Naked Capitalism, is priceless; Accrued Interest translates the refined prose into more every-day language.

However, I must take issue with Naked Capitalism’s characterization of the GSEs::

Cuomo astoundingly called the GSEs investment banks, and as the article points out, raises doubts about the value of their even though they are government backed. Huh? That is likely the basis for Lockhart’s “you may not understand remark.”

The last thing the securities market needs is doubts being cast on the creditworthiness of Freddie’s and Fannies’ paper.

GSEs are not, in fact, government backed. There is certainly a market perception that they are government backed … but if push comes to shove, Congress can let them rot. There is a very dangerous ambiguity in Fannie & Freddie’s status that should be clarified; they walk like banks, talk like banks and write cheques like banks – they should be regulated like banks. I often link to James Hamilton’s presentation to the Jackson Hole conference which addressed the issue: now I’ll link to it again. Speaking of Fannie Mae, they too aren’t doing too well in the current environment:

Fannie Mae, the biggest source of money for U.S. home loans, said its third-quarter loss more than doubled to $1.39 billion as a deepening housing slump increased mortgage delinquencies.

The net loss was caused by a $2.24 billion decline in the value of derivative contracts and $1.2 billion in credit losses among the $2.7 trillion of mortgage assets Fannie Mae owns or guarantees, the Washington-based company said today in a U.S. Securities and Exchange Commission filing.

Fannie Mae has a minimum capital requirement of $30-billion and maintains a 30% surplus over this figure. So say they’ve got twice the capital of Royal Bank (Fannie Mae is far more highly leveraged, due to the inadequacies of the legislation) … can you imagine the consternation if Royal Bank lost $700-million in a quarter?

A relatively calm day for preferreds, with good volume.

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

Thursday! The day when the US Commercial Paper Outstandings get reported! The Fed reports that ABCP outstanding declined by $29.5-billion, a marked increase in pace over the past month, as deleveraging is quickly becoming a major issue in the States. Bloomberg provides a review.

Bernanke is clearly a reader of PrefBlog – his testimony to the Joint Economic Committe echoed what I’ve been saying about Super-Conduit:

So … if it works properly I think it would speed up the recognition of values in part because it would remove some of the risk of fire sales, of rapid drawing down of assets in some of these vehicles and allow the market to stabilize and begin to make a better longer term valuation of what these assets are worth.”

He added, “If that’s the way it works, and again it depends on execution, it would remove some overhang from the market, it would create a stable financing source for those assets and it ought not to be inconsistent with the price discovery process.”

Mainly, though, he just told the politicians on the committee to mind their own bees-wax. Good for him! He may have enough to worry about soon enough – there’s at least one analyst raising the spectre of 5% headline inflation as the Ghost of Christmas Present!

Despite this horrifying projection (noting that, gee, the projection for core inflation isn’t quite so bad), Treasuries were up on expectations of a Fed cut, as early indications point to a lousy Christmas for retailers. 

In SIV news that I missed yesterday … one of the SIVs affected by Moody’s mass review was Links Finance … proudly owned and operated by our very own Bank of Montreal:

Links Finance Corporation (US$1.9 billion of debt securities affected)

Mezzanine Capital Notes

New Rating: Aa2 on review for possible downgrade

Previous Rating: Aa2

Standard Capital Notes

New Rating: A3 on review for possible downgrade

Previous Rating: A3

Links Finance’s net asset value declined to 83% from 94% since Moody’s last review on September 5th. Moody’s review will focus on the potential for further market value deterioration.

Cheery, eh? There’s more:

Managers of structured investment vehicles don’t expect their business model to survive as the value of assets shrinks and the companies struggle to borrow, Moody’s Investors Service analysts said today.

Sic transit gloria mundi.

Apropos of nothing, I ran across a Ministry of Finance puff-piece today, which made the claim:

The World Economic Forum’s Global Competitiveness Report for 2001-2002 ranked Canadian banks among the soundest financial institutions in the world (see Chart 5). The soundness of the Canadian banking industry has been demonstrated many times over the past several years. Canadian banks weathered the debt difficulties of the less developed countries in the early 1980s, the decline in real estate values a decade later, and the Asian crisis in the late 1990s without experiencing any systemic problems.

