Category: Market Action

Manor & Mendelson, co-founders of Portus Alternative Asset Management Inc., are being charged:

with 12 counts of fraud, money laundering, and possession of property obtained by crime on Wednesday, the result of a lengthy international investigation.

It has been quite some time since I saw Boaz – I look forward to seeing him in the dock. Regardless of guilt or innocence of these particular charges, he ran away from 26,000 customers, 100 employees, and me. That’s not cricket.

Inquiries into the Credit Rating Agencies has begun:

The SEC wants to know whether issuers pushed credit raters to “diverge from their stated methodologies and procedures,” Cox said in testimony prepared for the Senate Banking Committee today. In particular, the commission is “examining” whether firms were “unduly influenced by issuers and underwriters,” he said.

I have posted further detail of the hearings and will continue to plough through the testimony. Alex Cukierman has written an essay on VoxEU regarding central bank independence, which may possibly be a move in the Trichet / Sarkozy game. And this game is just simply a part of the markets / politicians tournament, just like the credit ratings agency investigations. I am attempting to form a troupe of attractive Swedish cheerleaders to encourage the Markets faction … if you qualify, drop me a line!

In somewhat related news, Larry Summers has (quite correctly) warned against giving the Feds too many hats to wear.

“I think it’s clear that when you vest regulation for consumer protection with agencies like the Federal Reserve whose primary mandate is the health of the financial system or the health of the lenders, you are going to get insufficient vigilance with respect to consumer protection,” he said during a panel discussion for the Brookings Institution’s Hamilton Project.

The next US jobs number, due a week Friday, will be closely watched – especially as there are some concerns that the last one might have been distorted:

Many economists suspect the drop in August payrolls was exaggerated by a fluky fall in local government payrolls, and new data from the Bureau of Labor Statistics supports that.

On Tuesday the BLS released state payroll data for August. If you sum up the changes across the 50 states and the District of Columbia, the total rose 159,000, compared to the decline of 4,000 in the national data.

With all the worries in the High-Yield market and concerns over the stability of the banking system,  yesterday’s news release regarding large loans syndicated in the US was a good sign.

The volume of Shared National Credits (SNC) rose by 21% in 2006, the fastest pace since 1998, reflecting, in part, significant merger and acquisition lending, according to the SNC² review results released today by federal bank and thrift regulators.
…
Criticized commitments rose to $114 billion, but still remain less than half of their peak dollar level in 2002. Criticized credits represent a modest 5.0 percent of total commitments, about the same rate experienced over the past three SNC reviews.

Which is not to say, of course, that everything is unfolding as one might have thought six months ago. It looks like the Sallie Mae takeover will not proceed as originally planned, if at all:

SLM Corp. said a group led by J.C. Flowers & Co. won’t complete the $25.3 billion purchase of the largest U.S. student loan company. The group said it’s open to negotiation.

The group doesn’t expect to complete the $60-a-share acquisition, Reston, Virginia-based SLM, known as Sallie Mae, said today in a statement. Under an agreement announced in April, SLM was to be sold for $60 a share to an entity 50.2 percent- owned by Flowers, with JPMorgan Chase & Co. and Bank of America Corp. each holding 24.9 percent.

Shake-ups in the Very Big Brokerage segment are coming! The Chinese brokerage, Citic, is now number eight globally, although that’s with rankings by market capitalization and:

The S&P 500’s measure of seven U.S. securities firms is valued at 8.8 times estimated profit, about a quarter of the 38 times for their four listed Chinese peers. Citic trades at 34 times estimated earnings, compared with 10 times profit for Bear Stearns, 7.9 times for Morgan Stanley, and Lehman’s 8 times. Haitong Securities trades at 52 times estimated profit, Hong Yuan is at 39 times, while Northeast Securities is at 28 times profit.

Still, it’s not too long since no such qualification would have been necessary. And it looks like Warren Buffet, saviour of Salomon, is sniffing around Bear Stearns:

Bank of America Corp., Wachovia Corp., and two Chinese companies, Citic Group and China Construction Bank Corp., also are among the potential bidders, the New York Times reported, citing unidentified sources.

I can just imagine the consternation if a Chinese firm takes over an iconic trader like the Bear – particularly given concern about the Chinese government’s commitment to the free flow of information. But then, the big brokerages have had a few problems recently:

Merrill Lynch & Co., the third biggest U.S. securities firm, may record losses of as much as $4 billion on fixed-income assets, resulting in the lowest quarterly earnings in almost six years, Goldman Sachs Group Inc. analyst William Tanona said.

And, in late news, it was announced that Canada’s getting into the act:

Australian investment bank Macquarie Bank Ltd will buy Canadian investment and brokerage firm Orion Financial Ltd for about C$147 million ($146 million) in cash and stock.

Menzie Chinn of Econbrowser notes that the latest dust-up in American politics is over a relatively picayune $5-billion for children’s health; suggesting there are other exposures that have been recklessly undertaken in the past five years. It is clear that some hard measures will need to be taken if the dollar is to retain value, a matter that Accrued Interest notes is of increasing concern. I’m just happy that the GAO is now referring to the decline of the Roman Empire as opposed to the fall of the Roman Republic as a metaphor. If we’re going to decline and fall all over the place, let’s at least get the metaphors right!

US Equities had a good day, with financials leading the way – attributed to the idea that Warren Buffett might possibly like the sector.

If it turns out that the sector does poorly, will there be a Senate Inquiry?

Tech stocks led Canadian equities up a bit.

Treasuries did almost nothing, but did it while attracting lots of bids to the quarterly refunding (it was the two-year today). One has to feel sorry for a reporter so abjectly desperate to make things sound interesting that she writes:

The benchmark 10-year note’s yield rose almost 1 basis point to 4.63

The only thing worse is having to quote such a report! Canadas were weak, but nothing out of the ordinary.

The preferred share market normalized a bit after yesterday’s repricing, but the PerpetualDiscount sector continued to fall. Volume returned to the light-but-still-reasonable levels that have been in effect all month.

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

Today’s word is confidence. Sadly, it’s only a word:

Consumer confidence slumped to the lowest level in almost two years and home sales weakened, threatening U.S. household spending and bolstering the case for the Federal Reserve to keep cutting interest rates.

The Conference Board’s index of consumer confidence fell more than forecast in September, to 99.8 from 105.6.

The consequences of extreme lack of confidence are currently illustrated by the continuing Northern Rock saga, in which some possible bidders are thought to think it’s worth more dead than alive:

Former Goldman banker Chris Flowers may join the Cerberus Capital Management LP and Citadel Investment Group LLC hedge funds in splitting up Northern Rock, the Sunday Telegraph reported Sept. 23, citing an unidentified person familiar with the proposal.

A Northern Rock bail-out might cause some embarrassment with UK regulators :

The U.K.’s Financial Services Compensation Scheme has 4.4 million pounds to protect deposits, compared with $49 billion at a similar fund in the U.S., the London-based Independent reported today, without saying where it got the information.

