Category: Market Action

There were some very interesting tid-bits of news today. Naked Capitalism posted an article regarding some of the unintended consequences of Credit Default Swaps. I have commented on this news more thoroughly on the PrefBlog CDS Primer Post.

And the SocGen Futures Fiasco continues its fascination:

Europe’s largest futures exchange queried the bank about its trades as early as November.

“Eurex was alarmed by the size of the positions,” Prosecutor Jean-Claude Marin said at a press conference today, citing Kerviel. He said the trader was able to explain away the concerns.
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Jean-Pierre Mustier, chief executive officer of Societe Generale’s corporate and investment bank, said on a conference call yesterday that trades by Kerviel that exceeded limits had been caught by the bank’s back office before.

“He would admit he had made a mistake, the transaction would be canceled and he would replace it by another one that would be controlled by another department,” Mustier said. “He wasn’t making more mistakes than other traders.”
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The case has raised fresh doubts about risk management at the world’s biggest financial institutions and prompted calls for increased disclosure from French President Nicolas Sarkozy. He also suggested top managers should bear a greater share of the blame.

“When someone is very highly paid, even when it’s probably justified, you can’t avoid responsibility when there’s a major problem,” Sarkozy told reporters today after giving a speech outside Paris.
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“There was clearly a fault in the bank’s control systems,” said Jean Peyrelevade, a former CEO of Credit Lyonnais and a member of the board of Barings when Leeson’s losses brought down the bank.

It pains me to have to quote Sarkozy actually saying something sensible on a topic related to capital markets, but hey – even a stopped clock is right twice a day!

Apparently, Kerviel didn’t take his vacations:

He took only four days off last August and postponed a vacation at the end of the year, Societe Generale said. Banks often make trading staff take time off so any concealed positions will become evident in their absence.

… and, although I can no longer find the link, was mentioned somewhere as having a departmental password that gave him some information. Well … maybe a departmental password is acceptable for access to the page that provides information about the staff Christmas party, but I can’t see any other rational use! And, of course, there’s the “calendar of the controls” issue that I mentioned on Friday.

There’s no real information available. It’s in the bank’s interest to make this guy out to be a combination of Einstein and Satan … it’s not in their interest to provide a full and dispassionate account of how the little accident occurred. This is particularly the case since given the short period of time since the discovery, the only people who really have a thorough knowledge of the situation and industry comparables are the ones with their asses on the line.

But really, it’s sounding to me more and more like everybody involved in the policy-making for the controls, from the department manager to the risk committee of the board of directors, now has the onus to explain why they should be allowed to keep their job.

Naked Capitalism also ruminates on the bond insurer bail-out and the failure of the ratings agencies to update the status of their reviews:

there is every reason to expect the rating agencies to knuckle under if Dinallo can raise a modest amount of dough, even as little as, say, $2 billion. The agencies through their mistakes have now created the situation where they could be the ones to Destroy the Financial World as We Know It. They will take any route offered to keep from pushing the button, in the hopes that either the economy will miraculously recover or other events will lead to credit repricing, so that the eventual downgrade of the insurers has far less impact than one now.

I still don’t think a bailout is likely to succeed, despite the considerable costs of a bond guarantor downgrade. But the fact that the rating agencies will probably go along with any remotely plausible scheme means that a smoke and mirrors version might be put into place.

With respect to this particular tale, it is fascinating to learn that JPMorgan has increased its Ambac stake to 7.7% from 5.4%.

And, in news that will be not be welcomed by those speculating that BCE / Teachers will succeed, another LBO in the States has bitten the dust … but for a novel reason:

Blackstone Group LP’s $6.6 billion leveraged buyout of credit-card payments processor Alliance Data Systems Corp. may collapse because bank regulators have placed “unacceptable” requirements on the acquisition.

Alliance Data plunged 35 percent in New York trading today after Blackstone said conditions requested by the U.S. Office of the Comptroller of the Currency would impose “unlimited and indefinite” liability on the firm. It will try to keep the deal alive, the New York-based company said in an e-mailed statement.
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The Federal Deposit Insurance Corp. also regulates Alliance Data because it operates an industrial bank. Before today, Alliance Data shares had dropped more than 10 percent four times since Nov. 29 on speculation the transaction will be reworked or abandoned. Three times Alliance Data issued public statements that the two sides were working to complete the deal.

Now, I don’t believe that banking regulators have any direct involvement in BCE / Teachers, but this deal’s collapse seems to have had a ripple effect anyway! BCE was down $1.34 on the day, to close at $34.95.

The TSX is late again with my daily prices. The indices (and HIMIPref™) are being updated at various odd hours, but will be unavailable on a daily basis until the data becomes available at a reasonable time.

The bond insurance business gets more interesting every day! Naked Capitalism has two pieces on it today, the first attempting to quantify the problem:

Bill Ackman of hedge fund Pershing Square has gotten a considerable amount of flack for his outspoken, negative views of the bond insurers, particularly MBIA and Ambac, which his firm has shorted. Ackman has been circulating a detailed analysis that estimates that the additional equity needed to maintain an AAA rating at the two biggest firms is roughly $15 billion.

This calculation is sharply contested by new rating agency Egan Jones (which also downgraded MBIA to a B+, a junk rating) which says the industry needs more than an order of magnitude more capital, namely $200 billion.

Egan-Jones was mentioned in PrefBlog on November 7. As a subscription-based credit advisor, they have an interest in saying exciting things … which is not to say they’re wrong, of course, but it is something to keep in mind. They received NRSRO status in December.

Naked Capitalism also takes a rather gloomy view of the New York Insurance Regulator’s bail-out facilitation – even gloomier than the one I remarked on yesterday. Until shown otherwise, I’m just going to assume the whole NY bail-out thing is plain-and-simple grandstanding … Mr. Dinallo, the head of the NY regulator, learned all about grandstanding in his last regulatory job:

Superintendent Dinallo served at the Office of Attorney General Eliot Spitzer from 1999 to 2003. As Chief of the Securities Bureau, he was charged with combining that bureau with the Real Estate Finance Bureau. The resulting Bureau was named the Investment Protection Bureau to reflect its focus, and Mr. Dinallo was named its first Chief. In that capacity, he led the reinvigorated Bureau’s investigations into the Wall Street Cases – conflicts of interest in the financial services industry, including research analyst cases and the spinning of hot initial public offerings. He produced more than 40 major civil and criminal matters, and led the Bureau through the beginning of the mutual fund industry investigations.

However, Barclays Capital has opined that there may be very serious knock-on effects should the insurers fail:

Banks that raised $72 billion to shore up capital depleted by subprime-related losses may require another $143 billion should credit rating firms downgrade bond insurers, according to analysts at Barclays Capital.

Banks will need at least $22 billion if bonds covered by insurers led by MBIA Inc. and Ambac Assurance Corp. are cut one level from AAA, and six times more for downgrades by four steps to A, Paul Fenner-Leitao wrote in a report published today. Barclays’ estimates are based on banks holding as much as 75 percent of the $820 billion of structured securities guaranteed by bond insurers.