… which was kind of cool. Our second place finish has been repeated in the 2007-2008 Report, although you have to poke around a bit to verify that. (hint: Country Analysis / Balance Sheet).

And, as far as preferreds go … another day of entirely reasonable volume but disappointing returns. The long corporates index is now yielding just a hair under 5.8%. So let me think about this. You can get the same pre-tax yield with better quality owning GWO.PR.H, at the closing bid. Potential tax benefits – or potential capital gains when others recognize the potential tax benefits – are merely icing on the cake. If this makes sense to anybody, please let me know.

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

Update, 2007-11-09 Holy smokes! Yesterday I titled this “October 8” and have now changed it to, er, the right month. I had the day and year right! I must have been feeling nostalgic …

It looks like the Super-Conduit MLEC is having difficulty getting started even as SIVs are getting shakier by the day. Naked Capitalism reprinted a piece about a downgrade today by Moody’s of 16 SIVs representing about 10% of the market; but only two capital notes were actually downgraded; the senior paper and other capital notes are merely (!) under review according to Moody’s:

Moody’s Investors Service announced today that it has substantially completed another review of the Structured Investment Vehicle (SIV) sector following continued market value declines of SIV portfolios since our most recent review completed on September 5th of this year. As a result of this review, Moody’s has confirmed the short term ratings of the senior debt programmes of Kestrel Funding PLC and Kestrel Funding LLC (which hold approximately US$3 billion of debt securities) that were on review for possible downgrade. Moody’s also downgraded, or placed on review for possible downgrade, the ratings of 28 debt programmes of 16 SIVs (which hold approximately US$33 billion of debt securities) as described below.
…
The ongoing liquidity crisis facing SIVs has continued almost unabated since September 5th, when Moody’s completed its last review of the sector. The inability of some of the SIVs to issue sufficient Asset Backed Commercial Paper (ABCP) or Medium Term Notes (MTNs) over a prolonged period has led to the crystallisation of mark-to-market losses in some cases and the potential for such losses to be realised in others.
…
Moody’s has taken certain rating actions as a result of deteriorating credit and other market conditions. It seems clear that the situation has not yet stabilised and further rating actions could follow. As with previous actions, the rating actions Moody’s has taken today in response to the current situation are not a result of any credit problems in the assets held by SIVs, but rather a reflection of the continued deterioration in market value of SIV portfolios combined with the liquidity crisis.
…
SIV senior note ratings continue to be vulnerable to the unprecedented large and sustained declines in portfolio value combined with a prolonged inability to refinance maturing debt. SIV capital note ratings will be affected primarily by further deterioration in the market value of the portfolio. The risk of realised losses on capital and even senior notes is likely to increase significantly if the SIV is placed in a position where it must sell assets rapidly in a “fire sale.”

A lot of the problems are related to turmoil at Citigroup; its support of its SIVs (through the purchase of $7.6-billion in commercial paper) was discussed yesterday. Even worse, Citigroup has increased its exposure to CDO-issued CP, which has had the effect of ballooning the amount of Level 3 ‘Mark-to-Make-Believe’ assets. Citigroup’s cost of borrowing, as proxied through Credit Default Swaps, is skyrocketting.

They’re all in trouble! Latest estimates (which may have been padded to make them more interesting) are that Wall Street will take massive writedowns:

U.S. banks and brokers face as much as $100 billion of writedowns because of Level 3 accounting rules, in addition to the losses caused by the subprime credit slump, according to Royal Bank of Scotland Group Plc.

It would appear that at least some of the money written-off is finding its way into the profits of hedge funds:

Hedge funds returned 3.2 percent on average in October, the biggest gain in almost two years, as managers profited from rising stock prices and declining values of debt tied to home mortgages.

The monthly increase brought the advance to 12.3 percent so far this year, according to a report today from Chicago-based Hedge Fund Research Inc.

It should be noted that the dollar figures in the above paragraphs are US Dollars, not real money:

The dollar is “losing its status as the world currency,” Xu Jian, a central bank vice director, told a conference in Beijing. “We will favor stronger currencies over weaker ones, and will readjust accordingly,” Cheng Siwei, vice chairman of China’s National People’s Congress, said at the same meeting.

