Category: Market Action

Arthur Levitt brought his travelling anti-Credit Rating Agency roadshow to Toronto yesterday, giving a speech at the 2007 Dialogue with the OSC. The Globe has a video of his remarks; they were reported as the same old same old:

Credit rating agencies have lost the trust of investors following the recent meltdown in commercial paper markets, leading to a “systemic shock” in capital markets, a former chairman of the U.S. Securities and Exchange Commission said yesterday.

Arthur Levitt, who led the SEC between 1993 and 2001, told an Ontario Securities Commission conference yesterday the rating agencies are deeply conflicted because they take money from companies to rate their securities, and also offer them consulting services.

“The agencies have become both coach and referee,” he said. “Indeed, I believe we’re facing the prospect of a systemic shock directly as a result of investors’ loss of confidence in the ratings that they have relied upon for so long to evaluate risk.”

He said regulators must examine the conflicts of interest that “plague” rating agencies. Beyond simply prohibiting them from doing additional consulting work for companies they rate, he said the SEC should be given more authority to regulate agencies.

Well, fine. Levitt believes the agencies have lost the trust of investors. My first question is “Where’s the evidence?” and my second is “So what?”. There are plenty of shops around, well staffed and just aching to sell a subscription to their services to anybody who wants to pony up the cash. Unless, of course, having decided that the agencies screwed up, the regulators want to start awarding and yanking licenses on the basis of track record …

David Wilson, Chair of the OSC, mentioned them briefly in his published remarks:

And, we’re talking with credit rating agencies that do business in Canada.
Global securities regulators are carefully reviewing:
• the use of credit ratings in regulated instruments;
• the conflicts inherent in the rating process for structured products; and
• the transparency of the assets held and leverage embedded in these structured product vehicles.

Wilson’s remarks are reasonable enough (a regulator should certainly have some vague idea of what’s happening in capital markets!), but the fact that they invited Levitt to speak at their showcase event is more than just a little odd. 

It’s worrisome. Same old story. If there’s one thing that drives a regulator crazy, it’s the thought that somebody, somewhere, is not filling out a form. To address this issue, the agencies should hire some staff away from the regulators at, say, $200,000 p.a. + benefits, and get some of that good old revolving door regulation going – just like RS is so proud of.

Perhaps I’m feeling a little grumpy today, but I didn’t really see anything new and interesting in a Financial Times essay on the credit crunch referenced by Naked Capitalism. There was an interesting graphic, though:

Note that the sawtooth pattern for the Euribor rate is due to anticipation of well-telegraphed policy increases.

There’s more on the story about the Florida government money-market funds, which were briefly mentioned on November 14 (with friend Levitt labelling them “disgraceful”). Clients are pulling out their money:

Florida local governments and school districts pulled $8 billion out of a state-run investment pool, or 30 percent of its assets, after learning that the money- market fund contained more than $700 million of defaulted debt.
…
The Florida pool, which was the largest of its kind in the U.S. at $27 billion before the recent spate of withdrawals, has invested $2 billion in SIVs and other subprime-tainted debt, state records show. Connecticut, Maine, Montana and King County, Washington, are among other governments holding similar investments, in smaller quantities.

The Florida pool’s $900 million of defaulted asset-backed commercial paper now amounts to almost 5 percent of its holdings. The paper, which carried top ratings from Standard & Poor’s, Moody’s Investors Service and Fitch Ratings as recently as August, was downgraded after declines in the value of collateral affected by the subprime mortgage slump.

I’ve had a look at the State Board’s 2005-06 Investment Report, an extremely glossy puff-piece with little worthwhile investment reporting, but there is a description of the fund in question.

When local governments in Florida have surplus funds to invest, they often rely on the Local Government Investment Pool (LGIP). As a money market fund, the LGIP invests in short-term, highquality money market instruments issued by financial institutions, non-financial corporations, the U.S. government and federal agencies. In managing the pool, the SBA strives to maximize returns on invested surplus funds to generate revenue that helps local governments
reduce the need to impose additional taxes.

It will be most interesting to see how this pans out!

There was some bad news on the US Housing front brought to us via a National Association of Realtors press release:

Single-family home sales were unchanged from September at the seasonally adjusted annual rate of 4.37 million in October, and are 20.8 percent below 5.52 million-unit level in October 2006.  The median existing single-family home price was $205,700 in October, down 6.3 percent from a year ago.

Existing condominium and co-op sales fell 9.1 percent to a seasonally adjusted annual rate of 600,000 units in October from 660,000 in September, but are 20.2 percent below the 752,000-unit pace in October 2006.  The median existing condo price4 was $223,500 in October, up 4.9 percent from a year ago.

The month/month figures is just noise; it’s the year/year statistics that look worrisome. The Wall Street Journal prepared a graphic of inventory:

I love the handy little arrow they added, to ensure we didn’t look at the chart upside-down or something. They also provided a round-up of commentary.

Prof. Stephen Cecchetti continued his VoxEU series today, which commenced on November 26. He concludes:

So, here’s the problem: discount lending requires discretionary evaluations based on incomplete information during a crisis. Deposit insurance is a set of pre-announced rules. The lesson I take away from this is that if you want to stop bank runs – and I think we all do – rules are better.

This all leads us to thinking more carefully about how to design deposit insurance. Here, we have quite a bit of experience. As is always the case, the details matter and not all schemes are created equal. A successful deposit-insurance system – one that insulates a commercial bank’s retail customers from financial crisis – has a number of essential elements. Prime among them is the ability of supervisors to close preemptively an institution prior to insolvency. This is what, in the United States, is called ‘prompt corrective action,” and it is part of the detailed regulatory and supervisory apparatus that must accompany deposit insurance.

In addition to this, there is a need for quick resolution that leaves depositors unaffected. Furthermore, since deposit insurance is about keeping depositors from withdrawing their balances, there must be a mechanism whereby institutions can be closed in a way that depositors do not notice. At its peak, during the clean-up of the US savings and loan crisis, American authorities were closing depository institutions at a rate in excess of 2 per working day – and they were doing it without any disruption to individuals’ access to their deposit balances.

Returning to my conclusion, I will reiterate that the current episode makes clear that a well-designed rules-based deposit insurance scheme should be the first step in protecting the banking system from future financial crises.

I quite agree with him. The Northern Rock episode – discussed in the context of deposit insurance on October 18, shows that politicians – and, by contagion, government sponsored departments – have squandered the trust placed in them. There have been too many broken promises, too many excuses. Additionally, it is completely unreasonable to expect small retail depositors to monitor the health of their friendly neighborhood bank, particularly at the height of a crisis. Banks should be supported by government sponsored deposit insurance as a social good; in exchange, they must pay insurance premiums based on their risk and submit to regulation of their capital adequacy.

The recent crisis is showing us that there is some cause for concern that this inner fortress of stability may not have been insulated enough from the outer, much less regulated, ring of the general capital markets; but I feel confident that the gnomes of Basel will be reviewing their stress tests over the next few years to account for new ways around the rules. As I mentioned on October 3, guarantees of liquidity and credit, particularly, need to be charged to risk-weighted assets at a higher rate. The default assumption must be that if the bank’s name is on a product – or if the bank is profitting from the product’s existence – then the risk of the product should be consolidated onto the bank’s books.

People invest in these things because of the banks’ reputations. The bank has a good name due largely due to regulation and deposit insurance. When – not if – a product fails, the banks’ reputation is harmed. Therefore, regulation should not pretend that there is no risk to capital from an off balance sheet sponsored product.

VoxEU also published an interesting paper on capital integration within the EU by Sørensen and Kalemli-Ozcan. Essentially, the authors argue that capital markets in the EU are, at least to a certain extent, balkanized, with saving regions refusing to invest in growing regions due to lack of trust.

Our findings suggest that Europe has a long way to go before its capital markets are as integrated as the U.S. market is internally. However, our work also suggests that much of the fragmentation stems from things that the EU cannot directly affect in the short run. Trust and confidence are things that evolve slowly. Policies that reward transparency and punish corruption may help but this is likely to take generations as exemplified by the low level of confidence in East Germany.

Good volume today – and at least some of the completely wierd prices that have become normal lately are starting to rationalize. I just hope there weren’t any Assiduous Readers waiting for the bottom on BNA.PR.C … but on the other hand, I don’t know where it’s going to open tomorrow. One shot wonder, or trend-reversal? Place yer bets, gents, place yer bets…

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

Update: cowboylutrell in the comments points out I screwed up the asset coverage for FTU.PR.A in the ‘Price Changes’ table. It has been corrected. Sorry!