I will have to do some more research into the bank capital regulations … it seems to me that having such levels of exposure to single names should attract a concentration charge on capital … I’m honestly not sure whether or not it does.

And Naked Capitalism draws to my attention (very good crop today, Yves!) an opinion piece by Willem Buiter, who is something of a regular on this blog:

Even with a few days worth of hindsight, the Fed’s out-of-sequence, out-of-hours 75 basis points cut in the target for the Federal Funds rate continues to look extraordinary and deeply misguided. Indeed, it looks less and less like a decisive pre-emptive move in response to unexpected bad news designed to meet the Fed’s triple mandate of maximum employment, stable prices and moderate long-term interest rates, than a knee-jerk panic reaction to a global stock market collapse.

Did the sharp global decline in stock values at the beginning of this week reflect a rational re-assessment of fundamentals? The only two candidate explanations I have heard are (a) that the collapse was probably triggered by concerns about the financial viability of the monolines and (b) that it was intensified by the unwinding by SocGen of the long equity positions taken by its employee of the year (not!). I find neither explanation convincing. If the collapse was a spurious, non-fundamental event, there is no reason for the Fed to react to it. The ability of the Fed to meet its fundamental objectives is seriously undermined if it is perceived as the poodle of the equity markets.

So sign up another member of the “But what about inflation?” camp.

Assiduous Readers will be familiar with my grumpiness about US Fiscal policy – the last six years have been permanent stimulation – but I’m in good company:

[Harvard Professor Jeffrey Frankel] explains:

“In 2001, very aggressive monetary and fiscal expansion reduced the severity and length of the recession. It is true that this time as well the Fed has been busy cutting interest rates and the government is working on a fiscal stimulus. But this time, before long, our policy makers will run into constraints. The government can’t keep cutting taxes, because the national debt is too high, the path of future deficits too steep, and the costs of the baby boomers’ retirement too imminent. The federal government needs to retain the confidence of the bond markets.

“This is different from 2001, which we entered with a record budget surplus, allowing room for stimulus. Similarly, the Fed can’t keep cutting interest rates because the dollar has been falling steeply, and America needs to retain confidence of foreign investors who are financing our deficits. This is different from 2001, when the dollar was strong, inflation was all but dead, and the Fed could cut interest rates by [5.5 percentage points].”

A few more details – and a bit more rational commentary – is emerging regarding the SocGen stock futures fiasco:

But a top French presidential advisor revealed that Kerviel had positions of more than 50 billion euros (73 billion dollars) — more than the bank’s current market capitalisation of 35.9 billion euros.
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Many experts said it was difficult to believe a lone trader could have successfully hid such colossal losses.”

“The feeling in the dealing rooms is that it is not possible for an individual to do all that. They think Societe Generale has overdone the fraud to cover up some bad market operations,” said Elie Cohen, an economy professor and research director for the National Centre for Scientific Research (CNRS).

One example of such feelings as were noted by Elie Cohen is:

Let’s get this straight: the MainSwamp media (who are such profoundly ignorant whip-kissers that they think that the wankfest at Davos is worth reporting on) would have you believe that a single trader whose entire remuneration package (including bonuses) was 100k euro, had such free rein that he could rack up positions with aggregate losses of A$9 bill, with nobody noticing. (To get to an aggregate loss of A$9 bill, you need an actual position larger than that, no?)

A bank with owners equity of about $20 billion, and its processes are so poor that such a thing could happen? The Banque de France – who audits every bank every year, and knows if an individual Frenchman passes a bad cheque – knew nothing of it?

Sorry lads – no sale.

What has happened here, I bet, is that SocGen has found an internal culprit, and is hanging as large an amount on him as they think they can get away with. So this geezer might have sent $100 mill to Money Heaven – that amount could possibly be hidden for a week or so – and the Bank has used him as a scapegoat and has attributed half its subprime-related losses to him rather than the subprime book.

… and a bit more delicately:

“That’s when he made his first mistake,” said Jean-Pierre Mustier, head of investment banking at Societe Generale. “He no longer knew the type and calendar of the controls.”

The trading loss raises questions about the bank’s risk management procedures.

“I find it really improbable that this trader was not abetted by at the very least incompetence, if not assistance from others,” said Joseph Mason, a risk-management researcher and professor of finance at Drexel University in Philadelphia. “Ultimately, we’re talking about a breakdown of fundamental operational controls.”

“Calendar of the controls”? No wonder SocGen’s lost so much. And finally (hat tip: Financial Webring Forum), Jim Sinclair reviews the data and offers the opinion:

The USD $7,000 million loss reported as an action of a junior trader hiding a losing position for a considerable amount of time as stated is total bull.

You would have to be totally IGNORANT of market mechanics to buy that plausible denial.

The public and much of the media are.

The reported loss was a buyout of a failed to or chosen not to perform derivative.

One theory regarding the mechanics of the scheme that has been suggested to me is that the trader was writing single puts on multiple futures/forward contracts rather than multiple puts on single futures/forward contracts, then fiddling with the documentation to make it look like one put = one contract, rather than the actual one put = multiple contracts.

Well, that may be. I responded that most cases like this aren’t very complicated, really. It’s usually just a matter of dumb stealing from dumber. Or, perhaps, dumber turning a blind eye, as long as dumb was making money.

I’ll admit, one thing that makes me a little nervous about the whole episode is the continued emphasis on his background in operations:

Kerviel drew on knowledge he acquired during six years in Societe Generale’s back office, where he went to work in 2000 after completing a degree in market operations at the University of Lyon II, according to an alumni Web page. He had to breach five levels of controls to get away with his trades, Bank of France Governor Christian Noyer said at a press conference yesterday.

His “intimate and perverse” knowledge of the bank’s controls let him avoid detection, co-Chief Executive Officer Philippe Citerne told reporters.

This is the type of thing that might make a particularly overbearing, paternalistic and incompetent regulator (please don’t cry, Assiduous Readers, some such do exist) forbid such transitions.

I came up through operations. It was while working in operations on starvation wages that I got interested in finance. The background has served me well … back-office bullshitters find I’m asking them questions they’d rather not answer, on occasion. I’m hardly alone in this; the traditional manner of becoming a trader is by first becoming a traders’ clerk – something I wish I’d know when I got my first full-time operations job and spent several years kicking myself for asking for the higher-paying dead-end choice.

But we’ll see.

There’s a new inhabitant of litigation-land!

this move by New York City and State to sue lead manager Goldman, 25 other underwriters and accounting firms over a Countrwide stock offering is routine securities fraud, in this case making misrepresentations about the company’s prospects. No one has yet to develop a legal theory to go after Goldman for the move that has many offended, being net short subprime related debt while continuing to sell them to investors. And the latter is unlikely to go anywhere (saver perhaps serving as fodder for Congressional investigations) because that action didn’t violate any securities laws.

There is no indication as yet as to whether the New York City and State portfolio managers have even been asked as to whether they did a due diligence.