Even that, though, is a huge bankroll compared to what we have in Canada: $1.4-billion as of 2006-3-31. The 2006 report is the one relevant to the 2007 Annual Public Meeting. Call the papers! I want to revise my confidence number!

The WSJ republished the IMF’s risk diagram, which is cool enough to be worth posting:

The further from the centre, the riskier the axis.

The S&P/Case-Shiller US Housing Price Indices were released today and flesh out the anecdotal descriptions of how bad the US market is:

10-City Composite was down 4.5% versus July of 2006, while the 20-City Composite was down 3.9% over the same time period.

This is the first significant yoy decline in these indices since the recession of Bush the Elder; the worst three cities for housing in the past year have been Detroit (-9.7%); Tampa (-8.8%); and San Diego (-7.8%). It’s Detroit that looks really ugly: the index level, set to a base of 100 in January 2000, is only 111.3 in July 2007, implying an annualized rate of return of less than 1.5%. So much for housing as a long term investment, in Detroit, anyway! For those who look at the detailed data and want a comparison, US Inflation data is available from the Bureau of Labour Labor Statistics: The Jan 2000 “All items less food and energy” index (US City Average, Not Seasonally Adjusted) was 100.3; July 2007 is 115.1, implying the average Case-Shiller index should be about 114.7 to stay even.

Since the 10-city composite is actually 215.9 and the 20-city composite is 198.4, there are two ways of looking at it: (i) What are those greedy Americans complaining about?, or (ii) Wow, they’ve got a lot further to fall. JDH at Econbrowser discusses the matter and worries about repercussions in the financial markets. If he’s not gloomy enough for your tastes, Dear Reader, try Nouriel Roubini:

So as JP Morgan rightly put it there is “no sign of a floor for housing”. The housing recession will continue throughout 2008 and the fall in home prices will continue into 2009 before any bottom is reached.

As an aside, the WSJ has highlighted some research by the Atlanta Fed showing that home ownership in the States increased from 64% in 1994 to 69% in 2005. The rate had been static from the mid-sixties to 1994.

Speaking of the CPI, a Bloomberg columnist has produced a column pandering to the ‘CPI Lie’ crowd. It’s certainly a pleasant change to see some actual meat on the bones of the slogan! He states, for instance:

Medical expenses are given short shrift as well. It wasn’t that long ago when employers could cover almost all of an employee’s health-care bills.

Now workers are shelling out an average of $3,281 from their paychecks for family medical coverage, according to the Kaiser Family Foundation, a non-profit organization based in Menlo Park, California. The average premium for a family policy is more than $12,000 annually.

So why is this a measure of inflation? It looks more like a cut in salary (via reduction in benefits) to me … which may come to the same thing to somebody attempting to maintain a standard of living with the same work, but should not be mis-labelled.

Willem Buiter took a break from writing for VoxEU to post to his own blog, criticizing Trichet for rising to Sarkozy’s bait. Buiter is quite right; Trichet should retain his dignity and leave the criticism of Sarkozy to me!

US equities were flat, with a few high-profile drops due to earnings-forecast revisions being greatly overemphasized by the media. Canadian equities were very slightly up, with a few advances desperately siezed on by reporters in dire need of something to report.

Treasuries had a good day, with predictions of further Fed cuts bringing some more highly-desirable term spread into the curve:

The difference in yield, or spread, between 10- and two-year yields was 63 basis points today, the widest since April 2005.

Canadas did nothing much.

It was an exciting day in the preferred share market today, almost certainly due to the BNS 5.25% Perp New Issue, which seems to have had the effect of repricing the entire spectrum of perpetuals. In other words, the universe has adjusted itself to the new issue, rather than the other way ’round.

Perpetuals dropped quite significantly, as perpetualDiscounts, yesterday priced to yield 5.09% suddenly dropped in price to yield 8bp more – exactly half of the distance between the universe and new issue yield, deciding 5.17% was a much better level.  The perpetualPremium index, formerly 5.13%, is now 5.29%. This figure is not only more than the new issue yield, but is more than the perpetualDiscount yield … I would normally expect discounts to yield more than premiums, to compensate for the greater – and more immediate – interest rate risk. Markets, however, sometimes don’t listen to me as well as they should.

The Claymore Preferred share ETF had a $0.35 drop in NAV today after a distribution of $0.2185. The fund offered by my firm, MAPF, did not have its most pleasant day ever recorded, but is now well ahead of CPD on the month to date. We’ll see what the last three trading days bring!

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

The WSJ has reported on an interview of Greenspan by a German newspaper, in which the question of Credit Rating Agency regulation arose. The information given is too interesting to be simply reported here and too small to deserve its own post: I have updated a recent post with the new opinion.

Former Treasury Secretary Larry Summers has written a short op-ed piece on moral hazard, pooh-poohing those who feel it should be a major consideration when central banks take action.

Charles Goodhart of the LSE has written a summary of his recent research into the ever-popular topic of downward-sloping yield curves and recessions. He suggests that:

historically, the additional predictive power of the spread for future output growth –over and above that already encoded in other macroeconomic variables – often appeared during periods of uncertainty about the underlying monetary regime.
…
On the other hand, when the monetary regime becomes (at least partly) uncertain, an increased risk premium will have to be added to expectations of future short rates. According to this view, part of the cause of the subsequent output decline is not that the yield curve is negatively sloping, but that it is insufficiently so, i.e. long rates are above those consistent with the subsequent resolution of the uncertainty, thereby imparting additional downwards pressure on output.

He has found a counter-example in the Anglo-Saxon bloc of the early 2000’s, but suggests that there might be some other factor at work. It’s an interesting idea …

Brad Setser has a guest blogger with an interesting thesis:

It is a basic assumption on my part that globalization cycles, of which by my count there have been six in the past two hundred years, are driven largely by new developments or structural changes in the financial system that cause a significant increase in global liquidity and a concomitant increase in risk appetite. Because of rising risk appetite this newly-abundant capital flows into a variety of risky countries or ventures – financing canals in the 1820s, railroads in the 1860, long-distance communication media in the 1920, the internet in the 1990s – and sets off the growth in international trade, capital flows, technological development (and, for some reason, the rebirth of liberal economic theory) that we associate with globalization.

His first ‘real post’ provides some background on China’s Sovereign Wealth Fund. Such funds, usually abbreviated SWF to make me feel like I’m reading a personals ad, have attracted some controversy in recent times, with quite a few calls for their regulation. There will probably be some kerfuffle in the papers tomorrow about PrimeWest’s Abu Dhabi honeymoon*:

Abu Dhabi National Energy Co., the state-controlled power generator and oil producer, agreed to buy Canada’s PrimeWest Energy Trust for about C$4 billion ($4 billion) in the biggest-ever North American takeover by a United Arab Emirates company.