Of most interest today (well … last night!) was the Abu-Dhabi SWF investment in Citigroup. As noted by Naked Capitalism, this deal was done, effectively, at a concession to the current market price, given that the preferreds are protected against a dividend cut on the common, have a dividend yield that is greatly in excess of the common yield, and convert to common at prices not all that much in excess of current prices in a few years’ time. The concession has not escaped notice:

The deal may dilute the value of Citigroup’s stock, reducing 2008 earnings by as much as 20 cents a share, Bank of America analyst John McDonald estimated.

Citigroup shareholders are “ultimately the ones who are paying,” said William Smith, chief executive officer of Smith Asset Management in New York, which oversees $80 million, including about 70,000 Citigroup shares. “If you look at 11 percent, that’s basically junk bond yields, and so it’s great for Abu Dhabi.”

However, the deal will reinforce Citigroup’s capital ratios and that’s what counts. A bad capital ratio could mean no profits to be diluted! Freddie Mac is also selling prefs at concessionary prices:

Freddie Mac, the second-biggest source of money for U.S. home loans, plans to sell $6 billion in preferred stock and cut its dividend in half to shore up capital depleted by record mortgage defaults and foreclosures.

The two-part sale will include non-convertible, non- cumulative preferred stock and a “substantially smaller” portion of convertible preferred shares, Freddie Mac said in a statement today.
…
Freddie Mac sold $500 million of preferred shares in September with a fixed dividend rate of 6.55 percent. The shares, issued at $25 each, were trading at about $20 today.

Those who are familiar with the rules for Tier 1 bank capital will be most amused by the following bizarre attempt to create a controversy (hat tip: Financial Webring Forum):

When either Freddie or Fannie attempt to build capital, they are handicapped by a peculiarity that very few investors know about: They cannot sell the most popular kind of preferred stock, the “cumulative” variety, because their regulator will not let these securities count toward capital.

What “cumulative” signifies in this context is that if dividends are missed, they pile up to be paid on some brighter day, if that arrives. To the extent that Freddie and Fannie issue preferred shares, therefore, they are forced into selling the “non-cumulative” variety. That means if a dividend is missed, say, in the first quarter of 2008, the owners of the preferred will never get that dividend. It’s just gone, zip!

Naturally, prudent investors are not wild about owning non-cumulative preferred shares, which is why there are not many of these securities around. What smart investor unnecessarily wants to put himself in the position – no matter how remote – of missing a dividend and never thereafter being able to capture it?

Note that Quantum Online lists 144 non-cumulative US issues. Cumulative issues are very nice to have, but they don’t count as Tier 1 Capital for banks. OFHEO is to be applauded for disallowing the inclusion of such issues in capital.

These deals, I think, may be classed in the same category as GWO’s sale of its US healthcare business, in that what is going on – once all the frippery is tossed aside, is a conversion of debt into equity. Lord knows what Abu-Dhabi has had its money invested in until now – I mentioned the transparency issue briefly on September 24 – but there is no reason why it can’t have been a savings account at Citigroup, which is now, as far as they’re concerned, moving up the ladder to become equity; with no effect on Citigroup’s cash, but salutary effects on their ratios.

GWO  is using the proceeds of their sale to repay the bridge debt on their purchase of Putnam, instead of selling term debt to finance this. Even if the buyer, Cigna, finances through debt it will be term debt from a strategic buyer.

There is another very similar – in its essentials – situation occuring in the SIV area. MBIA and its problems in finding financing for its conduit, Hudson-Thames was mentioned here on October 25. Now we learn that:

MBIA Inc., the largest bond insurer, is winding down its structured investment vehicle after failing to find buyers for the SIV’s short-term debt since August, Chief Financial Officer Chuck Chaplin said.

MBIA has shrunk its Hudson Thames Capital SIV to about $400 million from $2 billion through asset sales to bondholders, Chaplin said. The Armonk, New York-based company has taken an “impairment” on its own $15.8 million equity stake, Chaplin told a conference hosted by Bank of America Corp. in New York today.
…
MBIA asked holders of the lowest ranking bonds of Hudson Thames, known as capital notes, to buy a share of the SIV’s bank bonds, asset-backed securities and other holdings in proportion to the amount of debt they own.

The so-called “vertical slice” deals enable SIVs to raise cash while bondholders avoid the risk of their investment being wiped out in a fire sale, Fitch said in a report this month.

And this is how the credit crunch will be resolved. Equity holders will take their lumps; debt holders will move up the risk-return ladder at concessionary prices; and the indigestible debt will slowly, but as inexorably as the ticking of a clock, be run off the books.

I think.

There is shock and horror all over the place with the release of the Case-Shiller US Housing Price Index for September:

“The declines in the national figure are notable for two reasons,” says Robert J. Shiller, Chief Economist at MacroMarkets LLC. “First, the 3rd quarter decline, at 1.7%, was the largest quarterly decline in the index’s 21-year history. And, second, the year-over-year decline posted its second consecutive record low at -4.5%. Consistent with prior 2007 reports, there is no real positive news in today’s data. Most of the metro areas continue to show declining or decelerating returns on both an annual and monthly basis. All 20 metro areas were in decline in September over August. Even the five metro areas that still have positive annual growth rates — Atlanta, Charlotte, Dallas, Portland and Seattle — show continued deceleration in returns.”

Appallingly, the annualized internal rate of return for the indices since their base-date of January 2000 is a mere 9.15%. There’s a great post at the Irvine Housing Blog (hat tip: WSJ) about the loan history of a Very Nice House:

The property was purchased in January 2005 for $1,157,000. The combined first and second mortgages totalled $1,156,730 leaving a downpayment of $270. Let’s just call it 100% financing.

By April, they owners were able to find refinancing through Countrywide with a $999,999 first mortgage. This mortgage was an Option ARM with a 1% teaser rate. The minimum payment would be $3,216 per month.

Also in April of 2005, they took out a simultaneous second mortgage for $215,000 pulling out their first $58,000.

So look at their situation: They are living in a million dollar plus home in Turtle Ridge making payments less than those renting, and they “made” $58,000 in their first 4 months of ownership.

Apparently, these owners liked how hard their house was working for them, so they opened a revolving line of credit (HELOC) in August 2005 for $293,000. Did they spend it all? I can’t be sure, but the following certainly suggests they did.

In December of 2005, they extended their HELOC to $397,990.

In June of 2006, they extended their HELOC to $485,000.

In April of 2007, the well ran dry as they did their final HELOC of $491,000. I bet they were pissed when they couldn’t get more money.

So by April 2007, they have a first mortgage (Option ARM with a 1% teaser rate) for $999,999, and a HELOC for $491,000. These owners pulled $333,000 in HELOC money to fuel consumer spending.

Assuming they spent the entire HELOC (does anyone think they didn’t?), and assuming the negative amortization on the first mortgage has increased the loan balance, the total debt on the property exceeds $1,500,000. The asking price of $1,249,000 does not look like a rollback, but if the property actually sells at this price, the lender on the HELOC (Washington Mutual) will lose over $300,000.

Speculation about the forthcoming Fed meeting is ramping up, with Goldman calling for 150bp easing by the second quarter, but … what are the implications for inflation?

So far, inflation expectations have remained stable. Yet I consider those expectations more fragile now than I did four to six months ago. The rise in oil prices and the simultaneous increases in a broader basket of commodity prices suggest that significant inflationary pressures exist in the economy and thus the Fed must be very vigilant. If inflationary expectations rise, it could prove very costly to put the genie back in the bottle.

Very good volume in the pref market today, but performance continued to be (i) Weird and (ii) Poor. Splitshares bounced back (despite their expulsion from the S&P/TSX index), but that was more of a dead cat kind of thing than anything else – although it is rather pleasant to say that WFS.PR.A closed at 9.70-79, 121x10.

The PerpetualDiscount index broke below the 900-mark, setting yet another new low. But with all this volume, things must rationalize soon … mustn’t they?

 

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

The big news today was Quebecor World’s suspension of preferred dividends; but that has its own post.