Well folks …. sorry! Prices are not yet available from the TSX and I’m going out for dinner. I’ve been keeping the HIMIPref™ indices up to date, by the way, after cramming in the prices at odd hours, just not reporting them. But I’ll see what I can do over the weekend to – at least – get today’s index levels up.

A so-called rogue trader socked it to SocGen … 4.9-billion Euros’ worth. So called? I haven’t seen any proof yet and won’t ever see it. Assiduous Readers might not believe this – but there are still some people in the world who believe that the honchos at Barings Bank were shocked – shocked! – to hear that Nick Leeson was speculating rather than arbitraging in order to make 10% of the bank’s profits. Fitch Ratings announced it:

has today downgraded Societe Generale’s (SG) Long-term (LT) Issuer Default Rating (IDR) to ‘AA-‘ (AA minus) from ‘AA’ and the Individual Rating to ‘B’ from ‘A/B’. SG’s Short-term (ST) IDR and Support Ratings are affirmed respectively at ‘F1+’ and ‘1’. The Outlook for the LT IDR is Stable and the Support Floor is affirmed at ‘A-‘ (A minus).

This action follows the profit warning announcement made by the bank today. The EUR4.9bn fraud-related trading loss uncovered at the bank is very substantial and has arisen within the bank’s equity trading division, core to SG’s business. While Fitch understands that SG has been the victim of fraud undertaken by one single trader under very specific circumstances, the extent to which the fraudulent positions taken were concealed raises questions about the effectiveness of the bank’s processing systems and creates reputational risk for the group.

Not much news today, frankly. I felt very hopeful about a VoxEU piece titled Ratings Agency Reform, but there’s no substance to it – it’s just a list of options with no accompanying argument, discussion or opinion.

The Congressional Budget Office does not believe the US is, or will be, in a recession – a slowdown, sure, but not an actual recession. Of far more interest than inane hairsplitting over definitions is their view on the US Federal deficit:

Our baseline – which assumes no change in current law — suggests that among other factors, the slowing economy will boost the deficit to $219 billion, or 1.5 percent of GDP, this year. If Congress provides the additional funding for operations in Iraq and Afghanistan requested by the Administration, the deficit would rise to $250 billion. And if a fiscal stimulus package is enacted, the 2008 deficit could be substantially higher – and at least from a short-term stimulus perspective, that could be desirable. The fiscal 2007 deficit was $163 billion, or 1.2% of GDP.

A mere $250-billion for fiscal 2008, without counting the stimulus package? Not a problem – just sell foreign investors a few more banks. It will be a lot easier than selling them LBO debt!

This is going to end in tears, you know. In Canada, we hit the wall in 1994 and since then politicians have found religion – even the NDP appears to be sincere when calling for balanced budgets. Mind you, the exercise is farcical … the federal deficit in Canada was what? $31-billion-odd in 1991, on top of huge provincial deficits? And there wasn’t anything extraordinarily stupid going on, most of that was just automatic stabilizers (welfare, unemployment insurance, reduced tax collections) acting as they should. And now we’re sitting with a massive national debt, huge health costs and reduced government revenues as the boomers retire while being told that $2-billion annually is a prudent and rational amount to pay on the national debt. It’s silly, really.

But anyway, my point is that the political climate regarding fiscal policy in Canada, for all its faults, is a lot healthier than in the States – and that’s going to get ugly when the chickens come home to roost. It’s not hard to imagine a scenario whereby nominal US allies – the ones with money – are politely asked to help defray the costs of US bases … and in the schoolyards in my neighborhood, that’s called “tribute”, “protection money” or “extortion” according to taste.

Naked Capitalism takes a gloomy view of the proposed monoline bailout – which I haven’t mentioned before because it’s not very interesting. Mr. Smith is greatly irritated by:

Sean Dilweg, the commissioner of insurance in Wisconsin, which regulates Ambac, sat in on the meeting but said he would be working with Ambac directly. Mr. Dilweg said he met separately on Tuesday with executives at Ambac, which is based in New York but chartered in Wisconsin.

“Eric is looking at the overall issue, but I am pretty confident that we will work through Ambac’s specific issues,” Mr. Dilweg said in a telephone interview. “They are a stable and well-capitalized company but they have some choices to make.”

and Mr. Smith responds:

the moron of a regulator from Wisconsin is not only not on the same page, but is dumb enough to undermine Dinallo by saying to the press that all is well in the land of cheeseheads. The odds of Ambac pulling through look even more remote.

This seems like very strong language. The potential monoline demise was mentioned in PrefBlog on January 18 when Fitch downgraded the insurer from AAA to AA. I’d say the regulator from Wisconsin is right – or, at least, he has not yet been proven wrong. What’s wrong with an AA rating from Fitch? Lots of companies would LOVE to have a AA rating from Fitch. They won’t be able to write much new business with that rating and a negative outlook, but why should the regulator care? An AA rating implies a very high probability of meeting the current obligations.

I guess I just don’t understand why this is considered a regulatory matter. I can see that the regulators should be interested, sure, and maybe send over a SWAT (Special Warning Accountancy Team), but public involvement does not yet appear to be warranted.

Again, there will be no tables for indices, performance and volume. Sorry about that!  

Those who are feeling unusually cheerful may find a cure their unfortunate condition by reading through Naked Capitalism‘s latest round-up of gloom and doom … for example, George Soros says:

Until recently, investors were hoping that the US Federal Reserve would do whatever it takes to avoid a recession, because that is what it did on previous occasions. Now they will have to realise that the Fed may no longer be in a position to do so. With oil, food and other commodities firm, and the renminbi appreciating somewhat faster, the Fed also has to worry about inflation. If federal funds were lowered beyond a certain point, the dollar would come under renewed pressure and long-term bonds would actually go up in yield. Where that point is, is impossible to determine. When it is reached, the ability of the Fed to stimulate the economy comes to an end.

Assiduous Readers will remember that I’m already amazed that long-term bonds haven’t already gone up in yield. What’s the 30-year Treasury doing, yielding 4.25% at yesterday’s close? It’s even lower today. I consider this to be proof that today’s archetypal bond manager is under 40 years old. Punk kids. Think inflation is one of their grandfather’s pointless old stories. They should all read Steven Cecchetti’s latest VoxEU piece:

Starting with the data, since the beginning of the month we have seen a very poor employment report (released on the 4 January), evidence of a fall in real retail sales (15 January), information that industrial production was unchanged in December (16 January), and confirmation of a continued precipitous decline in residential construction (17 January). Taken together, this all suggests that the US economy may already be in a recession. My own guess is that the peak in the business cycle was November 2007 and that the economy is currently shrinking, albeit modestly for now.
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should not sign off without making some comment about inflation. As discussed in my most recent inflation update, recent readings suggest that inflation is on its way up. Most forecasts that I have seen suggest the inflation trend (as measured by the Consumer Price Index) will be not be lower a year from now than it is today. That means that we are likely to enter 2009 with a CPI inflation trend of at least 2¾ percent; surely above the 2 percent most of us would like to see. Clearly, today’s actions are not directed at combating this gathering menace. Instead, for now the FOMC is forsaking its inflation objective in an attempt to keep the recession from getting worse.