Chinese investors have reduced their holdings of U.S. Treasuries by 5 percent to $400 billion in the five months to August. China Investment Corp., which manages the nation’s $200 billion sovereign wealth fund, said last month it may get more of the nation’s reserves to invest to improve returns.

Analyst reactions to these specific remarks are split between yawning and mocking, but years of fiscal profligacy in the US are inexorably coming home to roost.  Maybe they should cut taxes again, or something. Giancarlo Corsetti provides a review of some possible outcomes; one scenario is

In their well-known work, Obstfeld and Rogoff (2005, 2007) propose the following scenario. Closing the US external deficit to within 5% of the US GDP will require the US terms of trade to fall between 5% and 15% – a surprisingly contained movement. By contrast, the fall in the internal relative price should be 3 to 5 times larger, namely the relative price of nontradeables inside the US must get between 20% and 30% cheaper.

To translate these figures into the current macroeconomic stance, keep in mind that, over time, productivity growth is faster in manufacturing (producing most tradables) than in services (mostly nontradables). These productivity differentials across sectors mean that the price of manufacturing decline steadily in terms of services. Now, relative to these long-run trends, we should see the price of US services drop by about one third in terms of US manufacturing, as the US eliminates their current account deficit.

… while another is …

Results from numerical exercises developed in joint work with Martin, and Pesenti, suggests that closing the US current account deficit (from 5% of GDP to zero) could lead to a combination of lower US consumption (-6%), and higher US employment (+3%), relative to trend. This would then correspond to a rate of real dollar depreciation of the order of 20% – close to what we have experienced so far.

We shall see! I will admit to having something of a bias in favour of Rogoff’s work – but only because he’s a chess player. I will have to ensure that bias doesn’t affect anything else!

To keep things interesting, there are predictions of bond-insurer failure:

MBIA may lose $20.2 billion on guarantees and securities holdings, Sean Egan, managing director of Egan-Jones, said on a conference call today. ACA Capital may take losses of at least $10 billion; New York-based Ambac may reach $4.3 billion; mortgage insurers MGIC Investment Corp. and Radian Group Inc. may see losses of $7.25 billion and $7.2 billion, respectively, Egan said.

“There is little doubt that the credit and bond insurers face massive losses over the next few quarters and many will be capital challenged,” Egan said.
…
Moody’s Investors Service and Standard & Poor’s will downgrade the ratings only after problems have become more obvious, Egan said.

Surprise!  Egan-Jones is a subscription-based rating service. Note that failure of an insurer could have serious knock-on effects in the US Municipals market.

Preferreds continued their recent showing of decent volume, but it seems like everybody was too busy financing their next trip to Buffalo by selling common shares to be fussed much about preferreds, which were … off a tad, but only technically.

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

The big news recently has been the Citigroup writedowns, ouster of the CEO and downgrade by Moody’s (to Aa2 from Aa1). Accrued Interest is experiencing deja vu … the search for sub-prime exposure after the writedowns is like the search for fishy accounting after Enron. Naked Capitalism points out that while both Merrill and Citi have taken huge write-downs, Citigroup has done nothing to reduce its exposure.

Nouriel Roubini thinks this is the tip of the iceberg (as does CreditSights) and pays particular attention to mark-to-make-believe accounting. Accrued Interest explains the rating volatility of CDOs with a simple model. Giovannini and Spaventa attribute the snowballing effects of the credit crunch to the information gap between investors and exposures and propose some solutions – most of which impose extemely onerous supervision. While none of the following elements is explicitly spelled out in their paper, or unequivocally endorsed, I interpret the remarks as proposing:

• licensing of mortgage brokers
• regulation of credit rating agencies and inspection of their models
• standardization of products traded over-the-counter
• increased disclosure of bank exposures under Basel II

The first three recommendations are inappropriate in the context of bank regulation. While these matters may well be desirable from other perspectives – and should be argued within the context of those perspectives – they have little to do with the regulation for the purpose of ensuring the stability of the banking system. Even the fourth suggestion is far too prescriptive for a free market: I suggest that the policy objective would be met by stating simply that any instrument for which the banks’ assigned credit profile cannot be verified due to material information not disclosed to the regulators should be charged to risk-weighted assets as if it were equity. This is sufficiently punitive that:

• the policy objective of encouraging transparency will be served
• the stability of the banking system will not be compromised by debt-rated securities that behave with, shall we say, greater volatility and less liquidity than most debt.