There was a fair bit of news on the MLEC/Super-conduit front. HSBC is bailing out its SIVs, taking $35-45-billion onto its balance sheet to avoid a fire-sale of the assets. It has been reported:

The SuperSIV is “is all good and well, but it’s not big enough,” said Tom Jenkins, a credit analyst at Royal Bank of Scotland Group Plc in London. “If you have a large SIV, you’re going to need to find another solution.”
…
Cullinan’s net asset value, the amount left over after selling all its assets and repaying debt, fell to 69 percent of its capital, Moody’s Investors Service said Nov. 7. Asscher’s net asset value has declined to 71 percent, Moody’s said.
…
HSBC plans to make a formal offer to investors in the SIVs’ lower-ranking mezzanine and income notes later this year or early 2008. It expects to complete the restructuring by August 2008.
…
“HSBC believes there is not likely to be a near-term resolution of the funding problems faced by the SIV sector,” the bank said.

It will be most interesting to see what kind of bid the capital noteholders will see – I bet HSBC sticks it to them!

Meanwhile, there is a report that marketting of the Super-Conduit is about to commence in earnest … but one can detect a certain jeering tone in the commentary:

“Why should we put something on our balance sheet that is going to result in further writedowns?” is how most contributors will respond, [Punk Ziegel & Co. analyst Richard] Bove said in an interview. “The job of the Treasury isn’t to go out and defraud investors.”
…
Bank of America “has far more to gain down the road” with regulators by backing SuperSIV, said Tony Plath, a financial professor at the University of North Carolina at Charlotte, who expects the plan to fail. “They are setting themselves up so they aren’t criticized when this thing falls apart.”
…
The fund’s lack of disclosure makes it “a necessary failure,” Bill Gross, manager of the world’s biggest bond fund at Newport Beach, California-based Pacific Investment Management Co., said in an Oct. 31 interview. “Transparency is what the Treasury and Fed are supposedly all about.”
…
Loomis Sayles & Co. declined to invest after receiving one of 16 invitations for a personal meeting last week with current Fed Chairman Ben Bernanke, said Daniel Fuss, who oversees $22 billion as chief investment officer at the Boston-based firm. The Securities Industries Financial Markets Association trade group extended the invitations, Fuss said.

“It’s so nice to get a personal invitation to go to Washington and have a one-hour visit with Ben Bernanke,” said Fuss, who decided participating wasn’t worth the risk to his firm. “Oh, boy, did I feel important for about 27 seconds, and then you smell a rat.”

Well … we shall see! But it is certain that a certain amount of forceful statements need to be made by the sponsors if there is to be any funding extended … but, on the other hand, if the idea is to stick it to the SIVs that are in trouble, how much sales will be needed? Given a choice between defaulting on their senior debt and getting a fistful of Super-Conduit term senior FRNs and capital notes, sponsors of troubled SIVs will find themselves between a rock and hard place. Naked Capitalism notes that Larry Summers writes in the Financial Times:

The priority now has to be maintaining the flow of credit. The current main policy thrust – the so-called “super conduit”, in which banks co-operate to take on the assets of troubled investment vehicles – has never been publicly explained in any detail by the US Treasury. On the information available, the “super conduit” has worrying similarities with Japanese banking practices of the 1990s that aroused criticism from American authorities for their lack of transparency, suppression of genuine market pricing of bad credits, and inhibiting effect on new lending. Perhaps there is a strong case for it, but that case has yet to be made.

Mr. Summers predicts a recession, but many disagree with him … for now:

Even bulls say that the biggest rally in government debt since 2002 has pushed yields on 10-year notes so low that they can only decline if the economy shrinks. None of the 68 economists surveyed by Bloomberg News from Nov. 1 to Nov. 8 expect the economy to contract before the end of 2008.

Prof. Stephen Cecchetti of Brandeis has been quoted here on August 27 (blaming rating agencies) and November 19 (wanting as much trading as possible on regulated exchanges) and has now commenced a four part series for VoxEU. In Part 1 he notes that:

Financial institutions have been allowed to reduce the capital that they hold by shifting assets to various legal entities that they did not own – what we now know refer to as “conduits” and “special investment vehicles” (SIV). (Every financial crisis seems to come with a new vocabulary.) Instead of owning the assets, which would have attracted a capital charge, the banks issued various guarantees to the SIVs; guarantees that did not require the banks to hold capital.

but does not suggest a solution, noting that:

under any system of rules, clever (and very highly paid) bankers will always develop strategies for holding the risks that they wanted as cheaply as they can, thereby minimizing their capital.

I have suggested that the 10% charge for a liquidity guarantee should (almost certainly) be increased; to avoid the next evasion, regulators should deem these guarantees to be in place if the bank is merely sponsoring the SIV without a guarantee; or if it has an economic interest in the survival of the SIV. Or maybe X% for an arm’s-length guarantee, double that if the bank has an economic interest.

Yes, it’s a bit like trying to plug a seive (hah!). But you do what you can.

He admits that another problem defies solution in this wicked world:

Think about the manager of a pension fund who is looking for a place to put some cash. Rules, both governmental and institutional, restrict the choices to high-rated fixed-income securities. The manager finds some AAA-rated bond that has a slightly higher yield than the rest. Because of differences in liquidity risk, for example, one bond might have a yield that is 20 or 30 basis points (0.30 or 0.30 percentage points) higher. Looking at this higher-yielding option, the pension-fund manager notices that there is a very slightly higher probability of a loss. But, on closer examination, he sees that this higher-yielding bond will only start experiencing difficulties if there is a system-wide catastrophe. Knowing that in the event of crisis, he will have bigger problems that just this one bond, the manager buys it; thereby beating the benchmark against which his performance is measured.I submit that there is no way to stop this. Managers of financial institutions will always search for the boundaries defined by the regulatory apparatus, and they will find them.

I don’t have much of a solution either! Enforcement of the Prudent Man Rule can only go so far … and if some paper defaults, it’s very difficult to show that the chance of this happening was underestimated at time of purchase. But … Prudent Man Rule will help, anyway!

Remember the Federal Home Loan Banks (FHLBs) mentioned here on October 30? It seems that FHLB Atlanta has credit policies that would be considered somewhat unusual in the private sector:

Countrywide Financial Corp. fell more than 10 percent in New York Stock Exchange trading after U.S. Senator Charles Schumer urged the regulator of the Federal Home Loan Bank system to probe cash advances to the largest U.S. mortgage lender.

Schumer said he was alarmed by the volume of advances the system’s Atlanta bank has made to Countrywide considering “the rapid deterioration” in the credit quality of some of the Calabasas, California-based company’s mortgages. Schumer expressed his concerns in a letter sent today to Federal Housing Finance Board Chairman Ronald Rosenfeld.

The Atlanta bank has made $51.1 billion in advances to Countrywide as of Sept. 30, representing 37 percent of the bank’s total outstanding advances, Schumer wrote, citing U.S. Securities and Exchange Commission filings.

In more cheerful news, Naked Capitalism reports on a hedge fund that’s hit a ten-bagger betting against sub-prime and Ed Yardeni, of Millennium Bug fame, offers up nine reasons to be thankful:

(1) The S&P 500 is up 53% since Thanksgiving 2002. The current bull market has been the third best since 1960.
(2) The 10-year Treasury yield was near 5.5% in early 2002. It is down to 4.0% this morning.
(3) The core CPI inflation rate in the US has been remarkably steady around 2%, and down from 2.6% to 1.8% on average among the 30 members of the OECD, despite the soaring price of crude oil, which is up from $27 a barrel to $99 a barrel since Thanksgiving 2002, based on West Texas Intermediate price.
(4) Notwithstanding all the nonsense about outsourcing, the unemployment rate was down to 4.7% in October vs. 5.7% five years ago as payroll employment rose 8.1 million to a record high of 138.4 million.
(5) Real disposable personal income was at a record high in September, up 16.0% since September 2002. Real per capita income is also at a record high and up 2.1% per year, on average, over the past five years.
(6) Real GDP is up 15.3% over the past five years.
(7) In the US, since the end of 2002, household net worth is up nearly 50% to a record $57.9 trillion.
(8) World exports have doubled since November 2002. The OECD world industrial production index is up 30% since then. Today, roughly three billion people around the world are aspiring and perspiring to improve their standards of living.
(9) Alan Greenspan’s book tour is over.

The New York Fed made headlines, pumping $8-billion into the term-repo market, stating:

In response to heightened pressures in money markets for funding through the year-end, the Federal Reserve Bank of New York’s Open Market Trading Desk plans to conduct a series of term repurchase agreements that will extend into the new year.