But Dean Croushore of the University of Richmond points out another nuance:

Fed Chairman Ben Bernanke’s first published economics article begins “This paper examines the possibility that the economy-wide level of bankruptcy risk plays a structural role in the propagation of recessions.” Published in the American Economic Review in 1981, Bernanke’s analysis showed how a recession causes lenders to reduce their lending so that they can remain solvent, which in turn causes the recession to become worse.
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How ironic it is that Bernanke should be Fed chairman during the first financial crisis in a decade and the first credit crunch in almost two decades. But also how fortunate that he understands, far better than most economists, why it is crucial that the Fed ensure that credit flows smoothly in the economy, despite the clear breakdown of mortgage markets and substantial losses by financial firms.

The danger, I suppose, is that if you’re an expert on hammers, all problems look like nails!

Sean Silcoff of the Financial Post writes a very good article urging restraint with respect to the BCE / Teachers deal (link courtesy of Financial Webring Forum):

A sure thing? A lot of smart money doesn’t think so, fearing the deal could fall apart. After all, it requires about $33-billion in new debt, and the banks that committed the funds last summer are in worse shape than they were then, amid the bleakest credit crisis in 20 years. The lead backer, Citigroup, is one of the worst basket cases; it can hardly afford to take on more LBO debt. The LCDX, an index of high-yield loans, is trading at $90, implying a 10% discount for holders of high-yield debt.

There are $21-billion in such loans in the BCE deal. So they are worth $2-billion less to the financiers. There is another $11-billion in high-yield bonds to be sold. You can assume a 15% discount there. So anxious lenders are already US$3.5-billion in the hole, on capital they can hardly afford. The prospect of killing the deal and paying the $1-billion break fee to BCE must seem like a good trade.

The court case, in which BCE bondholders are attempting to quash the deal, continues:

In final arguments in court, BCE lawyers said the bondholder suits rely on a series of misrepresentations and incorrect or misleading evidence.

BCE says the bondholders are sophisticated creditors who know the potential risks and shouldn’t have been surprised by news of the sale.

So I guess all the widows and orphans bought the stock, leaving the bonds for the sophisticated creditors to buy.

Remember SIVs? Geez, it’s been a long time since I’ve written about SIVs. There was some more bail-out news today:

American International Group Inc., the world’s biggest insurer, will bail out its Nightingale Finance structured investment vehicle, according to Moody’s Investors Service.

AIG Financial Products Corp., a unit of the New York-based insurer, will either buy the SIV’s $2.2 billion of senior debt or replace it with loans, Moody’s said in an e-mailed statement today. Moody’s affirmed its top Aaa ratings for the U.K. Channel Islands-based SIV’s senior debt.
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“Any realisation of current or future mark-to-market losses will be avoided given the support of AIG Financial Products, provided that AIG FP remains a going concern,” the New York-based ratings company said in the statement.
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Bank of Montreal has shrunk its Links Finance Corp. SIV from $23.4 billion in July last year to $15.1 billion in mid- January, the Toronto-based bank said earlier this month.

Well … it’s after 9:30 and I still can’t download prices from the TSX. I can only suppose that the staff is so busy writing thank-you notes to Bernanke that they’ve run out of time to update the historical databases. I’ll update once I have something to update with.

Shock and awe in the markets today as the Fed cut 75bp to 3.5% and the Bank of Canada cut 25bp to 4.0%. James Hamilton at Econbrowser labels the Fed move an attempt to mitigate damage:

a 75-basis-point cut can not prevent a recession, if one is indeed already under way, any more than the 50-basis-point cut in April 2001 prevented that downturn. But, while many members of the public may believe in the Fed’s omnipotence, I doubt that members of the FOMC share that illusion. I expect that Bernanke instead simply intends to do what he can to mitigate the damage.My bottom line? I believe the FOMC cast its vote today with those who declare that a recession has already begun.

But even after this massive move, many market players are calling for more, e.g.:

The Fed will cut rates again at next week’s meeting by either [a quarter of half percentage point]. The Fed has been unwilling to disappoint the market and fed funds futures are leaning very strongly toward a half-point cut next week. However, we disagree with the Fed over the longer-term outlook for inflation — to us, events have a strong stagflationary feel about them. –Bear Stearns

Bloomberg has some interesting colour regarding the Bond Insurer Implosion:

The first to fall was ACA Capital Holdings Inc., whose ACA Financial Guaranty Corp. unit guaranteed $26.6 billion of CDOs backed by subprime mortgages, according to S&P. The New York- based firm was founded in 1997 by H. Russell Fraser, a one-time chairman of Fitch, to insure municipal bonds that triple-A rated insurers wouldn’t cover.
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“I knew that if they played with fire long enough, they were going to get burned,” says Fraser, 66.

He left the company in 2001 over a dispute with the board about insuring CDOs, he says. Back then, it was debt of Enron Corp. and WorldCom Inc. — companies that later filed the two largest bankruptcies in U.S. history — that was being shoveled into CDOs.

‘But’ roars the crowd, ‘We’re not interested in ancient history! Can we go back to sleep yet?’ Not according to Moody’s!:

Moody’s placed under review for possible downgrade BAC’s senior debt, rated Aa1, and Bank of America N.A.’s financial strength, rated A, on January 11, 2008, when the company announced its planned Countrywide acquisition. The bank’s Aaa deposit ratings and all Prime-1 short-term ratings are not under review.

“The rating review is focused on BAC’s capital position, which is further stressed by a barely profitable fourth quarter and the payment of substantial dividends”, said Rosemarie Conforte, Moody’s Senior Vice President. Moody’s said continued CDO write-downs and increased credit provisions severely affected BAC’s earnings performance during the fourth quarter 2007. Ms. Conforte added, “Bank and holding company liquidity are soundly managed and any capital-raising initiatives would be evaluated during the rating process.”

All in all, it was a pretty interesting day in the financial markets. James Hamilton at Econbrowser took a look after the close and pointed out that 10-year Treasuries yield less than 3.50% and:

All of which invites the question, What’s left for the Fed to do at their regular meeting still scheduled for next week? Futures market participants, whom we left on Friday in the belief that a 75-basis-point cut by the end of January was more likely than a 50-basis-point cut, roared out of the box today, bidding the February fed funds futures contract up to 96.95, implying an expected fed funds rate of 3.05%. That sounds like an additional 50-basis-point cut at the meeting coming up next week, or, if not, a good chance of another intermeeting move in February.

I’m appalled, frankly. If the Fed is trying to inflate its way out of the credit crunch, the yield curve should be WAY steeper than it is now … let’s say inflation becomes a large-but-not-disastrous 3% … and we want 2% real-yield on 10-years (at least! 2% is skimpy) … my calculator must be broken, I get an answer that’s nowhere near 3.5%. Where are the bond vigilantes when you need them?

Somebody, somewhere, is saying that US real-estate is a major deflationary force. Let’s hope they’re right … but until I see some convincing analysis, I’m gonna agree with Bear Stearns, quoted above.