Meanwhile, Citigroup filed its third-quarter ’07 10-Q today, chock-full of interesting information!

The current lack of liquidity in the Asset-Backed Commercial Paper (ABCP) market and the resulting slowdown of the CP market for SIV-issued CP have put significant pressure on the ability of all SIVs, including the Citi-advised SIVs, to refinance maturing CP.

While Citigroup does not consolidate the assets of the SIVs, the Company has provided liquidity to the SIVs at arm’s-length commercial terms totaling $10 billion of committed liquidity, $7.6 billion of which has been drawn as of October 31, 2007. Citigroup will not take actions that will require the Company to consolidate the SIVs.

Master Liquidity Enhancing Conduit (M-LEC)

In October 2007, Citigroup, J.P. Morgan Chase and Bank of America initiated a plan to back a new fund, called the Master Liquidity Enhancing Conduit (M-LEC) that intends to buy assets from SIVs advised by Citigroup and other third party institutions. This is being done as part of an effort to avert the situation where the SIVs will be forced to liquidate significant amounts of mortgage-backed securities, resulting in a broad-based repricing of these assets in the market at steep discounts.

SIVs, including those advised by Citigroup, have experienced difficulties in refinancing maturing commercial paper and medium-term notes, due to reduced liquidity in the market for commercial paper.

Well! As far as I know, that’s the first official admission that the Citigroup SIVs are in enough trouble that they’re going to sell to Super-Conduit (MLEC), assuming that Super-Conduit ever gets off the ground! This may not be a death-blow to my thesis that Super-Conduit = Vulture, but it’s a pretty good hit!

In a similar development that I missed on its publication October 18, there is speculation that BMO has purchased $13-billion of its own ABCP.

Citigroup has previously announced:

Citi also announced that, while significant uncertainty continues to prevail in financial markets, it expects, taking into account maintaining its current dividend level, that its capital ratios will return within the range of targeted levels by the end of the second quarter of 2008. Accordingly, Citi has no plans to reduce its current dividend level. 

But Accrued Interest – a bond guy after my own heart – has looked at the various impairments of the various banks with the horror that only a bond guy who’s afraid he won’t get paid can muster and has made a modest proposal:

This leaves the surviving banks with better pricing power and/or ability to dictate lending terms. Overall, the long-term prospects for banks should be quite positive.However, in order to realize this long-term opportunities, banks must find a way to survive the current contagion with as much capital preserved as possible. Long-term shareholders appreciate this need for capital preservation. It would not serve shareholders interests to sell assets at fire-sale levels to raise capital. Nor would shareholders benefit from a bank being forced to issue new equity shares, particularly at a time when equity prices are weak.

There is one obvious way for banks to retain more capital: eliminate the dividend.

We shall see if any of them take him up on it!

A good day for prefs, with perpetuals resuming their upward trend of the past week … but splitShares went out of style today, with some large declines.

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

Well … today was fairly busy, so there’s not much commentary! Just to keep my faithful readers entertained, however, I have uploaded the PerpetualPremium index … look at CU.PR.A and CU.PR.B! A fine company and a solid credit … but should these issues really be trading 60+bp through Power Financial? There will be a small prize awarded to anybody who can give me a satisfactory explanation of this phenomenon.

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

US Jobs number MUCH better than feared! Canadian Jobs number GREAT! Merrill thumped on credit quality! Citigroup thumped on credit quality! Canaccord thumped on credit quality! (Canaccord? Who is this “Canaccord”?) SIV chatter! (nothing much new)

There won’t be much commentary today, I’m afraid. I’m exhausted.

There is a highly illuminating discussion on FWF the possibility of, and the repercussions of, a bank “breaking the buck” on a money market fund:

If any Canadian bank broke the buck on one of its MMF and walked away from it, I would sell all of my mutual funds not just any MMF that I owned as well as my fundco stocks and never buy again. Reason: no bank/fundco is to be trusted. (Although MMFs are not guaranteed, their history is such that they might as well be.)

I hope that the Canadian Bank Regulator is reading this thread!

We remember that National Bank bailed out its MMF:

Altamira Investment Services Inc., manager of the Altamira Mutual Funds, announced that National Bank of Canada has completed the acquisition, announced on August 20th, of all the asset backed commercial paper (“ABCP”) held by the Altamira Mutual Funds.