The first such operation will be arranged and settle on Wednesday, November 28, and mature on January 10, 2008, for an amount of about $8 billion. The timing and amounts of subsequent term operations spanning the year-end will be influenced by market and reserve developments.

In addition, the Desk plans to provide sufficient reserves to resist upward pressures on the federal funds rate above the FOMC’s target rate around year-end.

The Bloomberg story seems a bit peculiar – they claim that:

Fed officials acted after the average U.S. overnight lending rate between banks exceeded their target seven of the past eight days, suggesting a reluctance to lend amid mounting subprime mortgage losses. In most years, banks face year-end pressures as they adjust their books to show ample liquidity and at the same time meet a jump in demand for cash from consumers.

While there may well be pressures, Fed Funds Data show that, in terms of averages, we’re only talking about a basis point or so. However, the maintenance period ended November 21 was clearly tighter than the period ended November 4 – and we don’t know what they had to do to keep the actual rate so well aligned with target. They may well have been influenced by the fearsome size of the TED spread:

The cost of borrowing dollars for three months rose as banks hoarded cash to cover their commitments through the end of the year. The London interbank offered rate, or Libor, for dollars rose 1 basis point to 5.05 percent, for a four-week high and the ninth straight day of gains, the British Bankers’ Association said today.

That pushed the “TED” spread, or the difference between three-month Treasury bill yields and Libor, to 1.92 percentage points from 1.82 percentage points on Nov. 23. The yield on the three-month bill fell 9 basis points to 3.12 percent.

Preferreds saw heavy volume today and violent random (as far as I can tell!) price movements based on the latest headlines. PerpetualDiscounts hit a new post-2006-6-30 low, as did SplitShares, the latter now having provided negative return since the start of these temporary indices.

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

Today’s phrase is “Minsky Moment” and today’s question is “Have we arrived at one?”.

Prof. Charles W. Calomiris of Columbia explains a “Minsky Moment” with:

The late Hyman Minsky developed theories of financial crises as macroeconomic events. The economic logic he focused on starts with unrealistically high asset prices and buildups of leverage based on momentum effects, myopic expectations and widespread overleveraging of consumers and firms. When asset prices collapse, the negative wealth effect on aggregate demand is amplified by a “financial accelerator”; that is, collapsing credit feeds and feeds on falling aggregate demand credit. A severe economic decline is the outcome. Many bloggers refer to this as a “Minsky moment” (see Minsky 1975 for the real thing.)

… in other words, a self-feeding collapse of the economy.

In an paper posted at VoxEU which summarizes his Not (yet) a Minsky Moment paper published by the American Enterprise Institute, he says (as one may surmise by the title) that we’re not there yet and provides eight reasons. Naked Capitalism takes violent exception to this view … so, let’s have a look at the reasons.

Calomiris: Housing prices may not be falling by as much as some economists say they are.

Smith: Real estate industry participants who have an incentive to say things are fine are instead saying they are terrible.

This is simply the old story: forecasts vs. experience. Neither player is particularly convincing.

Calomiris:Although the inventory of homes for sale has risen, housing construction activity has fallen substantially.

Smith: Per these charts, overhang is much worse than in 1988-1989, and rental vacancies are considerably higher as well. So you can’t take too much comfort from the fall off in housing starts.

I’ll award that point to Smith. Calomiris (both in the summary and the full paper) simply states that the trend in housing starts is in the proper direction; he performs no analysis of how long it will take to work of the excess inventory he acknowledges exists.

However, I would like to see more work done to relate the overhang to affordability. The latest NAHB Housing Affordability Index (MS-Excel File) shows a nationwide value of 43.1%. According to the NAHB:

“The latest HOI indicates that 43.1 percent of new and existing homes that were sold in the United States during this year’s second quarter were affordable to families earning the national median income,” said NAHB President Brian Catalde, a home builder from El Segundo, Calif.

… which is good enough, but I’m looking for something more like RBC’s Affordability Analysis, which indicates the percentage of household income taken up by ownership costs. Even this isn’t really good enough because what we are really interested in is the potential take-up of housing by those who don’t currently own houses. There must be somebody, somewhere, who’s devoted his life to the analysis of the work-out of housing inventory overhangs! Let’s find out who he is and talk to him … but I bet he’s a pretty popular guy at the moment.

Calomiris: The shock to the availability of credit has been concentrated primarily in securitisations rather than in credit markets defined more broadly (for example, in asset-backed commercial paper but not generally in the commercial paper market).

Smith Securitization has been taking market share from traditional credit intermediation (bank lending) for the last 30 years. Corporate lending, commercial and residential real estate loans, auto and credit card receivables and LBO loans are all securitized to a considerble degree. Residential real estate now depends on securitization; if there is no rebound in securitization, we will see a heap of trouble. That’s why policymakers are so keen to revive it.

Point to Calomiris. He is arguing that there is still credit around – albeit at a higher price – and (with the exception of Northern Rock) there are plenty of buyers around for commercial paper, provided the seller is willing to discount the price. Smith does not address the point raised.

Calomiris: Aggregate financial market indicators improved substantially in September and subsequently.

Smith: Events subsequent to the writing of his paper prove make this view inaccurate. The S&P 500 is on the verge of giving up its gains for the year. Bloomberg today reports that Treasuries are enjoying their longest rally in 5 years as investors seek safety.

Point to Calomiris. The fact that the S&P 500 “is on the verge of giving up its gains for the year” isn’t the most terrible thing that could happen, and hardly supports the idea that we have entered a self-feeding collapse. The point about Treasuries is stronger, but while spreads have widened, yields on mid-term bank & finance paper have more or less stayed the same.

Calomiris: nonfinancial firms are highly liquid and not overleveraged. Thus, many firms have the capacity to invest using their own resources, even if bank credit supply were to contract.

Smith: I’m not sure what his sample is. Average ratings of corporate issuers have declined, with nearly half the bonds now junk rated.

Point to Calomiris. He disclosed his sample, Federal Reserve Statistical Release Z.1, Table B.102, and Smith’s other points are irrelevant. They may be a cause for concern about the stability of the financial system, but they do not indicate that we are now in the midst of a collapse.

Calomiris: households’ wealth is at an all-time high and continues to grow. So long as employment remains strong, consumption may continue to grow despite housing sector problems.

Smith:  It won’t be for very long if housing continues on the trajectory that most anticipate, and will decline even more if the stock market follows.

Easy point to Calomiris (I should even consider giving him a bonus point). Smith is mistaking the existence of gloomy forecasts for evidence of horrible current conditions.

Calomiris: Of central importance is the healthy condition of banks.

Smith: Many are believed to be otherwise. Financial stocks hare dropped sharply this year, and large banks are now paying as much as 6% in dividends when Treasuries yield a mere 4%.

Point to Calomiris. Market prices – Smith’s idol – are down, but Tier 1 capital ratios are not showing evidence of disaster. Tough times are not a disaster. Citigroup is getting hammered – the stock is down 40% over the past year – but what’s really going on?

Deutsche Bank AG analyst Michael Mayo wrote in a report yesterday that Citigroup shares may fall to $29. He reiterated his “sell” rating and said the company may be prevented by regulators from making acquisitions because “recent risk management mishaps seem to violate” terms of an earlier agreement.

“It looks to us that recent problems with CDOs and their lack of disclosure reflect a serious risk management breakdown,” Mayo said. At $29, Citigroup would trade at eight times estimated earnings for 2008, he said.

‘Sell the stock!’ cries Mayo, ‘The earnings yield’s less than 12%!’ There may be no growth, and there may be more risks than were previously deemed to be the case, but Citigroup is still making lots of money. Dividends won’t grow much over the next few years as they rebuild their balance sheet … but this is not the end of the world. It’s a pause.

Calomiris: Banks hold much more diversified portfolios today than they used to. They are less exposed to real estate risk than in the 1980s, and much less exposed to local real estate risk, although US banks’ exposure to residential real estate has been rising since 2000

Smith: Not directly addressed.

Full point by default to Calomiris.

So I score the match 6-1 to Calomiris, with one point considered lost by both. And what’s more, I agree with him – which may, of course, have influenced my scoring. Times are tough. There’s a big indigestible mass of dubious debt on the books all over the place, but – as far as I can see – the financial system is not melting down and we are not in a depression. I’ll simply repeat what I’ve been saying for the past several months: Times are tough. Firms that have been living on the edge may find they fall off. There may even be a spectacular blow-up or two, if a financial institution finds out its risk controls aren’t what they might have wished them to be. And I most certainly would not want to be earning my living as a casual labourer in the US housing industry. But it’s a pause, nothing more.