Those who have read my most recently publicized article When Will Preferreds Recover will remember that March-November 2007 marked the greatest peak-to-trough decline in the BMOCM-50 Preferred Share Index going back to at least 1993-12-31. Such readers will doubtless be interested to note that, as of today, the calculated NAV for CPD now shows a decline of 1.06% for January to date, vs. a gain of 1.14% in December. In other words, we are now within a whisker of deepening the trough. Have a nice day!

Mind you, though, the PerpetualDiscount index now has a weighted average bid-yield-to-worst of 5.63% … with interest-equivalency of 1.4x, that’s the equivalent of 7.88% interest, compared to the Long Corporate Yield of about 5.75% … so the spread to bonds still looks pretty good! The Bank of Canada has the long Canada benchmark at 4.06% (!!), so spread-to-long-Canadas is a whopping 3.82%, a noticable increase from the high point shown in Chart 4 of my latest masterpiece.

By and large, preferreds ignored the excitement of the wider financial markets and just did their own thing … with a certain amount of weakness! Volume picked up a bit, to the low side of normal

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

Unlike Quebecor, the monoline ACA Capital Holdings (of CIBC and Merrill Lynch fame) was given a little breathing room by its creditors, presumably on the grounds that it doesn’t make much difference. Three comments from the story are of interest:

Most of those guarantees are in the form of derivatives. Unlike insurance, these contracts are required to be valued at market rates.
…
“The monolines are dead, their business model is dead,” said David Roche, head of investment consultancy Independent Strategy in London. “The government is going to have to recapitalize this industry or there will be communities in the U.S. where they can’t even flush their toilets” because they can’t afford the services.
…
New York State Insurance Superintendent Eric Dinallo is examining whether to limit the types of debt that can be guaranteed by bond insurers, department spokesman David Neustadt said last week.

The first item of interest is the explicit recognition of the problem inherent in the originate-and-distribute model … or perhaps we should refer to it as a problem in the originate-and-hold model! When a bank grants a mortgage, funds it with, say, a GIC and keeps everything on their books, mark-to-market problems are minimized. But if it buys that same mortgage as a security, it is exposed to market fluctuations in the value of that mortgage. I’m sure I’ve mentioned this issue before, but can’t find my reference! Perhaps this exposure to price volatility should have been mentioned as a “friction” in the Fed research paper by Ashcraft & Schuermann.

The second note … well, I’m certainly not an expert on the US Municipal market! Sounds to me a little bit like hysteria, though!

And the third not shows what we can expect over the next few years – the dead hand of regulation stifling the securities business, or at least threatening to do so.

Naked Capitalism reprinted an interesting piece by Wolfgang Munchau regarding the nature of the … projected? imminent? current? …US recession, arguing that it will be extended due its nature:

Interest rate cuts work their way through to the real economy by a number of transmission channels. During the 2001 recession in the US, the most important was housing credit. The rate cuts came at a time when the housing market was already booming. They turned the boom into a super-boom. Inflationary expectations were low. People expected interest rates to remain low. It was a great moment to take on extra debt, and this was precisely what Americans did.

The current US downturn could not be more different. House prices are falling, and have further to fall before reaching a more sustainable level (in terms of the price-to-rent ratios as well as several other measures).
…
The corporate credit channel works more slowly. A company faced with an acute downturn in demand for its products is not going to start investing immediately when interest rates fall.
…
With core inflation stubbornly over 2 per cent, the current 10-year yield of 3.8 per cent seems a touch optimistic. So we might be seeing a simultaneous fall in short-term rates and a rise in long-term rates.
…
Cui bono? The banks, of course. The bank-bailout channel will be the only monetary transmission mechanism to function like clockwork. The steeper the yield curve, the greater the profits for banks, which make a living by borrowing at short interest rates and lending at long rates.
…
As time goes on, the financial sector’s health will gradually improve. Eventually, the credit squeeze will be over – and the next irresponsible lending boom can begin.

These are important concepts … particularly for those who are outraged by the banks’ so-called defiance of the Bank of Canada, reported here January 16.

Great excitement in Canadian equities today:

The Standard & Poor’s/TSX Composite Index fell 604.98, or 4.8 percent, to 12,132.14 in Toronto for its worst drop since Feb. 16, 2001. The benchmark has retreated 17 percent from near a record on Oct. 31 to the lowest in 15 months, approaching a “bear market” drop of 20 percent.

Given that Tokyo is now getting hammered, it should be an official bear market at the opening tomorrow.

Oddly enough, the carnage spilled over into preferred shares, with the S&P/TSX  Preferred Share Index down 0.87%. Panic? Confusion? Cool-headed efficiency? You tell me. Volume was on the light side of normal.

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

Bobby Fischer, RIP. 

Naked Capitalism reviews the Credit Default Swaps market with an emphasis on the new two-ton gorilla in the room: counterparty risk. CIBC shareholders learnt all about counterparty risk on December 19; Merrill Lynch shareholders got a reminder more recently:

concerns ratcheted up when Merrill announced that $3.1 billion of its $16.7 writedown was due to the apparent worthlessness of hedges written by an obscure (to those not following credit guarantors) counterparty, ACA Financial Guaranty.

He also highlights the issue of insider trading, mentioned in the CDS Primer:

The Journal also mentions regulatory issues:

This market poses challenges for would-be regulators. It isn’t clear, for instance, how securities laws on fraud and insider trading would apply to credit-default swaps, because it’s not clear in what way they are even securities; they are private contracts.

Of all the regulatory concerns, fraud and insider trading are low on the list.

Mr. Smith does not explain his reporting of the ranking of fraud and insider trading. I will certainly grant that the question of regulatory capital requirements for “normal” transactions should be the number one concern [hint regarding my position: shorting a CDS and buying the notional amount of BAs is roughly the same exposure as an outright investment in the underlying corporate credit, for a term equal to the term of the contract], but fraud and insider trading are always concerns.

And the monolines continue to career down the road to oblivion:

Ambac Financial Group Inc. scrapped a plan to raise equity capital after the bond insurer’s shares plunged 70 percent in the past two days, putting its AAA credit rating in jeopardy.
…
MBIA raised $1 billion last week in the sale of surplus notes and last month entered a deal to sell $1 billion of equity to private-equity firm Warburg Pincus LLC. Both companies slashed their dividends and took out reinsurance on some securities to help shore up capital.

The surplus notes plunged as low as 70 cents on the dollar today, indicating a yield of about 25 percent, traders said. MBIA dropped $1.63, or 18 percent, to $7.59 on the New York Stock Exchange, extending its 56 percent decline this week.

And, as the market closed, Naked Capitalism republished news and commentary on the Fitch downgrade of Ambac.

More speculation in the press about the BCE / Teachers deal:

The Montreal-based company’s shares were down for the fifth consecutive trading day, losing 16 cents to $36.37 Friday.

The shares are down from a peak of $41.80 in July.