James Hamilton has commented on the monetary implications of the Fed Rate cut. He reviews the meaning of the term ‘printing money’ and the actual mechanisms involved to conclude:

This is not to insist that concerns about higher inflation are unfounded. But, if one wanted to motivate such concerns from a monetarist perspective, one could not point to money that has been printed so far. Instead, the story would have to be that, in order to achieve the path for the fed funds rate that the Fed is now likely to set for the following year, the Fed will eventually need to add more reserves that do end up as more cash in circulation. In this scenario, markets have been reacting to an anticipation of future money creation and not to something that has already happened.

There can be no more doubt regarding the motivation for Sarkozy’s hostility towards credit rating agencies and ECB President Trichet … his Prime Minister has let the cat out of the bag:

French Prime Minister Francois Fillon warned Monday that the country’s public finances were in a “critical” state and need drastic action to reduce worrying deficits.

Fillon urged France to “change its attitude” towards state spending two days before his centre-right government presents its 2008 draft budget, which is expected to show a deficit of 41.5 billion euros (58.5 billion dollars).

It was the second time in three times that he has sounded the alarm. On Friday, the prime minister said France was in a “situation of bankruptcy”.

France’s debt is over 60% of GDP, about the same as Canada’s, but their budget balance is headed in the other direction – fast. It will get faster:

But opposition Socialists said the budget had been aggravated by President Nicolas Sarkozy’s tax cuts — voted through after his May election — which is estimated to cost between 11 and 16 billion euros a year.

  It would appear that Sarkozy’s attempt to distract has the same motivation as that of an underperforming portfolio manager.

Things aren’t much better in Britain:

The U.K. had a larger budget deficit than economists forecast in August as spending jumped and revenue from profits fell, piling pressure on the government to save money as income from financial services dwindles.

The 9.1 billion-pound ($18.4 billion) shortfall was the highest for the month since records began in 1993, the Office for National Statistics said in London today. It exceeded the median 6.5 billion pounds forecast in a Bloomberg survey of 20 economists.
…
Debt stood at 36.7 percent of GDP in August.

The US Treasury is currently executing a three week test of pandemic preparedness:

One of the biggest challenges financial institutions will face is how to cope with absenteeism. In week one, the Treasury exercise directs the financial organizations to assume that 25 per cent of their work force is not coming to work, either because of illness or because of fear of being infected or because they are staying home to take care of children who can’t go to school because the schools have closed.

To decide who is absent, the Treasury directs the institutions to assume that everyone whose last name begins with certain letters, which could cover the bank president down to the local teller, cannot come to work. The 25 per cent absentee rate will jump to 49 per cent in week two.

Holy smokes! The mind boggles at the thought of 49% absenteeism across the entire financial sector … as, I guess, it’s supposed to do. Something on this level will definitely uncover a few weak links … let’s hope we never find out if they were all fixed.

Accrued Interest has posted a fascinating discourse on CDOs and I am very hopeful that the comments will help me understand what all the fuss is about. I’ve also referenced this post on my post about the IMF’s recommendation.

In one of the Harper government’s finest moments of leadership, Flaherty has announced a committee:

In his speech to a gathering of derivatives specialists, Flaherty also reiterated his call for the creation of a common securities regulator that would replace Canada’s 13 regulators.

Flaherty said he expects to name in the next two or three weeks members of an expert panel being created to advise the federal, provincial and territorial governments on how to address the issue. He would expect to hear recommendations from the panel within eight months of its creation.

I’m holding my breath, Mr. Flaherty! Please tell them to hurry!

US equities fell a bit which was blamed on the market’s astonishment that the credit crunch isn’t over yet. And it’s been going on for almost six weeks! Fortunately, the sad news did not reach the TSX.

Treasuries were quiet and Canadas were quieter.

Preferreds also had a quiet day but volume, while restrained, remained within normal boundaries.

*Senior moment alert! Does the phrase “Abu Dhabi Honeymoon” ring a bell with anybody besides me? I was convinced it was a movie title, but it’s not listed on IMDB. Maybe it was a fake movie that the Flintstones went to see, or something? Please help!

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

More Teachers’ / BCE news! I don’t think anybody will be surprised to learn that:

The arrangement was approved this morning at a Special Meeting of shareholders by more than 97% of the votes cast by holders of common and preferred shares, voting as a single class, greatly exceeding the required 66 2/3% approval. Of the total outstanding common and preferred shares, 62.5% were voted at the meeting either in person or by proxy.

In a sign that things are starting to return to normal, junk bond indices hit a two-month high amidst signs that deals are starting to move off the dealers’ balance sheets. I should stress here that by “normal” I do not mean “good”. What I mean is that we are returning to an environment in which investors are willing to take a look at possible trades and price them according to normal risk/return forecasts, rather than simply sitting on cash, petrified by fear.

In what must be taken as a good sign of this, it looks like the buy-out of Harman International Industries is dead:

Kohlberg Kravis Roberts & Co. and Goldman Sachs Group Inc. abandoned their $8 billion takeover of Harman International Industries Inc., maker of Infinity and JBL audio equipment, citing a decline in the firm’s performance. 

Issuance is, in fact, picking up a bit:

R.H. Donnelley, the biggest independent publisher of Yellow Pages telephone directories, led the biggest week for junk bond sales since July after the Federal Reserve’s rate cut spurred demand for high-yield, high-risk debt.

Speculative-grade borrowers issued $1.83 billion of fixed- income securities, according to data compiled by Bloomberg. Corporate bond sales totaled $28.2 billion, compared with $26.6 billion last week and the average this year of $23.4 billion. Cary, North Carolina-based R.H. Donnelley sold $1 billion of bonds to repay debt, increasing the offering from $650 million.

Junk-rated companies sold bonds for the first time in three weeks as the Fed’s half-percentage-point reduction in its benchmark rate on Sept. 18 helped lower the yield premium that companies pay to borrow over similar maturity Treasuries by the most in four years, Merrill Lynch & Co. index data show.

While in signs that nobody really expects a return to frenetic trading levels, RBC fired 40 US bond salesmen and HSBC is closing its sub-prime business, which will throw 750 out of work.

US equities rose, capping a fine week (send a thank-you not to Bernanke) as did those in Canada.

Treasuries managed a dead-cat bounce, as did Canadas

The pref market was unable to sustain yesterday’s volume increases, but put in a good solid performance. The perpetuals look a little uncertain – whether that’s worries over inflation or simply noise, I cannot begin to guess.

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

The USD has been hammered to the point where it is at parity with CAD. Fortunately for Americans, however, there is some evidence that import prices remain constant in USD terms:

“Foreign exporters have simply been more willing to vary their margins when selling into the U.S. market. Moreover, this difference in pricing behavior seems, if anything, to have become more pronounced in recent years,” the study says.