Wachovia has also purchased ABCP from its MMF:

In addition, late last week Wachovia Corp. revealed that it had booked a $40 million loss on asset-backed securities that it purchased from the portfolio of money-market funds run by its Evergreen Investments money-management unit in August.

I imagine there’s others – feel free to advise me of them.

If this kind of thing makes good business sense for the banks – then good for them! I am well aware that their profits on funds are utterly ridiculous and well worth protecting.

However: if bank-sponsored MMFs are really “covered bank deposits” … they should be booked like covered bank deposits!

There should be full consolidation of all MMFs onto the banks’ balance sheets; the investments should be fully reflected in the risk-weighted assets. Otherwise, we are allowing implicit support of the the banks’ various off-balance sheet activities (like SIVs, MMFs and other investment vehicles) without properly accounting for the risk; this endangers the stability of the financial system, as well as providing a subsidy (via deposit insurance and Bank of Canada credit lines) to certain fundcos, but not to other fundcos.

Another good day for the perpetual sector! (Geez, you know, it’s been a long time since I’ve made that comment!)

Still lots of yield-wierdnesses, but volume is still good. Don’t misunderstand me … I’m not saying I don’t like yield-wierdnesses … but I want them to develop until exactly the time I take a position and then revert.

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

US ABCP outstanding declined another $9-billion (slightly more than 1% of the total) in the last week of October, in a continued indication that the unwinding process is proceeding in at least a somewhat orderly fashion. To me, the highlight for the four weeks ending October 31 is that domestic non-financial CP outstanding is down by $12.9-billion while domestic financial CP outstanding is up $52.6-billion; for the month, ABCP outstanding is down $31.5-billion. These numbers suggest – and only suggest, since I haven’t dug very deeply into these numbers! – that re-intermediation is happening big-time in the States, with non-Bank issuers being gradually shut-out or priced out of the market – which is in line with theory.

Naked Capitalism today continued its search for nefarious intent regarding the Super-Conduit. There is little new information. The thing I don’t like about such conspiracy theories is that they depend on people being stupid – or, at the very least, the ringleaders of the plot assuming that investors are stupid. I’m not about to defend the 100% accuracy and rational judgement of the market place (hah!) but I’m not going to assume stupidity until I’ve looked at everything else. And, as I’ve stated many times before, it makes sense if it’s a vulture fund.

Otherwise, you’re asking me to believe that these major banks are going to provide backstop liquidity for a grossly undercapitalized SIV. Or that two major banks are going to help bail out a competitor out of the kindness of their hearts. Or that three major banks have mutual funds in danger of breaking the buck and are willing to risk their existence to avoid it. I won’t say that any of these hypotheses is impossible … but I want something more than “Big Capital is Evil” before I take them seriously.

Preferreds had a very good day today, with volume continuing high and a solid move upwards in the perpetual sector. Turning point? Bear trap? Random noise? I’ll let you know in a month or so.

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

American GDP grew at an annualized rate of 3.9% in the third quarter, but economists were not impressed. On a positive note, ADP Employment data was stronger than expected, which implies that next Friday’s jobs number shouldn’t be disastrous, at any event.

In other words: we’re confused! So what else is new?

The Fed cut to 4.50% today, as expected. When the market is unanimous, the Fed usually listens. Accrued Interest looks to the future and sees the potential for future cuts measured in terms of bank rescue rather than broader inflation/economic concerns.

The more things change … in 1993, the US had the steepest yield curve since the Civil War, as the Fed was busy bailing out the banks’ profitability (this was in the aftermath to the S&L crisis, remember). Then, in 1994, the music suddenly stopped and Orange County, among others, couldn’t find a chair. It will be most interesting to see how this cycle unfolds!

Well, thank heavens that month’s over! There have been a huge variation of the returns in the HIMIPref™ indices over the past month and the fund was unfortunate enough to have identified a broad pricing discrepency just as the panic got started. Returns this month are not a complete disaster, I hasten to add, but will have underperformed the index.

Mind you, the yield on the fund’s holdings is now well above the index and credit quality is great … so the faster that things normalize, the happier I’ll be! Results should be published on Saturday November 3, or Sunday at the latest.

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