Crandall said the share price suggests many investors now believe there’s only a 50/50 chance the company will be sold to a group led by the Ontario Teachers’ Pension Plan. The group offered $42.75 per share in June for BCE and plans to finance the deal with up to $40 billion of debt.
…
Toronto Dominion Bank chief executive Ed Clark this week reinforced his bank’s commitment to provide $3.8 billion to the BCE deal.

“I know everyone stews and worries about it. I would like to tell you that I’m stewing and worrying, but I’m not,” he said at a conference of bank CEOs on Tuesday.
…
But Teachers spokeswoman Deborah Allan said the prospective buyers of Canada’s largest telecommunications won’t be distracted by “the noise that’s in the marketplace.”

“As far as this transaction is concerned, we have an agreement, we’re committed to it and we’re focusing on closing the deal,” she said in an interview.

Now, as PrefBlog’s Assiduous Readers will know, the way to read a press release is to see what it is that they DON’T say. Have a look at Deborah Allan’s remarks (as quoted by the CP reporter, Ross Marowits). Did she actually say anything at all meaningful? We know they have an agreement (it’s on SEDAR), we know they’re committed to it (they signed) and it’s not clear to me what “we’re focusing on closing the deal” means. We know that TD is happy about financing 10% of the price, but … where’s the other 90%?

Given everything that’s happened to the credit markets and to BCE over the past seven months, I suspect that a loss of a mere $1-billion break fee is a pretty cheap exit. But, I say again: what do I know? Either way it’s a speculation on basically zero information; I can have more fun playing blackjack.

As part of its continuing effort to prevent business from being done in Canada, Regulation Services has released Guidance on the Supervision of Algorithmic Trading, with the lovely little paragraph:

If a Participant has provided Dealer-Sponsored Access, commonly known as direct market access, to a client (“DSA Client”), the Participant, as part of its on-going supervision of client orders, must be aware of the origin of the orders entered by the DSA Client, including whether the DSA Client employs the use of algorithmic trading systems. The Participant must ensure the proper testing of any algorithmic trading system used by a DSA Client to enter orders on a marketplace by means of the Dealer-Sponsored Access provided by the Participant.

In other words, it’s not sufficient to take responsibility for your orders. Your process must be questioned, tested, validated and approved by Responsible Authorities. Assiduous Readers will remember that the purpose of rules only very rarely has anything to do with accomplishing anything … the purpose of rules is to give authorities their authority. Hail RS!

It is my understanding that a lot of proprietary traders (day traders who work for dealers) are finding out that their bonuses (and profits of the banks dealers) have not been due so much to their uncanny understanding of the market and brilliant exploitation of subtle shifts in supply and demand as they were to control of the order flow, better access to data and execution than their buy-side competitors and tick-sizes on prices of more than a penny.

Principal revenues earned from proprietary desks and market-making activities also succumbed to the market downturn. Equity trading revenues were off $209 million, a whopping 120 per cent lower than the previous quarter and off 123 per cent against the same period in 2006. For the quarter, equity trading resulted in a net loss of $35 million. This represents the first time since the third quarter of 2002, about the same time the TSX bottomed out from the tech market collapse, that the industry reported a net loss from their principal equity trading business.

Don’t expect much squawking from the street on this one.

After yesterday’s fall, the preferred share market took a little breather today – volume was way down and, overall, losses were minor. All eyes are on equities at this point … the Monday back from a weekend of worrying and second-guessing can often be rather exciting. What effect the US holiday will have on this process is something that I’m afraid even to contemplate!

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

Prof. Hamilton’s use of the unadjusted 10-year Nominal/TIpS spread, mentioned here yesterday, attracted some criticism in the comments to his post. The Cleveland Fed adjusts the raw data for (a) the inflation risk premium, and (b) liquidity premium.

The naive method of pricing real return bonds is:

Nominal Yield = Real Yield + Inflation Expectations (Wrong!)

If this were the actual equation, there would be no incentive for the issuers to issue the bonds; they would just go with nominals. However, the correct equation:

Nominal Yield = Real Yield + Inflation Expectations + Inflation Risk Premium (Right!)

adds a term. A buyer of nominals must not only forecast inflation, but (if he’s prudent) add a little bit extra just in case his expectations are wrong. By issuing real return bonds, the issuer can capture that Inflation Risk Premium for itself.

The liquidity premium doesn’t need a lot of explanation – especially in this environment, where the liquidity premium on some issues – especially US financials – is enormous. When you buy treasuries – or Canadas, to a lesser extent – you can trade a boatload of them without moving the price. Want a quote on 10-years, $50-million a side? The quote will come back at you with a ten cent spread. Why not? The dealer’s ‘phone is always ringing, he can keep turning over his inventory and earning the spread with ease, and he can alter the directional bias of his trades by shading his quote a few pennies one way or the other.

This is – ahem! – not the case with instruments of lesser liquidity. Therefore, you are willing to pay less for instruments of low liquidity (which increases the yield required) to compensate for the risk that you’re going to want to – or have to – sell them prior to maturity anyway and be subject to the tender mercies of the dealers and their book of inventory.

I have added a link to the Cleveland Fed’s calculations at the sidebar. Curious readers will see that the adjusted series is volatile and has been sharply increasing in recent months.

The implosion of the weaker monolines, Ambac and MBIA, continued today.

Michael Woodford of Columbia University wrote an interesting piece on the ideal methodology of central bank communication with investors:

All of the big-3 central banks (the Fed, Bank of Japan and the ECB) have experimented over recent years with more explicit forward guidance through their official communications. Generally it is through the use of “code words,” such as removal of policy accommodation at a “measured pace,” or the exercise of “strong vigilance” toward inflation risks.
…
I suspect that other central banks are becoming more cautious as well about the use of code words that are taken to directly indicate future interest-rate decisions, under the current rapidly changeable conditions in financial markets.

He suggests that the use of fan charts would be preferable. To my chagrin I have been unable to find a linkable example of a fan chart, but the name should be self explanatory. Draw your projection of … whatever … into the future. Draw in confidence limits at, say, 50%, 75% and 95% confidence. Colour them in. Voila! See, for example, Chart#3 in the Norges Bank 2006-03 Inflation Report.

At a 2006 Bank of Canada conference, such fan charts were lauded:

The Reserve Bank of New Zealand is the pioneer not only in inflation targeting but also in introducing and publishing explicit instrument-rate paths that can be interpreted as optimal instrument-rate plans. The bank has done so since 1998 (Archer 2004, 2005; Svensson 2001a). The Reserve Bank has for many years been alone in taking this bold step. However, Norges Bank, an enthusiastic and competent newcomer to the inflation-targeting camp, has recently started to publish explicitly optimal instrument-rate paths with uncertainty bands, together with criteria for optimal inflation and output-gap projections and other innovations in transparent monetary policy (Norges Bank 2005; Qvigstad 2005). This should be an example to other central banks.

There was a bit more speculation about BCE today:

Shares of BCE Inc. Canada’s biggest telecom company, continue to trade well below the offer price in its $34.8-billion buyout as investors remain worried the deal may be repriced, abandoned or face further delays.