There has been some news of interest to the carrion feeders: remember CPDOs? One of them is liquidating after a mark-to-market breached the terms of the deal. That’s the trouble with these things – it’s a great strategy, as long as there aren’t any margin calls or mark-to-markets. Moody’s assigned them a Aaa long term rating on July 6, 2007, put them under review for possible downgrade on August 21, and now they’ve defaulted. I hope UBS took its management fee in advance!

Highly leveraged muck – but, of course, when they work, they really work well. The problem with the market is, as always, stockbrokers: they’ll buy anything so long as somebody with a deep voice tells them it’s good. I cannot begin to tell you how much stuff I’ve been offered over the years that (so the salesmen say) may certainly be placed in a fixed income portfolio, but has a payoff based on something that won’t behave like a bond in the slightest. Somehow it sells. 

It’s a lot like buying an GIC from a bank with the return linked to the stock market and pretending to yourself that, because it’s a GIC, it’s really a fixed income instrument. It may be good, it may be bad – but it sure as hell ain’t a bond!

And another CDO is liquidating as the senior note-holders have decided they want their money back. I’ve had a look at the prospectus … I would like to say I can’t understand why anybody would invest in such a thing, but unfortunately, I know only too well. You can offer nice interest if you lever up to hell and gone.

The saga of Canadian ABCP continues, with Alberta Treasury Branches disclosing their write-down. They have assets of $22.5-billion, of which $1.2-billion is in ABCP and they’re taking a hit of 6.6%.

“ATB Financial has year-to-date earnings of $73 million despite absorbing a $79.6-million ABCP provision,” CEO Dave Mowat said in a release.

In more cheery news, there is a school of thought that predicts a takeover of E-Trade:

Ameritrade has an advantage as a potential buyer because it’s 40 percent owned by Toronto-Dominion Bank, Canada’s third- largest bank, Repetto said. “The bank has deep pockets and it has the ability to deal with some of the issues at E*Trade,” he said.

Exactly the kind of thing the bank should be doing … as long as they’re willing to walk away without a deal after starting negotiations.

Bond insurers, which I have discussed yesterday, took heart from the recent French bail-out and were up a lot on the day.

Still, on the lighter side, remember Flaherty and his Big Plans to Help Canadian Consumers? He was told about one of the problems at the time:

Diane Brisebois, of the Retail Council of Canada, said Flaherty should help retailers by cutting duties collected at the border.

“If you bring in sneakers from China, for example, retailers in Canada pay 18 per cent taxes. Retailers in the U.S. pay absolutely nothing,” she said.

So I thought of him today when I read this amusing snippet:

So how did the Buffalo-area mall prepare for the post-Thanksgiving shopping madness?

For one thing, Goodwill collection bins were situated at three entrances for all the clothes and shoes the crowds from the north have been ditching in restrooms and parking lots. Many shoppers have been wearing their new clothes home to avoid paying hefty taxes and duty at the border.

Good volume again in the pref market; Floaters got beat up again. It could be simply a credit thing on BAM; it could be that people are selling other BAM names to buy the perpetuals (and the derivative split share!); it could be that people are just getting out of floaters and picking on BAM to sell for other reasons. Who knows?

I continue to be utterly amazed by the yield on BNA.PR.C, which had yet another rough ride today, down 0.9444% to close at 17.83 bid, yield 8.39% to maturity. 8.39%! Basically, 11.75% interest equivalent!

I confess, I thought for a fleeting moment today that it might be inventory overhang from a barely successful underwriting … but that doesn’t seem to fit the data. They started trading January 10 and hung around at the $25.00 level until early May, when they – quite reasonably – got caught up in the downdraft. Markets were strong in the first part of the year – if the dealers had been left holding the baby, surely they would have, and could have, blown it out the door at $24.00 in, say, March.

The fund has a position in this issue and I’m getting killed on it. But how can it possibly be fairly valued at 160bp over the similar-and-parri-passu BNA.PR.B? On the bright side, looking at the price chart is highly entertaining … I’ve found a new illustration for the word “parabola”.

Such is the life of a preferred share investor …

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

The travails of Fannie & Freddie continued to attract attention, with James Hamilton of Econbrowser reviewing their purpose, capital structure and capital adequacy and concluding:

Perhaps you think we’ll probably muddle through OK, unless the sale of Freddie’s assets would so depress the market as to hinder extensions of new loans to creditworthy borrowers, thereby reducing home sales further, thereby depressing house prices further, thereby inducing more borrowers to default, so that we go from the good equilibrium to the bad equilibrium. But figuring out exactly where we stand currently on that slippery slope between A and B is not an easy matter.

Here’s my bottom line: if Freddie cuts its dividend, that’s a good thing. All the rest is worrisome.

The disagreement at issue is expressed by Felix Salmon:

According to the WSJ, Freddie Mac has serious capital-adequacy problems, and they’re basically the fault of the Office of Federal Housing Enterprise Oversight
…
because OFHEO is being strict with Freddie, it’s being forced to sell tens of billions of dollars’ worth of mortgages.
…
Instead, they’re dumping mortgages onto the secondary market in order to comply with OFHEO’s capital-adequacy requirements. There’s a time and a place for those kind of requirements, and it is emphatically not now.

My position remains that the GSEs walk like banks, talk like bank, make profits like banks and should be regulated like banks – as James Hamilton implied at Jackson Hole. I have been unable to determine what the Tier 1 and Total Capital ratios of the GSEs would be were this to be put into effect, but OFHEO head James B. Lockhart’s March speech to America’s Community Bankers is telling:

Presently, Fannie Mae and Freddie Mac have low regulatory minimum capital requirements compared with other financial institutions. The 1992 Act that created OFHEO requires them to maintain stockholder’s equity equal to 2.5 percent of assets. The FHLBanks hold 4 percent, albeit with a much different capital structure, and major banks hold over 6 percent. Given Fannie Mae’s and Freddie Mac’s present condition, I am certainly more comfortable with today’s extra 30 percent add-on for operational risk.

OFHEO’s risk-based capital test is also prescribed by that 15-year-old statute and needs to be modernized. Risk-based capital should be based on the full array of Enterprise risks — market, credit, and operational risk, as well as the risks they present to the overall financial markets. A new, stronger regulator needs the flexibility and authority to change both the risk-based and minimum capital requirements through a regulatory process supplemented by the ability to respond quickly to changing conditions.

So … my bottom line is that the GSEs are grossly undercapitalized. If they want to grow, let them issue more equity. If it is deemed to be a social good that they grow, enough of a social good that the US Government is explicitly willing to bear some losses if things get really bad (right now the guarantee is only implicit) then fine! Make that decision! Have the US Government buy and pay for a big fat whack of common and preferred stock! 

In other news, it looks as if the MLEC / Super-Conduit is getting under way slowly, though not without carping from Naked Capitalism:

am now wondering who, exactly, will purchase the commercial paper that will fund this new entity. While this is anecdotal, I have heard a fair number of people, including financially savvy ones, say they would take money out of a money market fund that invested in this entity. So retail money market funds are somewhere between a hard sell and a non-starter. Enhanced cash management fund would have been the perfect target, but a number have broken the buck recently. Some mangers are contributing cash to the fund to make investors whole; others are letting investors take losses. As a result, that type of fund is operating under a cloud right now. Expect there to be near-term net withdrawals and greater conservatism in investment, which works against the SIV rescue program.

Hey – show me that the assets are fairly valued, show me that I’m senior to a good whack of mezzanine and capital notes, and show me that there’s a solid liquidity guarantee and I’ll invest! To be fair, Naked Capitalism has been dubious from the beginning as to whether my first condition would be met!

Naked Capitalism also provides a round-up of recent news concerning the bond insurance industry. ACA Capital and its woes – and subsequent vulnerability to a deep-pocketted strategic acquirer – was briefly mentioned yesterday. A ratings downgrade of the firm could have significant effects:

ACA Capital Holdings Inc., the bond insurer under scrutiny by Standard & Poor’s, may have its credit rating cut, forcing banks to take on $60 billion of collateralized debt obligations, JPMorgan Chase & Co. analyst Andrew Wessel said.

After all, there has just been a bail-out of a French insurer by those with a deep interest in its continuing health!