Unfortunately:

There is an important caveat to the study’s implications for the dollar’s recent fall. It notes that local-currency profit margins for foreign companies selling to the U.S. peaked in 2002 and have since declined, showing the dollar’s fall is taking a toll on profit margins. “It remains an open issue as to whether profit margins on exports to the United States are now ‘too narrow’ or margins were unusually high several years ago,” they say. Left unsaid: if indeed margins are “too low” now, then exporters may be reaching the limit of their ability to keep prices in the U.S. stable, and the dollar’s drop may be more inflationary in coming years than it has been to date.

The USA will not return to fiscal sanity until forced – the way Canada was forced to get religion in the ’90’s and that wasn’t a whole lot of fun for a lot of people. We’ll see.

US ABCP outstanding declined again this week, as reported by Bloomberg:

The U.S. commercial paper market shrank for a sixth week, extending the biggest slump in at least seven years and signaling Federal Reserve interest rate cuts haven’t yet drawn investors back to short-term debt.

I suggest that confidence is an awfully hard thing to regain, once lost. There are a lot of firms dancing close to the edge; a lot of financing is still being done at high rates, with all terms of USD ABCP yielding more than 5% – about half a point more than financial paper. And those, remember are average rates. While the cuts will have put a lot of companies back into positive carry territory, they will be much more risk averse than they were; at the margins, structures will be delevered and terms will be extended into bonds.

My guess is that we’ll see continued delevering at least until Christmas, as the market adjusts to whatever the new paradigm is. But who knows? Pays yer money and take yer chances.

Charles Wyplosz makes an argument at Voxeu in defense of the wholesale liquidity injection, accepting as a necessary evil the fact that ‘bad banks’ will benefit from this injection as much as bad banks. While agreeing with his conclusions, I disagree with his arguments, which are very interventionist –

Once the dust settles, the time of punishment will come. Inquiries should be conducted and those who violated the law must be brought to account.

Let’s start with first principles – Wyplosz states that the root of the problem to be addressed is:

What each financial institution does not know, and should not know, is what is on the books of the other financial institutions with which it trades daily. The old result, which goes under the colourful name of lemon’s markets, is that, suspecting the worst, no financial institution wants to lend to the others. The consequence is that liquidity is plentiful inside most financial institutions, but not available on the interbank market

I take the view that the problem is not so much one of the financial institutions not trusting one another – although that clearly is a factor – as one whereby the banks do not know which of their contingent lines will be drawn on in the near future. Countrywide Credit rather famously drew down USD 11.5-billion in one shot in August; this will not have been an isolated occurance. The banks will, I suspect, be happily engaged in the practice of grossing up their balance sheets by lending to their own customers right now, at penalty rates. This will be consistent with the work of Gatev & Strahan which I quoted on September 14. The banks, wishing to keep their powder dry, will not make term loans to one another (a term loan meaning, in this, ‘longer than overnight’) because their customers might want the lines tomorrow.

In such a case, liquidity injection is the desired policy since as long as there is liquidity then well-capitalized banks will be able to make term loans while at the same time retaining the extra capacity required to meet their commitments. My concern – which I am sure will be explicitly addressed by regulators over the next year – is whether such contingent claims from customers and off-balance sheet entities (e.g., bank controlled ABCP issuers) are adequately reflected in risk-weighted assets.

As far as punishment for excessive risk-taking is concerned … the market is meting that out quite efficiently, as Northern Rock’s shareholders can testify. Coventree’s employees are in a position to confirm this. The ‘real banks’ have bailed out the ‘non-banks’ to a greater or lesser extent, which is their function, at a greater or lesser cost to the non-bank’s shareholders, which is their punishment.

BoE Governor King testified to a parliamentary committee that:

U.K. banking laws prevented the central bank from a covert rescue of Northern Rock Plc, which it would have preferred.

“The bank would have preferred to have acted covertly as lender as last resort, to have lent to Northern Rock without publishing it,” King told a parliamentary committee in London today. “As a result of the market abuses directive (of 2005) we were unable to carry that out.”

This is interesting. Those with long memories will remember the Panic of 1825 and commentary by Larry Neal that:

The first mention of the crisis occurs on December 8, 1825, when “The Governor [Cornelius Buller] acquainted the Court that he had with the concurrence of the Deputy Governor [John Baker Richards] and several of the Committee of Treasury afforded assistance to the banking house of Sir Peter Pole, etc.” This episode is described in vivid detail by the sister of Henry Thornton Jr., the active partner of Pole, Thornton & Co. at the time. On the previous Saturday, the governor and deputy governor counted out £400,000 in bills personally to Henry Thornton, Jr., at the Bank without any clerks present. All this was done to keep it secret so that other large London banks would not press their claims as well. A responsible lender of last resort would have publicized the cash infusion to reassure the public in general. Instead, the run on Pole & Thornton continued unabated, causing the company to fail by the end of the week. Then the deluge of demands for advances by other banks overwhelmed the Bank’s Drawing Office.

The propriety of the BoE’s actions will surely be debated for decades. If the two views can be reconciled at all, one mechanism is through introduction of the idea that the public no longer trusts public institutions – at least, not to the extent that they did in 1825, when a man’s word was his bond. There have been far too many instances in recent history when those in authority have stated ‘We will not devalue, we will not devalue, we will not devalue, we have just devalued, we will not devalue again, we will not devalue again …’

And they do this, of course, without blushing.

Another way to reconcile the two theses is through introducing the idea of discretion; it may well be that Governor King agrees with the publicity desired by Neal in general, but not in this particular instance, for very well-founded reasons. And it may be that Neal will agree with him. It has always amazed me to see how much money is being paid to people – judges, regulators, high-school principals, whatever – while at the same time their discretion is circumscribed to ludicrous extremes with often ludicrous results. Perhaps Northern Rock was one of these time … perhaps not. The facts will emerge at some time long after public interest has evaporated, and become the topic of discussion in specialized journals.

In sub-prime news, it appears that credit anticipation plays by Goldman Sachs and Bear Stearns were right and wrong, respectively. And … a CDO has blown up, a victim of mark-to-market:

TCW Asset Management, the money manager owned by France’s second-biggest bank, is selling $3.2 billion of mortgage securities backing collateralized debt obligations after the value of the bonds fell.
…
Fitch Ratings last week said another five Westways Funding CDOs might have to sell assets under the CDOs’ rules.
…
A $200 million CDO in the Enhanced Mortgage-Backed Securities series of market-value CDOs managed by MassMutual Financial Group’s Babson Capital Management LLC has finished liquidating after failing a similar test, Fitch said yesterday.

Isn’t forced liquidation fun? Boy, the guys who have all their analytical ducks in a row and have some capital available must be making a killing. Unfortunately, these buyers include the US GSE’s, who are able to finance themselves due only to the implicit guarantee of the US Government – the market would never allow them to survive as independent companies with their current capital structure. There is some pressure to reduce this source of false economic signals. Tom Graff has prepared a numerical example of why you need players in the system who are prepared to increase leverage when nobody else will – currently this role is being played largely by the banks and the US GSEs.