The buyer group, which includes the Ontario Teachers’ Pension Plan, Providence Equity Partners, Madison Dearborn Partners and Merrill Lynch Global Private Equity, has offered $42.75 a share to take the company private.

However, its shares were at $36, down $1.01, on the Toronto Stock Exchange on Thursday afternoon, despite repeated assurances from both BCE and Teachers’ that the deal remains on track.

A BCE spokesman said on Thursday the company is still “looking forward to closing the deal” in the second quarter.

A Teachers’ spokeswoman was not immediately available for comment.

My guess is that the Teachers’ spokeswoman was in the Ladies’, throwing up. But what do I know?

Today’s response in the preferred market to the new BNS 5.60% Perpetual certainly makes my “frothy” correspondent of January 7 and January 8 look like a genius! The correspondent now feels that (a) long-term, prefs are a buy; (b) short term, it might be better to wait; and (c) if another issue comes out before the new issue settles, take the day off and buy a bottle of something tasty. 

Volume, rather surprisingly, was good, but by no means heavy. Make of that what you will.

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

Rule #1 states that the world always looks more interesting than it really is, an idea mentioned in a previous post, The Bond Market is Excitable. James Hamilton of Econbrowser took a look at the retail sales numbers that had everybody so excited yesterday and yawned.

I don’t know whether this marks the beginning of a trend or not, but there are two new posts out there complaining about executive pay amidst all the current shock and horror. Accrued Interest focusses on Countrywide CEO Angelo Mozilo, while Naked Capitalism republishes a more general article by Martin Wolf regarding bankers pay in general.

The latter essay espouses the popular ethic that this would be a much better world if only there were more rules. When considering the current devastation:

Up to now the main official effort has been to combine support with regulation: capital ratios, risk-management systems and so forth. I myself argued for higher capital requirements. Yet there are obvious difficulties with all these efforts: it is child’s play for brilliant and motivated insiders to game such regulation for their benefit.

So what are the alternatives? Many market liberals would prefer to leave the financial sector to the rigours of the free market. Alas, the evidence of history is clear: we, the public, are unable to live with the consequences.

An alternative suggestion is “narrow banking” combined with an unregulated (and unprotected) financial system. Narrow banks would invest in government securities, run the payment system and offer safe deposits to the public. The drawback of this ostensibly attractive idea is obvious: what is unregulated is likely to turn out to be dangerous, whereupon governments would be dragged back into the mess.

No, the only way to deal with this challenge is to address the incentives head on and, as Raghuram Rajan, former chief economist of the International Monetary Fund, argued in a brilliant article last week (“Bankers’ pay is deeply flawed”, FT, January 9 2008), the central conflict is between the employees (above all, management) and everybody else. By paying huge bonuses on the basis of short-term performance in a system in which negative bonuses are impossible, banks create gigantic incentives to disguise risk-taking as value-creation.

I certainly agree with the need for a continuous update of regulation – I have argued for increased capital requirements for loan committments (e.g., liquidity guarantees for SIVs) and more recently, for recognition of the credit risk on bank-sponsored Money Market Funds. And while it is indeed “child’s play for brilliant and motivated insiders to game such regulation”, it is also child’s play for a bored routiner at the regulator to update regulation. Remember: bank regulation does not need to be perfect. It only needs to be good enough. To date, I have seen no evidence that it hasn’t been good enough.

However, as I made clear in my comments on Willem Buiter’s Prescription, I am a fan of the “narrow banking” approach – although my idea of “narrow” is a lot wider than Mr. Wolf’s! You want the regulated banking sector to be fairly wide: firstly because, in general, regulation is slow to change and we should, as a society, be putting potentially good ideas to the test quickly; and secondly because the shadow banking system should not encouraged to grow so large that it will seriously endanger the entire economy.

And finally, I take exception to the last sentence quoted: “By paying huge bonuses on the basis of short-term performance in a system in which negative bonuses are impossible, banks create gigantic incentives to disguise risk-taking as value-creation.” No, Mr. Wolf. It is not the banks that are creating these gigantic incentives. It is the banks’ owners who are doing this. And if the owners of Citigroup and CIBC are so enthralled with the idea of paying fortunes of intergenerational size to bozos with no conception of risk control – why not let them?

On a related note, the monoline credit insurance agency Ambac Financial Group:

ousted its chief executive officer, slashed the dividend 67 percent and will raise more than $1 billion to preserve its AAA credit rating after announcing the biggest-ever writedowns by a bond insurer.

And remember those deeply subordinated MBIA notes, that I pointed out were really equities? They should have sold more!

MBIA Inc.’s surplus notes have tumbled as much as 12 percent since they were sold last week on concern that the world’s largest bond insurer may need to tap investors for more money.

The AA rated debt fell as low as 88.5 cents on the dollar today, according to bond traders. That’s the equivalent of a yield of 18 percent, data compiled by Bloomberg show. The notes were trading at 97.5 cents yesterday, according to Bloomberg data.

Perhaps not surprisingly, S&P will be re-evaluating the insurers:

because losses on subprime mortgages will worse than the firm anticipated.

The ratings company will examine whether insurers including MBIA Inc. and Ambac Financial Group Inc. have enough capital to withstand reductions in the ratings of the mortgage-backed securities they guarantee. The credit test will be completed within a week, said Mimi Barker, a spokeswoman in New York.

S&P is now assuming losses on 2006 subprime mortgages will reach 19 percent, up from 14 percent, as housing prices decline further than previously thought.

US headline inflation was in the headlines today:

Overall inflation in 2007 ran at its fastest rate since 1990, although core CPI inflation [excluding food and energy prices] moderated to 2.4% in 2007 from 2.6% in 2006.

By me, these figures indicate that there are no real inflationary problems – yet! – for the US, but there are two wild cards for the coming year: first, any Fed easing will increase the risk that inflation will again rear its ugly head; second, it is not apparent that the decline in the greenback relative to its trading partners has been fully reflected in these figures. It seems to me that there should be some curve steepening in the next while, particularly if central bank easing becomes the order of the day, as monetary policy controls the short end of the curve while inflation expectations rule at the long end.

James Hamilton of Econbrowser points out that:

The Fed bases its actions not on what inflation has been, but rather on what it anticipates for the future.

… and quotes a Bernanke speech that caused market excitement on January 10 when everybody else quoted a different part. Prof. Hamilton draws attention to:

Thus far, inflation expectations appear to have remained reasonably well anchored, and pressures on resource utilization have diminished a bit. However, any tendency of inflation expectations to become unmoored or for the Fed’s inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and reduce the central bank’s policy flexibility to counter shortfalls in growth in the future. Accordingly, in the months ahead we will be closely monitoring the inflation situation, particularly as regards inflation expectations.

Prof. Hamilton looks at two series: the 10-year Treasury yield and its spread against 10-year TIPS to conclude:

As long as those two series stay in their recent territory, the Fed thinks it has the maneuvering room to be aggressive about addressing the dangers of an economic downturn and financial collapse. And that’s why we’ll see at least a 50-basis-point cut in the fed funds target at the next meeting, despite the “highest inflation rate of the last 17 years”.