Natixis SA’s bond-insurance unit, CIFG Guaranty, will be taken over by the French bank’s controlling shareholders in a $1.5 billion rescue to preserve its top credit rating.

Natixis, France’s fourth-largest bank by market value, rose 16 percent in Paris trading after Groupe Banque Populaire and Groupe Caisse d’Epargne, French mutual banks that jointly control Natixis, said today they will provide the capital and assume full ownership of CIFG. They said the purchase will be completed “as quickly as possible.”

And continuing on the bond insurance theme, Accrued Interest has taken a look at AMBAC and doesn’t like what he sees:

I have completed a deep dive of AMBAC’s insured portfolio. The conclusion: I don’t see how they maintain a AAA rating without raising new capital.
…
So how much in capital would they need to retain their rating? Probably at least $2 billion.
…
Whether they can raise this kind of capital or not is difficult to see. It will be a question of whether a well-capitalized partner sees long-term value in their lucrative municipal insurance franchise in excess of the losses expected in ABS. I don’t doubt that many potential partners would be interested in the municipal business.

We’ll see how it goes … speaking for myself, and without having done any analysis or understanding the culture … I say this is a Canadian banking opportunity. Come on, guys! You’ve got great balance sheets and a strong currency behind you! Put them to work!

The links under “US Fixed Income Data” in the right-hand panel of this blog now includes a link to the US Yield-to-Maturity Convention, continuing my struggle to remind the world that YTM is not annualized-IRR.

It was a thoroughly horrific day for preferred shares, although the nature of the market showed itself by having normal volume even though the US was closed. The Floater total return index fell below its 2006-6-30 value – negative total return for floaters over a 16+ month period – on what appears to be a combination of BAM-bashing and a conviction that Canada Prime is going to zero. Split-shares only just barely managed to hang on to positive 16+ month returns, as bids just evaporated.

P.S.: I almost forgot. The PerpetualDiscount index hit a new post-June-30-2006 low today. JH

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

Update 2007-11-22: HardMaturity price of WFS.PR.A noted in table of price changes has been corrected. Sorry!

Menzie Chinn of Econbrowser wrote a good piece yesterday reviewing the dollar’s decline, noting:

So while there is a tremendous amount of inertia in a currency’s reserve role, what we might be seeing now is the interaction of cyclical factors (low U.S. interest rates and dollar depreciation) and structural factors (the strains on dollar pegs and consequent erosion of demand for dollar assets) which could lead to a substantial drop in the dollar’s value.

It’s always the way. Any kind of accident – whether in the financial markets or in everyday life – generally results from a confluence of factors … the one percent chance that you don’t look when crossing the street will sometime coincide with somebody else’s one percent chance of not checking carefully when making a turn. The comments to the post are quite good, but I confess I’m not looking forward to the next year … an economics discussion on the Internet about the US during an election year? The mind boggles.

In a related essay, Richard Baldwin writes an excellent review of a paper by Martin Feldstein that provides an intellectual framework for thinking about currency values:

Feldstein makes a bold simplification that helps him to think clearly about the messy world. He takes US savings and investment as primitives and views the value of the dollar as the variable that adjusts to make things fit. As he writes it: “This line of reasoning leads us to the low level of the U.S. saving rate as the primary cause of the high level of the dollar.”
…
If the US saving rate rises without a dollar drop, there is no narrowing of the trade gap to offset the closing saving/investment gap. Aggregate demand falls and we get a US recession or at least growth deceleration. More to the point facing us today, Feldstein notes that since a falling dollar stimulates net exports only with a lag, avoiding a slowdown in US aggregate demand growth would have required the dollar to fall before the saving rate rises, maybe a couple of quarters earlier. Or, as he puts it: “the domestic weakness will occur unless the dollar decline precedes the rise in saving.”

There was another insight into A Day in the Life of a Bond Guy on Accrued Interest; a discussion of an investment in Washington Mutual that the author is not prepared to support any more. After all the analysis, all the securities filings, all the worry … it all comes down to trust. In the comments section, AI floats the possibility of a takeover of WM … now that’s something that looks interesting. Every morning I rush to the newspaper, looking for the news that I am convinced will come in the near future: Major Canadian Bank Makes Massive Purchase in States.

The Canadian banks have balance sheets that are very strong by world standards – never mind just by comparison to US banks – AND we’re sitting on a hot currency AND the US financial sector is getting beat up beyond the bounds of rationality. If there was ever time to do something like this, it’s now. It doesn’t have to be another bank, or a big-name company like WaMu … it could be something like ACA Capital Holdings, which is not having a very nice time.

In more news of interest, yet another “enhanced yield” product was found to be in danger of breaking the buck and is getting a cash transfusion from Federated Investors. Note that Bear Stearns Cos.’ Enhanced Income Fund and General Electric Co.’s GEAM Trust Enhanced Cash Trust both broke the buck without support from their sponsors.

Readers will remember the concept of covered bonds and some will be aware that BMO is planning an issue. However, in addition to deterorating market conditions …

Abbey National Plc, the U.K. home lender owned by Banco Santander SA, became the third financial company to cancel an offering of covered bonds within a week today as investors demanded banks pay the highest interest premiums to sell bonds in the 12 years since Merrill Lynch & Co. began collecting the data.

“We are in a deteriorating situation,” Patrick Amat, chairman of the Brussels-based ECBC, said in a telephone interview. “A single sale can be like a hot potato. If repeated, this can lead to an unacceptable spread widening and you end up with an absurd situation.”

… there is now a recommendation from the trade association that:

“In light of the current market situation and in order to avoid undue over-acceleration in the widening of spreads, the 8-to-8 Market-Makers & Issuers Committee recommends that inter-bank marketmaking be suspended, temporarily, until Monday the 26th of November 2007. As this recommendation relates only to inter-bank trading, market-maker obligations to investors will remain unaffected.”

Fascinating. I have been advised that this recommendation only applies to extant market making agreements that commit the banks to calling a market in good size and is not a flat (unenforceable) prohibition of trades between two banks that want to trade. The Covered Bond Fact Book states:

Market Makers’ commitments define bid/offer spreads for sizes up to 15 million EUR for different maturities as follows:
> up to 4 years maturity – 5 cents;
> from 4 to 6 years – 6 cents;
> from 6 to 8 years – 8 cents;
> from 8 to 15 years – 10 cents;
> from 15 to 20 years – 15 cents; and
> from 20 years upwards – 20 cents.

I wrote about Fannie Mae and its accounting on November 16 … Accrued Interest has fleshed that out a little more (with the benefit of an American market background!) in a post about Freddie Mac.

Good volume for prefs today, and some of the more egregious silliness was smoothed away, but all in all performance was poor.

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

I do apologize … many things came up today, so you’ll just have to do your own literature review.

PerpetualDiscounts didn’t go down today!

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

Gary Stern, President of the Minneapolis Fed, gave a speech in Singapore titled “Credit Market Developments: Lessons for Central Banking, which has provoked sharp disagreement from Yves Smith of Naked Capitalism

The theme of Mr. Stern’s speech is that there are no easy answers:

certainly some situations are far from resolved, and thus identification of principal lessons learned from the disruption will necessarily be incomplete and probably prioritized inadequately as well. Nevertheless, I think we can say something meaningful about potential reforms and about the tradeoffs inherent in their adoption. These are important matters; if I am right about tradeoffs, then some reforms might impose significant costs and contribute to outcomes we would prefer to avoid.
…
Policymakers will certainly find opportunities to improve current regulations and practices; the status quo will need to change in some areas. But, as we will see, and as foreshadowed previously, tradeoffs suggest that policymakers will want to be extraordinarily careful in addressing perceived inadequacies in the current environment.

This seems reasonable enough, but Mr. Smith says:

How do you want to count the damage that we need to count on one side of this tradeoff? Let’s see, we have subprimes at anywhere from $150 to $500 billion. We have the train wreck that is just starting in commercial real estate, which may be a mere $100 to $150 billion. Then we have losses and writeoffs on collateralized debt obligations, which we have said could add up to $750 billion (although some of that is already included in subprime losses). Of we could simply rely on the forecast by Goldman chief economist Jan Hatzius that home foreclosures could reach $400 billion and will trigger a $2 trillion reduction in lending, which in turn will trigger a “substantial recession.”

Even though regulation entails costs in terms of reduced efficiency and reduced profitability, the scale of the damage argues for incurring those costs. Yet, incredibly, Stern is arguing against meaningful change despite overwhelming evidence of serious problems.