US Equities had a bad day, attributed to fears that the Fed Cut – and more like it? – will cause inflation; the excuse for Canadian equities was the fear of expropriation … er … I mean, a fairer royalty sharing scheme in the oil patch. CNR was in the news again …

Canadian National Railway Co. (CNR CN) declined C$1.19, or 2.1 percent, to C$56.65. The country’s largest railroad agreed to sell its Central Station complex in Montreal to Homburg Invest Inc. (HII/B CN) for C$355 million ($350 million). Canadian National will lease back its headquarters and passenger rail facilities from Homburg as part of the agreement, the Montreal-based carrier said in a statement. Homburg shares fell 15 cents, or 2.7 percent, to C$5.50.

Yesterday I mentioned CNR’s new bond issue … they seem to be raising a substantial amount of cash. An answer may – may! – be these notes in their financials:

Revolving credit facility
As at June 30, 2007, the Company had letters of credit drawn on its U.S.$1 billion revolving credit facility of $303 million ($308 million as at December 31, 2006) and had U.S.$442 million (Cdn$471 million) of borrowings under its commercial paper program (nil as at December 31, 2006) at an average interest rate of 5.29%.

Accounts receivable securitization
The Company has a five-year agreement, expiring in May 2011, to sell an undivided co-ownership interest of up to a maximum of $600 million in a revolving pool of freight receivables to an unrelated trust.
At June 30, 2007, the Company had sold receivables that resulted in proceeds of $575 million under this program ($393 million at December 31, 2006). The retained interest in the receivables was approximately 10% of this amount and is recorded in Other current assets. At June 30, 2007, the servicing asset and liability were not significant.

Delevering time! Term Extension Time! Note that I spent a grand total of about 45 seconds looking at their financials … I bring this up as something interesting to be investigated further. If anybody has any (links to) interesting commentary, let me know!

Treasuries had a horrible day, with the ten-year falling in price over a buck, with steepening. Would you like your Fed Cut with a side of inflation? I’m unable to find a good link to Canadian bonds – not surprising, given the pathetic state of Canadian media, and even good old Reuters let me down today – but trust me, Canadas did horribly too. Just not as horribly as Treasuries.

Volume returned to the preferred share market today, with some nice chunky crosses getting done. The various floating rate indices were dragged down by BCE issues, presumably a reaction to yesterday’s news that the bondholders are going to fight the Teachers’ deal in court.

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

Thanks, Rebel Traders (via WSJ)! 

Inflation numbers came out today, with the core rate in the US easing to 2.1% yoy, which some have taken as a validation of the Fed’s rate cut. The core rate in Canada is 2.1% yoy, but there are storm clouds on the horizon:

Signs inflation may pick up include a Sept. 14 Statistics Canada report showing unit labor costs, the cost of paying workers to produce an extra unit of a good, jumped 4.8 percent in the second quarter from a year earlier, the fastest since 1991. Also, average hourly wages rose the fastest in six years in August with the jobless rate at a 33-year low of 6 percent.

There are hopes that the PCE index will also come down – we will see! 

Another interesting trend is the increased linkage between energy and foodstuff prices. We’ve heard about the Italian pasta strike and Mexican tortilla protests. We may well see Canadian Jos. Louis riots if the trend continues.  

The authorities in general are loosening standards! Do they know something we don’t or what? The Bank of England has reversed its position on loosing loan standards, while the portfolio limits on the US Government Sponsored mortgage lenders are being relaxed. I suspect that James Hamilton will not be pleased. In addition to raising the portfolio limits, there is also pressure to increase the permitted size of each mortgage: Bernanke is not pleased:

“Both the size and composition of the portfolios should be tied to reforms that both reduce the systemic risks posed by the portfolios and also clarify the public purpose,” Bernanke said.

But – look at the situation: record foreclosures:

U.S. home prices fell by a record 3.2 percent in the second quarter, according to the S&P/Case-Shiller Index. Lawrence Yun, chief economist for the Chicago-based National Association of Realtors, has warned that year-over-year prices will fall for the first time since the Great Depression of the 1930s.

And the Congressional Budget Office has adopted a somewhat gloomy tone:

The recent market turmoil and a weakening of consumer confidence could “pose serious economic risks,” and as a result have “heightened” the chance of a recession, Congressional Budget Office Director Peter Orszag says in testimony before the Joint Economic Committee this morning.

The Brookings institution has published a commentary on current economic and regulatory issues – the author concludes, inter alia, that although the Fed wasn’t perfect in the 2004-06 period, they weren’t all that wrong, either. He also agrees with most of Levitt’s credit rating agency recommendations. 

On September 10 I noted a report of the destabilizing effect of mark-to-market accounting;  Moody’s has produced an interesting commentary:

The world would be a much safer place if all securities were held by “real money” buy-and-hold investors who did not have to mark to market, and who therefore did not have to make forced sales into panicked markets. Unfortunately, literally trillions of dollars of securities are now held by leveraged mark-to-market institutions relying on other people’s money to finance sometimes opaque, complex and risky investments.

CNR had a new bond issue today for USD 550-million that showed a few signs of the times: the purpose of the issue is to repay commercial paper and reduce the size of the accounts receivable securitization programme; and there is a poison put, whereby the bonds are puttable to the company at $101 upon a credit downgrade. While as a bond-guy I like the poison-put feature (and will pay more for the issue than its comparables because of it), as an amateur-economist guy and equity-guy, I’m not so sure. This will have the effect of forcing the bond market’s mark-to-market woes onto the operating company, which will have to find financing (or sweeten the terms of the deal and negotiate their way out of it) at the worst possible time. Hmm …

Other issuers today were Lehman and GE as well as Suncor. Money abounds for solid credits; the market is operating as it should in this, the most perfect of all possible worlds.

Another hedge fund has stopped redemptions, in what seems like a rather complex story in which the portfolio manager quit:

Homm said yesterday he quit after directors declined to follow his lead by turning down bonuses and contributing shares to support the funds during market turmoil. Absolute Capital said today it approved the bonuses Homm recommended.

Homm didn’t answer calls to his mobile phone, and Chief Executive Officer Jonathan Treacher didn’t immediately return calls to his office and mobile phone. In an interview yesterday, Treacher said he was “surprised” by Homm’s departure. “We never discussed him resigning,” he said.

The BCE saga, last reviewed about five weeks ago has taken another twist: the bondholders are going to court:

They want the deal declared a “reorganization” under the terms of the 1976 and 1996 trust indentures, which would require bondholder approval.

BCE bondholders argue the takeover is unfair will see them take “significant losses” since the debentures have lost “hundreds of millions of dollars” in market value since talks of the company going private began earlier this year.

As well, the debt for the leveraged buyout and related interest costs have caused one rating agency to downgrade the debentures from investment grade to junk status, the bonderholders argue.

It’s interesting that a rating agency downgrade should be considered worthy of mention – I thought we weren’t paying attention to them any more. PrefBlog’s crack investigative reporting team has discovered the fact that the issuer, BCE, is paying the credit ratings agencies! Video at 11.