Further to yesterday’s note about Menzie Chinn’s post about automatic stabilizers, the Congressional Budget Office has release a report outlining the the political options (hat tip: WSJ Economics blog). It is interesting to note:

Automatic fiscal stabilizers also reduce the risk of recession. As the economy slows, slower growth of income, payrolls, profits, and production causes tax receipts to fall relative to spending––and causes outlays on programs such as unemployment compensation and Food Stamps to rise. That combination temporarily boosts demand for goods and services, thereby helping to offset some of the weakness in demand. The Congressional Budget Office (CBO) estimates that, since 1968, automatic stabilizers have added between 1 percent and 2.5 percent of gross domestic product (GDP) to the deficit during recessions, which translates to about $140 billion to $350 billion in today’s economy, and thereby helped mitigate past economic downturns. The automatic stabilizers already built into current law will partially offset any further weakening of the economy.

With the rather exciting headline Big banks consider defying rate cut, Heather Scoffield and Tara Perkins of the Globe noted:

Some of Canada’s big banks are contemplating holding their prime rates steady in the face of a rate cut by the Bank of Canada, a move that could destabilize the country’s monetary policy.

The central bank is expected to cut its key interest rate by a quarter of a percentage point on Jan. 22. But since the global credit crunch has driven up the cost of borrowing for commercial banks, some are questioning whether they should match the central bank’s move, banking sources say.

The comments on this story are, as usual, a hoot. Given that banks are now paying higher rates than non-financial corporations (due to credit concerns) and that RBC’s (for instance) cost of funds is so low:

Deposits include savings deposits with average balances of $46 billion (2006 – $46 billion; 2005 – $46 billion), interest expense of $.4 billion (2006 – $.4 billion; 2005 – $.3 billion) and average rates of .9% (2006 – .8%; 2005 – .6%).

… it is perhaps not as surprising as it might be otherwise that overnight vs. prime will decouple – at least to a limited extent. The credit crunch is affecting the markets in new and exciting ways!  Mind you – I have checked Bank of Canada data for the past ten years and the difference has only fleetingly been different from 175bp … so such a change, if effected, will be a relative novelty. Some may wish to review  BoC Working Paper 2003-9:

Although the magnitude of the impact differs between the models, the CPF and CF models respond similarly to the tighter credit conditions. As expected, the tightening of credit conditions leads banks to reduce lending and increase the loan rate. Firms react by cutting back on external funds to finance intermediate-good inputs, which causes in a fall in production. The central bank allows the deposit rate to also rise as it injects money (i.e., creates an inflation expectation) to offset the negative consequences of credit shocks. The restriction of credit impacts negatively on aggregate supply, as firms cut back on production, leading to a fall in final output. In an attempt to accommodate the deterioration in credit conditions, the monetary authority reacts by injecting more liquidity into the economy. The rise in liquidity plus the negative shift of the aggregate supply curve combine to push up the inflation rate.

The persistence of credit shocks is estimated to be quite high (i.e., rz = 0.7817). The result is that the tighter credit conditions generate persistent movements in all variables. In each case, we find that the variables do not return to their steady-state values even after 10 quarters. The implication of this result is that a worsening of credit conditions can be very persistent and have a lasting impact on economic activity. There could also be a persistent increase in the inflation rate if the monetary authority offsets the credit shock by infusing additional liquidity into the economy.

As the Banks’ researchers noted in 1994:

Banks try to avoid frequent changes in the prime rate, and they fund prime-related loans more often with 1-month or 3-month term deposits than with overnight deposits.

Most readers will be aware that the Bill/BA spread has gone completely nuts over the last six months … is it really all that surprising that the Overnight/Prime spread is at risk?

PerpetualDiscounts managed to return to their winning ways … barely! Volume was steady.

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

Well, stores didn’t sell anything in December (which attracted a lot of comment, so investors thought they’d fill the need. And the equity infusions just kept coming:

Citigroup, the biggest U.S. bank, is getting $14.5 billion from investors including the governments of Singapore and Kuwait, former Chairman Sanford Weill and Saudi Prince Alwaleed bin Talal, the New York-based company said today in a statement. Merrill, the largest brokerage, will receive $6.6 billion from a group led by Tokyo-based Mizuho Financial Group Inc., the Kuwait Investment Authority and the Korean Investment Corp.

Wall Street banks have now raised $59 billion, mostly from investors in the Middle East and Asia, to shore up balance sheets battered by more than $100 billion of writedowns from the declining values of mortgage-related assets. Citigroup was propped up in November by a $7.5 billion investment from the Abu Dhabi Investment Authority. New York-based Merrill was helped by a $5.6 billion cash infusion last month from Singapore’s Temasek Holdings Pte. and U.S. fund manager Davis Selected Advisors LP.

As was reported on January 11, the capital to bail out Countrywide is actually domestic, but Bank of America is by no mean immune to the shift in fortunes:

Bank of America Corp., the second- largest U.S. bank, plans to cut 650 jobs from its corporate and investment bank and sell the prime brokerage unit that caters to hedge funds.

The bank is slashing its so-called structured products business, which packaged and sold real estate loans to investors, and will reduce investment banking in Europe and the U.S., Chief Executive Officer Kenneth Lewis said in a meeting with reporters today in New York.

Meanwhile, Menzie Chinn of Econbrowser attempts to cheer us up by reminding us of the preferred government response to recessions:

One reason to favor temporary modifications to automatic stabilizers, as opposed to permanent changes in the tax code, is that the current full-employment budget balance is probably around negative one percentage point of GDP, and we are facing an expanding deficit in the future, given the press of demographics and medical costs (see Orszag’s speech [pdf]).

The interesting stories in Canada are, of course, Quebecor and BCE. Quebecor is close enough to crisis that I gave it its own post today; Bloomberg has an interesting filler story:

A telephone repairman for Canada’s BCE Inc. barreled through a red light in May when the brakes on his company truck failed. He managed to stop only by shifting into low gear and hauling on the handbrake.

As investors led by a teachers’ retirement fund prepare to purchase BCE for C$52 billion ($51.1 billion), analysts say the cost of avoiding such perils may require selling all or part of its C$3.5 billion-a-year wireless business. Canada’s largest phone company needs to repair an aging fleet of trucks and add a TV service while paying down about C$34 billion in debt.
…
The wireless unit, whose growth is second only to the smaller satellite-TV division, may be the only BCE business that could attract investors, said Lawrence Surtees, an analyst at IDC Canada in Toronto who wrote a book on BCE. “Everything else is either flat or declining,” he said. He didn’t have an estimate for what the unit might fetch.

PerpetualDiscounts finally had a down day today, due largely to three issues of a certain bank that will remain nameless. The last down-day for this index was December 21 (the penultimate day of tax loss selling – and the last full day, since Dec 24 was an early-close); since then, the PerpetualDiscount index increased 4.56% to January 14, with thirteen consecutive trading days of gains. 

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