… which doesn’t strike me as being a particularly useful response. There are certainly Bad Things happening, but this doesn’t mean that the system is not working as it should. As has so often been reiterated, markets exist in order that risks might be transferred. The fact that sometimes those risks have large effects – perhaps unforseen effects – is not sufficient to justify a full-court press on the regulatory front. Most importantly, before implementing regulatory changes, it is necessary to have a pretty good idea that rule changes will, in fact, be a net benefit … which is all that Mr. Stern is saying.

Mr. Stern’s first example is the “Originate and Distribute” model that results in so much asset securitization:

Because of the many hand-offs in the process—and the terms of the contracts between at least some of the firms—a number of the firms involved in the process did not have a clear stake in the longer-run performance of the mortgage. The incentives in this model, then, may have encouraged large-scale production of low-quality mortgages.
…
And the alternative—the originate to distribute model—has a core and fundamental economic advantage propelling it: specialization. Over time, firms have developed that specialize in the distinct steps of the lending process, from originating the loan to funding it. Such specialization contributes importantly to cost efficiencies, innovation, and a broadening of access to financial capital.  Another advantage of the model is diversification; the originate to distribute process allows a firm to significantly diversity the asset side of its balance sheet.

… to which Mr. Smith replies …

Ahem, don’t the 15% to 20% fall in housing prices, a falling dollar, and the recession that Hatzius and his colleagues increasingly predict represent an “adverse consequence for living standards’?

And Stern seeks to scare his audience into submission with a false dichotomy: you either accept the originate to distribute model as is, or you go back to having banks hold loans on their balance sheets. There is no willingness to consider methods to improve incentives or information flow, or more clearly define liability, that may reduce the bad outcomes of this system while keeping many of its virtues.

Mr. Smith’s suggestion for incremental improvement of the system is:

All residential mortgage brokers will be subject to Federal reporting and oversight (presumably at least along the lines of the requirements for brokers employed by regulated banks, although those may need to be toughened too).

… which is more than just a little vague. Federal reporting of what? oversight of what? you qualify for a license how? what do you need to do to lose it? Mr. Smith does not provide any argument for mortgage broker registration, merely the assertion that Rules Will Make Life Better.

According to a study released in 2005:

Among the findings for 2004 are these: there are 53,000 operating brokerages and they accounted for 68% of last year’s total origination activity; the mean firm originated $34.5 million with a mean of 7.9 employees; employment at the nation’s brokerages totaled 418,700; subprime and Alt-A loans accounted for 42.7% of brokerage’s total production volume; the average LO originated 26 loans in 2004; the average brokerage used a mean of 13 wholesale lenders; and average gross income per loan was 170 bp.

It’s a pretty big industry! What’s more, there is a host of existing laws and regulatory authorities at the State level already extant. What benefits are intended by federal regulation? What problems would these seek to correct?

Remember: it is not enough to say ‘there is a problem’. A solid argument that the proposed fix would be of net benefit is also necessary. It should also be remembered that the archetypal sub-prime borrower is not a Dickensian poor but honest family of four. The archetypal sub-prime borrower is a speculator, who put up the minimum downpayment while thinking of it as an “option to buy” more than anything else. I alluded to this on October 10 and a looking at data that is in this speech:

A first finding is that recent foreclosures have been disproportionately related to multifamily dwellings. In Middlesex County, Massachusetts, multi-family properties accounted for approximately 10 percent of all homes, but 27 percent of foreclosures in 2007. This highlights a potentially serious problem for tenants, who may not have known that the owner might be in a precarious financial position.

Yes, I know it’s not the most conclusive evidence that may be generalized! If anybody has any good data on the speculator/poor-but-honest-homeowner split amongst defaulting sub-prime, let me know!

Mr. Stern next addresses the Credit Ratings Agency issue in a manner that warms the cockles of my heart:

To be specific, it could be exceptionally costly for each investor to build the infrastructure required to conduct serious credit analysis, and these costs need to be weighed against the losses suffered by investors in the current regime. Moreover, were the agencies unique in underestimating the losses in, say, the subprime mortgage market?  It is not obvious that a different infrastructure will produce better results.
         
More positively, the rating agencies represent one way of economizing on the production of information on credit instruments. And by charging issuers, they also try to address the public nature of this information for, once the information is produced, there is almost no cost to distributing it and hence it is otherwise difficult to get paid. Absent these charges, there could be too little credit information produced.  Overall then, reforms that might compromise the viability of the agencies or discourage use of ratings present the tradeoff of potentially raising costs and ultimately requiring another solution to the issues the agencies help to address.

Now, I would like to hear more information about the proposal to lift the exemption from Regulation FD that now applies. But Mr. Stern admirably summarizes the major issue.

The next section is “Excess Liquidity”; I won’t re-hash the arguments about whether central banks should target asset prices here. In the conclusion to this section, Mr. Stern states:

Interestingly, the excesses in asset prices perceived in recent years seem related, at least casually, to innovation. Consider the run-up in prices of technology stocks in the late 1990’s and this year’s turbulence linked to pricing of structured financial products and subprime mortgages.  It may be costly to try to address these situations ex ante if, in fact, such actions would inhibit the underlying innovation. Common to all of these concerns is the difficulty of appropriately valuing financial assets.  It is quite plausible that, in pursuing preemptive action, the unintended consequences rival or exceed the desired outcomes.

which attracts the ire of Mr. Smith, who appears somewhat confused:

Similarly, his argument about innovation is specious. Innovation is not a virtue like faith or charity. A particular innovation is not valuable by virtue of merely being innovative (if so, virtually every venture capital proposal would be funded and become a barn-burning success); the measure of the value of an innovation is whether on balance it is beneficial. The jury is out on subprimes, but is it already clear that a lot of the so-called innovations, like no-doc loans, teasers, and high LTV loans, particularly in combination, weren’t innovations, but simply bad ideas.

Big Pharma is full of examples of promising drugs that never made it to market. Why? Either they failed to show sufficient efficacy, meaning they didn’t offer a compelling benefit, or they had potentially dangerous side effects. Why should the world of financial services innovation be any different? Their so-called innovations often deliver limited user benefits (but are more attractive for the producer) and in the case of products like subprime loans, came with toxic side effects, like bankruptcy.

It is not apparent how Mr. Smith would test financial innovation prior to putting it on the marketplace.

Mr. Stern’s concluding example is with respect to government support. He suggests:

In fact, by taking steps to reduce the threat that the failure of a large bank, or decline in asset values in one market, will spillover to other institutions or markets, policymakers can actually increase market discipline and simultaneously achieve greater financial stability.

… which suggests to me that if policy makers have sufficiently guarded against contagion to ensure that one failure won’t topple the system, they will be a lot more willing to allow that one failure; knowing this, banks will strive more carefully to ensure that they don’t become that isolated example; and creditors will strive more carefully to ensure they’re not (overly) exposed to that one example. It seems perfectly clear – but not to Mr. Smith:

“Limiting the size of losses” means “intervening earlier.” The lower the downside for taking risk, the greater the incentive to be reckless. How could this possibly increase moral hazard?

No, Mr. Smith, “Limiting the size of losses” does not necessarily mean “intervening earlier”. It may also mean “limiting contagion”. Mr. Stern made that clear.

All in all, a rather bland speech by Mr. Stern, a violent over-reaction by Mr. Smith.

Stephen Cecchetti was briefly mentioned here on August 27, and has now written another piece for VoxEU: Preparing for the Next Financial Crisis. He is apparently conducting a campaign to force as much financial trading as possible to occur on organized (and regulated!) exchanges; a previous essay that I missed was the topic of another Naked Capitalism post.

The core of Prof. Cecchetti’s argument is:

In order to reduce the risk that it faces, the clearinghouse requires parties to contracts to maintain deposits whose size depends on the details of the contracts. And at the end of every day, the clearinghouse posts gains and losses on each contract to the parties that are involved – positions are marked to market.

Since margin accounts act as buffers against potential losses, they serve the same role as capital does in a bank.   And marking to market creates a mechanism for the continuously monitoring the level of each participants capital.

It is important to realise that because they reduce risk in the system as a whole, clearinghouses are good for everyone. They are what economists refer to as “public goods”.