Brad Setser has reviewed the larger implications of the liquidity crunch:

My wild guess is that some kind of new financial innovation will be necessary to end the (financial) droid wars …

Either that or there may be a lot of CDOs containing some housing exposure may be sitting around on various firms balance sheets for a very long time.

My guess? Hedge funds will arise that are more than happy to take care of the problem at a discount to market. I don’t think the banks will mind – the big losses will have been taken by by the original owners that were forced to sell. Not a big deal, really.

Cleveland Fed researchers have reviewed the slope of the yield curve again and its implications for recession probabilities, but note:

First, probabilities are themselves subject to error, as is the case with all statistical estimates. Second, other researchers have postulated that the underlying determinants of the yield spread today are materially different from the determinants that generated yield spreads during prior decades. Differences could arise from changes in international capital flows and inflation expectations, for example.

I suggest that any such readings taken now will reflect plain and simple panic. Let’s wait until panic has subsided and uncertainty has returned to normal levels before drawing any conclusions from the slope of the government yield curve.

US Equities continued their huge rally, but Canadian equities fell:

Canadian stocks fell, led by Suncor Energy Inc., on concern that a proposed oil and gas royalty increase may cut energy companies’ profits.

The province of Alberta should raise royalty rates to reap the benefits of rising prices, a report from a government-appointed task force said yesterday after markets closed.

The phrase “markets closed” should be read “markets closed Tuesday“, by the way.

Treasuries fell with steepening due to inflation fears.  Canadas followed.

Something of an odd Pref market today, with the PerpetualPremiums down and the PerpetualDiscounts up … given the action in the bond market, with the long end having an awful day, the opposite might have been expected. Assigning reasons to day-to-day fluctuations in any market, let alone the pref market, is something of an exercise in frustration, so we’ll just let that slide, shall we? Volume picked up a little today, a good sign.

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

The Fed cut by 50bp today, giving equities a big boost at the expense of long bonds and the greenback. As justification, their statement said:

Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.

Readings on core inflation have improved modestly this year. However, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

 For those keeping score, a handy guide to predictions of the Fed move by the brokerages houses was compiled by the WSJ Economics blog. Post-event reactions ranged from ‘Bold!’ to ‘Irresponsible!’. Tom Graff at Accrued Interest supplies an interesting prediction for the next two years.

James Hamilton of Econbrowser noted:

The Fed deliberately took a step back from its longer-run mission of containing inflation today. I don’t think Bernanke did so because he’d like to see 3-1/2 instead of 2-1/2 percent real growth next year. I’ve been saying all along that his intention is to squeeze inflation as much as possible without sending the economy into recession or financial crisis.

The verdict is still out on whether we’ve avoided one or both of those last two pitfalls. If we have, I’m not sure that the market’s confidence in another 50 basis points of cuts is warranted. If we haven’t, today’s exuberance in equity markets cannot be rational.

Well, US Core PPI looks OK anyway!

Over the past 12 months, producer prices rose 2.2 percent, down from a 4 percent increase in July. The year-over-year increase in costs excluding food and energy also eased to 2.2 percent compared with 2.3 percent in July.

In a highly interesting Canadian ABCP development, it looks like Dundee Bank flamed out:

Scotiabank will pay C$260 million in cash for Dundee Bank, a small bank that had been raking in deposits but was recently shaken by its exposure to a troubled corner of Canada’s asset-backed commercial paper sector, a short-term debt market that ground to a halt last month.
…
That was even after DundeeWealth said it will realize a net loss of about C$70 million on the sale of Dundee Bank “as a result of certain investments that are currently being valued below initial cost.”
…
DundeeWealth revealed on August 23 that the group was holding about C$400 million of commercial paper, instruments that are currently locked in a moratorium while the biggest players in that market try to hammer out a solution to prevent defaults.

I’d love to have more details on this. $70-million is an awful lot of mark-down on a $400-million position that, by all accounts, is reasonably well-secured with underlying assets anyway (albeit of a much longer term than originally intended). I wonder what else is going on with them? According to my interpretation of today’s DBRS rating confirmation, the problem was that they simply can’t place the money that has been deposited with them:

Aside from not yet achieving ongoing profitability, the Bank’s business model had become somewhat constrained given the recent credit market disruption. Without a lending operation, the Bank was relying on investments in collateralized loan obligations (CLOs) and asset-backed commercial paper (ABCP) to support its deposit liabilities, a strategy that is no longer practicable in the current market. The Bank grew to about $2 billion in assets since it began operations in September 2006.

Dundee Wealth has a ten-year retractible, DW.PR.A, in the preferred share market, rated Pfd-3 by DBRS. The issue soared on the news, presumably on market speculation that it is effectively an obligation of Scotiabank now and therefore of much higher quality.

Does everybody remember my speculation about the possibility of  a spectacular flame-out if a large bank suddenly discovered its risk controls weren’t exactly perfect? Looks like one shop, anyway, has come close:

Calyon, the investment banking arm of France’s Credit Agricole SA, said third-quarter profit will be “sharply down” after an unauthorized proprietary trade cost the bank 250 million euros ($347 million).

Calyon discovered an “unusually large market position” on diversified credit market indexes at its New York unit on Sept. 4, the Paris-based company said in a statement today. The trade, which breached authorized limits, has no relation to the subprime mortgage market, the bank added.

And, finally …

US Equities roared upwards after the Fed rate cut, as did the Canadian market.

Treasuries pivoted:

The difference in yield, or spread, between two- and 10-year notes widened to 0.5 percentage point, the most since Aug. 21. The gap was about 0.38 percentage point before the Fed statement.

Always remember: the short end trades on monetary policy while the long end trades on inflation expectations (the 10-years trade on futures & mortgage hedging!). One of the most educational graphs I’ve ever seen was of the Gilt market for a period of some years in the ’90’s … a beautiful, huge, smooth pivot, centered on the 10-year which barely moved.

Canadas pivoted.

The preferred share market continued its quiet ways. Volume continues to be light; entertainment was provided by the DW.PR.A mentioned above.

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

Panic, thy name is retail:

Despite the credit-market uproar, redemptions from money market funds were described as lower than expected at $915.5 million. Bond funds had $368.1 million in net redemptions excluding reinvested distributions, and Canadian equity funds had net redemptions of $578.4 million.

The only positive major category was balanced funds, offering conservative managed combination of stocks and fixed-income holdings. Canadian balanced funds endured $271.5 million in net redemptions, but the global balanced segment showed net sales of $670.5 million.

I’m sure that somebody, somewhere, has studied mutual fund cash flows vs. 12-month future returns. If anybody knows where I can find such a thing, let me know and I’ll post the link.

The Northern Rock crisis continues in Britain, with the stock dropping, customers crowding the withdrawal window and the Bank of England’s actions being questioned. The part I don’t understand is:

Northern Rock credit-default swaps increased 15 basis points to 170 basis points, according to JPMorgan Chase & Co. The cost of the credit-default swaps, which traded as high as 210 basis points on Sept. 14, rises as creditworthiness deteriorates.

Only 170bp? You don’t have to look very hard to find higher prices than that in the North American markets … Countrywide & CIT Group are quoted in the mid-200s, for instance, and with all their problems they’re not actually suffering a run and getting publicly announced support from the Fed. Bear Stearns & Lehman are in the low-100s. Still – I haven’t actually looked at NR’s financials, so I’ll just pass on the tidbit without further comment.

But! After the UK markets closed, the following announcement was made:

The British government is to guarantee all existing deposits at troubled bank Northern Rock, Treasury Chief Alistair Darling said Monday.

People can continue to take their money out of the Northern Rock, but if they choose to leave their money in the bank it will be guaranteed safe and secure,” Darling said at a Downing Street press conference.

Now, that is a bail-out. I don’t know what to make of it … but my gut reaction is unfavourable.

Meanwhile, in LBO news … Blackstone might be getting a black eye:

PHH Corp., the mortgage lender and vehicle-fleet manager that agreed to be bought by General Electric Co. and Blackstone Group LP, said the sale may unravel after Blackstone failed to get $750 million in loans.

And Credit Suisse is taking a hit on First Data:

Credit Suisse, the lead arranger of financing for First Data Corp.’s LBO, last week agreed to lower the amount of loans that banks initially will sell to $5 billion from $14 billion, and cut the price to 96 cents on the dollar, said three people with knowledge of the talks. The discount alone could cost about $200 million.
…
Deutsche Bank AG, Germany’s biggest bank, and JPMorgan, the No. 3 U.S. bank, found buyers last week for the highest-yielding loans financing KKR’s purchase of U.K. pharmacist Alliance Boots. The banks had abandoned selling 6 billion pounds ($12 billion) of mostly senior loans in August because buyers weren’t interested.

Investors agreed to buy the loans at 95 cents on the dollar, according to bankers.

That concession followed the sale of loans to back the purchase of Allison Transmission, the Indianapolis-based auto- parts supplier, by Carlyle Group and Onex Corp. Banks led by Citigroup, the biggest U.S. bank, sold $1 billion of loans for the Allison purchase for 96 cents on the dollar.

The fact that these loans are moving at all, albeit at a hefty discount, will be welcome news for holders of BCE Prefs. BCE common was down a tad today, but well within the boundaries of random jiggle-jaggles.

Oil prices set a new record today, which might have long term implications for the Gulf states:

It should go without saying that the strong oil/ weak dollar mix creates real problems for all the Gulf countries that insist (still) on pegging to the dollar.   They are effectively importing a weak currency and low nominal interest rates when there economies are booming.   The result: massive inflation and very negative real rates that are adding to the boom now, but risk creating problems later.

Three income trusts have celebrated oil’s rise by cutting their distributions:

Income-trust distribution malaise spread through the oilpatch Monday as Enterra Energy Trust (TSX: ENT-UN.TO) suspended its payout while Wellco Energy Services Trust (TSX: WLL-UN.TO) cut its distribution in half.

Those moves followed a 10 per cent distribution reduction Friday by Pengrowth Energy Trust (TSX: PGF-UN.TO) and extended a wave of payout disappointments for investors, particularly in energy services trusts.

NovaStar, mentioned here on September 4 is in the news again:

NovaStar Financial Inc., the subprime home lender trying to survive by conserving cash, scrapped plans to pay a dividend on 2006 profit and will forfeit its real estate investment trust tax status as a result.

The mortgage company, one of more than 110 that have halted lending or left the business since the start of 2006, said in a statement that the loss of REIT status will have a “significant adverse impact” on third-quarter results. Kansas City, Missouri- based NovaStar is reviewing its listing requirements with the New York Stock Exchange.

“Clearly, we did not anticipate the drop in market value or the level of demands on liquidity caused by the market turmoil this summer,” said Chief Executive Officer Scott Hartman in the statement. “Canceling the previously planned dividend is the only reasonable and prudent course of action.”

James Hamilton of Econbrowser thinks enormous pressure for increased regulation is inevitable – and, at least to some degree, desirable. Econbrowser’s other principal, Menzie Chinn, notes:

As social scientists, we should try to explain why the current Administration behaves in this manner. One approach is the capture and ideology perspective of Kalt and Zupan (1984). Although not directly applicable (since their study was of legislative actions), the framework is of interest. If policy is captured by economic interests, then analysis is irrelevant. If ideology is paramount, then again analysis is irrelevant.

Oh, it’s a glorious world, where evidence, argument and analysis are irrelevant!

US Equities were off a bit, having run aground on the Northern Rock (and a sudden realization that maybe the Fed doesn’t actually have to cut by 50bp tomorrow if they don’t feel like it); Canadian equities followed.

Short-term Treasuries also fell, flattening the curve; Canadian ten-years rose, flattening the curve.

Preferreds didn’t do much on low volume, although the SplitShare and InterestBearing sectors drifted up a bit.

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

Retail Sales in the US were unexpectedly weak in August, adding to the rationale for a Fed Rate cut (although the numbers are considered highly adjustable by some). Tom Graff uses a Taylor Rule (parameterized as a trading indicator, not as a policy gauge) to estimate the future Fed Funds Rate as 3.75% down 150bp from current, while emphasizing that he considers it a qualitative measure of direction, rather than an actual prediction. Fed Funds Futures are now predicting a value of about 4.5% at year-end. The use of the Taylor rule to determine neutrality – and the effects of getting it wrong – was discussed at the recent Jackson Hole conference. Economic chatter leans to a 25bp cut.

It will be most interesting to see the reaction of USD LIBOR and USD CP rates to whatever the Fed ends up doing. There are definite indications that USD ABCP investors are anticipating a rate cut – perhaps the next weekly Federal Reserve report on ABCP will not show such a huge decline. That will annoy the banks! Cushioning fear-driven liquidity shocks is their bread and butter:

This paper argues that banks have a unique ability to hedge against market-wide liquidity shocks. Deposit inflows provide funding for loan demand shocks that follow declines in market liquidity. Consequently, one dimension of bank “specialness” is that banks can insure firms against systematic declines in market liquidity at lower cost than other financial institutions. We provide supporting empirical evidence from the commercial paper (CP) market. When market liquidity dries up and CP spreads increase, banks experience funding inflows. These flows allow banks to meet increased loan demand from borrowers drawing funds from pre-existing commercial paper backup lines, without running down their holdings of liquid assets. Using bank-level data, we provide evidence that implicit government support for banks during crises explains the funding flows.

From the same paper, incidentally:

Banks’ functioning as liquidity insurance providers originated early in the development of the commercial paper market. In 1970, Penn Central Transportation Company filed for bankruptcy with more than $80 million in commercial paper outstanding. As a result of their default, investors lost confidence in other large commercial paper issuers, making it difficult for some of these firms to refinance their paper as it matured. The Federal Reserve responded to the Penn Central crisis by lending aggressively to banks through the discount window and encouraging them, in turn, to provide liquidity to their large borrowers (Kane, 1974). In response to this difficulty, commercial paper issuers thereafter began purchasing backup lines of credit from banks to insure against future funding disruptions (Saidenberg and Strahan, 1999).

David Dodge is quoted in The Economist as saying:

He acknowledged that the Bank of Canada may itself have played a role in stoking the excesses by not raising interest rates enough. “One can see in retrospect that we should have been driving those rates harder than we did, because in reality credit conditions were being eased by increased securitisation and movement of stuff off balance [sheet],” he says.

Presumably, therefore, decreased securitization and movement of stuff onto balance sheet is a de facto tightening.

Meanwhile, China is hiking rates due to inflation concerns. There is evidence that the effect of high levels of imports from China is shifting to inflationary from deflationary. And Brad Setser is puzzled about the current account deficit and how it relates to the investment income balance:

Since the US has a borrowed a lot more – about $ 5 trillion more — than it has lent out, mathematically, a constant deficit on the interest balance implies that either that the interest rate on US lending has to be rising faster than the interest rate on US borrowing or that the interest rate on US borrowing has to be falling faster than the interest rate on US lending.

If I did all the calculations correctly, it turns out that the implied interest rate on US lending has been constant (at around 4.7%) while the implied interest rate on US borrowing is actually falling, from a bit under 4.4% in 2006 to 4.25% in the first half 2007.

The Credit Rating Agencies are beginning to take a little more action to polish their public profile. Moody’s has published some reflections on liquidity and flight to quality, and promise more. They note:

The need for a liquid and transparent secondary market for structured product may delay a recovery in primary issuance as investors will avoid purchasing an asset in the primary market if a similar asset can be purchased in the secondary market at a lower price. Therefore, greater transparency will be required of the secondary market as well as lower prices (or better protection) in the primary market. The liquidity risk premium is going to be higher and investors will be reluctant to buy these products unless there is some degree of standardization and secondary market liquidity. Marked to market actors may be reluctant to buy customized product, and higher risk premia could temporarily reduce the economic attractiveness of securitization for certain classes.

Illiquidity was highlighted as one of six “key vulnerabilities” of the UK financial system in the Bank of England’s Financial Stability Report of April 2007:

Unusually low premia for bearing risk, especially in credit markets. Benign current economic conditions, the greater dispersal of credit risk and confidence that market liquidity will remain high may have weakened risk assessment standards. If risk perceptions were to adjust, unexpectedly large shifts in market liquidity might lead to sharper asset price changes than anticipated by market participants, with knock-on effects on counterparty credit risk.

The moral of the story is: liquidity is a risk! Investors may intend to buy and hold but the consequences of having to sell (or wishing to sell due to credit concerns) into an illiquid market can be severe. The best defense is, as always, a broadly diversified portfolio with the individual elements bearing a wide variety of risk/reward profiles. Just look at HSBC: what they’re losing on sub-prime, they’re making up on insurance.

Thomson, issuer of the TOC.PR.B floaters, has been downgraded by Moody’s from A3 to Baa1. Moody’s did not specifically address preferred shares; I believe they have a mandate only for Thomson’s USD debt.

BCE holders will be interested in the latest news from junk-land. Prices on TXU and First Data common have gotten closer to the deal price on hopes that financing will not kill the deal. Several others have also narrowed, but poor old Sallie Mae is a wallflower, now that Dad’s cutting her allowance. The First Data bond deal is getting done, albeit at a spread almost 100bp more than originally intended, with more restrictive covenants. Investment grade issuers are issuing lots of paper, swallowing the high spreads; presumably they are calculating their spread to some kind of ‘non-panic’ government yield rather than actual market levels.

US Equities finished a great weak on a quiet note; as did stocks in Canada. Both Treasuries and Canadas were boring.

Volume in preferred shares was extremely light, which is leading to some strange pricing moves. The market looks quite sloppy, although now that the BCE issues are acting a little bit more like Pfd-2(lows) again, my curve-fitting is showing reasonable goodness-of-fit. It’s one of them conundrum thingies!

There were NO other $25-equivalent index-included issues trading over 10,000 shares today.

Goldman’s Global Alpha fund lost 22% in August:

The fund, managed by Mark Carhart and Raymond Iwanowski, has dropped by a third in 2007 and 44 percent from its peak in March 2006. Investors notified New York-based Goldman last month that they plan to withdraw $1.6 billion from the fund, or almost a fifth of the assets as of July 31.

Global Alpha’s biggest loss in the month stemmed from the managers’ decision to sell Japanese yen and buy Australian dollars. The so-called carry trade unraveled when the Australian dollar fell 6 percent against the yen in August. Equities holdings, including stocks in the U.S., Norway and Finland, declined 4.7 percent.

Red Kite, a $1-billion metals fund, lost about 20%.

In the junk world, financing is being arranged for KKR Boots, while negotiations continue on the $26-billion First Data deal (there is a late report that talks have been suspended for a week). Tom Graff has some historical commentary, focussing on the perils of market timing.

American ABCP outstanding continued to decline according to the regular Federal Reserve release. Yield spreads to government paper are still extremely high, however.

The news is good; it looks like things are starting to get moving again – creakily – but we’re by no means out of the woods yet. There will be lots of firms hanging on by their fingernails (Xceed Mortgage Corp., for instance, has just eliminated its dividend) and confidence is always slow to recover. However, it is nice to see that the hedgies have fulfilled their function by losing a lot of money and helping to stabilize things.

After the markets closed there were reports that Northern Rock, a UK mortgage lender, has received emergency funding from the BoE. This news had an immediate effect on New Zealand and Australian currencies.

Menzie Chinn has criticized Bernanke’s Savings Glut hypothesis:

To sum up, the Bernanke explanation for the US current account deficit relies upon a particularly small effect of budget deficits on current account deficits, and treats the US housing boom and associated mortage equity withdrawal as largely exogenous, or primarily a function of foreign excess saving. If you believe these points, then the saving glut story is the story for you.

And Brad Setser poked holes in the argument that China is forced to finance the US current account deficit:

The standard argument that China would shoot itself in the foot, financially speaking, if it stopped lending to the US is wrong.   China would certainly shoot its export sector in the foot if it stopped lending to the US.   And it is true that if China stopped lending to the US, the value of the RMB would rise relative to the dollar would increase and the value of China’s existing US assets would fall.  But China would still be better off, in the purely financial sense, if it took its lumps now.

That’s enough to make you feel good, isn’t it? The US economy is a Ponzi scheme. Maybe they should cut taxes, or something.

US Equities were euphoric over some indications that the credit crunch is less crunchy, while Canadian equities experienced similar dizziness over the prospect of oil at $80+. An ill wind will always blow some good somewhere!

Treasuries fell in a slight reversal of the flight to quality, as did Canadas.

It was a quiet day for prefs with not much volume.

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