Well … I don’t buy it, although I would like to see further argument. If a particular security is 20 bid, 90 offered right now on the OTC market, I can think of all kinds of reasons why it will probably be 10 bid, par offered on a public exchange. The major effect of such a change will be to add a lot of instruments to the publicly quoted market that will be an awful lot like preferred shares … sure, you can trade small amounts through open outcry, but to get a big piece done you’ve got to call up a dealer who (if you’re lucky) will get busy and set up a cross.

Mainly, what you’re going to get is another big bureaucracy and 100,000 listed intruments with ludicrous spreads and no volume. Better pricing? Maybe sometimes. But Malachite Aggressive Preferred Fund has a section in the offering memorandum about pricing … if I don’t like the posted bid and offer, I can substitute my best guess (within limits!). I have seen lots of instruments quoted with no bid; many quoted with no offer; and lots quoted at spreads that make your eyes go pop. And believe me, prefs trade a lot more often than a lot of corporate bonds.

Mr. Ceccetti goes on to say:

On the information side, it is important that less-sophisticated investors realise the importance of sticking with exchange-traded products.  The treasurer who manages the short-term cash balances for a small-town government should not be willing to purchase commercial paper, or any security, that is not exchange traded. 

It is not and should not be the exclusive purpose of financial regulation to make life safer for the little guy. The treasurer in this example – and we shall assume for the moment that he’s just another wage-slave accountant, making a good faith effort to Do The Right Thing, but without the experience or the available time to be considered a market professional – should not purchase commercial paper at all. As I’ve pointed out before … there are plenty of institutional money market funds out there, available for 10bp per annum – if that – that provide all the good things regular mutual funds do for Joe Lunchbucket: instant diversification and professional management.

Mr. Cecchetti does not make clear just what problems exist in the current system that will be fixed – with net benefit – by a move to exchange trading. More information is urgently required!

There is good news today! Michael Mendelson (ex-president of Portus Asset Management) has been convicted of fraud. Hurrah!

What a strange day in the preferred share markets today! As far as I can tell, there is a “flight to brand-names” going on – sell everything that doesn’t have an ad on television!

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

Accrued Interest wrote an interesting post regarding market volatility, which is particularly timely in view of kaspu’s question in the November 15 comments. He reviews the constant 1-2% moves in the market (“Sub-prime’s over!” “Sub-prime’s worse!” “Buy!” “Sell!”) and concludes that as far as day-to-day excess volatility is concerned:

So if the market isn’t manic-depressive, and fundamental buyers don’t tend to jump in and out of their investments from day to day, who really is moving the market and why?The answer is so-called fast money. Mostly prop desks at the big dealers and some hedge funds.

I will agree that these players have a big influence; but will note that sometimes “real money” accounts hire “hot money” traders and, for better or worse, a huge pension fund can be taking a completely speculative ten-minute position. Lots of pension funds are explicitly invested in hedge-funds, for example, so the taxonomy becomes a little confused.

Other influences should not be disregarded. There are, for instance asymettric asymmetric rewards to stockbrokers: say that an issue that should be at $20 is trading at $18. After getting all their information and advice together, they are as sure of this as they will be of anything. But … say this thing is a pref that might default. If it goes to $20, they’ve made 11% on the investment and the client’s a little happier than otherwise. If it defaults, they lose the client. So they sell. Asymettric Asymmetric and non-aligned risk/reward profiles! If it subsequently defaults, they’ve got something to discuss with their clients for the next twenty years or so. If it subsequently goes to $20, they can simply emphasize how lucky the company was to avoid default and how no rational conservative investor would take such chances.

I myself have had extremely frustrating discussions with clients who want to sell something because it has gone down. If they sell it, they won’t have to worry about it any more. End of analysis.

Be that as it may, I think there’s some stuff left out of that; most notably that prices are set by the marginal buyer and seller. Royal Bank shares have a volume of what, maybe 2.5-million shares a day? The TSX advises that 1,276,215,683 common shares are outstanding, so daily volume is, on average, about maybe 0.2% of outstanding. So if Royal Bank goes up 2%, we can say that this is because investors worth 0.2% of the company decided it was worth 2% more, but holders of 99.8% of the company didn’t change their minds. There is no reason why every single one of the 0.2% minority can’t be real money.

It should be emphasized here that a great many models of efficient markets assume infinite liquidity – and infinite liquidity does not exist. If I’m a real money investor and I need to raise $10-million, the only things I can sell are the things I already own. So bang! there goes a $10-million sell order on the stock I choose and it may be expected that the price will go down, even though I haven’t changed my mind regarding that particular stock at all.

Such things are called market impact costs, virtually ignored by academics because it’s hard to measure, hard to model, and because it contradicts the Holy Efficient Market Hypothesis. One can make a whole lot of money – and many, many, many players do make a whole lot of money – simply by selling liquidity to the marketplace, taking the other side of those trades.

Accrued Interest makes another point with which I do not entirely agree -or, at least, that I feel deserves elucidation:

And of course, if XYZ is getting beat up, then other names in the same industry get beat up also. Maybe the buyer of protection on XYZ had a view specific to that company, but now there is momentum. Dealer desks will start buying protection against related companies. Suddenly a whole sector is 30-50bps wider on no news.

I have no doubt that in lots of cases the transmission mechanism is as silly as AI describes, but there is a more rational explanation.

Say I have a certain amount of my portfolio invested in Banks. At 9am I’m very happy about my portfolio, because it’s all in the cheapest bank, “A”. Without any news – or, at least, with no news I deem significant – Bank “B” starts diving. Quick! Update the valuation model! Yes! A swap is possible! Sell “A” and buy “B”! Thus, while acting as a strictly fundamental value investor, I am converting weakness in “B” to weakness in “A”.

Anyway … there was a bit more clarification on the Fannie Mae accounting panic discussed briefly yesterday. Fannie was so worried, they held a conference call. From what I could make out – without having done any prep on this, you understand; the kerfuffle is over one table in a set of three filed documents each being 100-odd pages long – what happens is this:

• FNMA securitizes & guarantees mortgage pools
• One mortage with a principal value of $100,000 goes bad.
• Fannie buys it from the pool for $100,000 (this is where they earn their guarantee fee)
• Fannie determines the actual value of the mortgage using its internal models
• Fannie determines the market value of the mortgage (this is the fun part … getting quotes on delinquent mortgages in this environment)
• Fannie puts the asset on the books at the lower of the two prices (guess which one that is) and charges the balance to expenses

As far as I could make out from the call, they are claiming:

• the expense skyrocketted this quarter because market value has plummetted, not because of any huge increase in volume, or because their internal recovery expectations have changed much
• they expect the majority of the delinquencies to be cured
• the loss recovery rate will be fairly large and will come back onto the balance sheet as income

I think. Bloomberg has a story on it too.

Same old same old in pref-land: volume is good, prices are strange.

 

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

Update, 2007-11-18: Spelling of assym asymett asymmetric has been corrected. Thanks to a Keen-Eyed Assiduous Reader!

Well, there won’t be much today, I’m afraid! What with fixing (well, patching, anyway) my server problem and a … rather exciting day in the markets, there hasn’t been much time to Stay Abreast of Current Events.

Richard Portes of the London Business School has written a very good essay on VoxEU: International Stability by Design which serves as an executive summary for a major work that he co-authored International Financial Stability.

Now, it is a little fishy of me to comment on his VoxEU essay without purchasing and reading the work on which it is based – but hey! I’m sure he doesn’t mind a little publicity. He deals with hedge funds first, denying any pressing need for regulation:

Many regulators in the US and other major markets believe that the best way to monitor hedge fund activity is indirectly, through their sources of funds.
…
We see no clear benefit from additional regulation.

So far so good! It was only yesterday that I reiterated my prediliction for a non-regulated – lightly regulated, anyway! Things like insider trading and false advertising still need to be looked at! – sector of the financial markets, where innovation is king.

He is not concerned about the potential for financial market destabilization due to carry trades.

He is concerned, however, about the regulation of Large Complex Financial Institutions:

This suggests that not only regulators, but also the major central banks must cooperate more closely in dealing with liquidity shocks.

but does not provide any specifics – in this summary – of what he means by this. The Bank of England lists LCFIs as:

LCFIs include the world’s largest banks, securities houses and other financial intermediaries that carry out a diverse and complex range of activities in major financial centres. The group of LCFIs is identified currently as: ABN Amro, Bank of America, Barclays, BNP Paribas, Citi (formerly Citigroup), Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JPMorgan Chase & Co., Lehman Brothers, Merrill Lynch, Morgan Stanley, RBS, Société Générale and UBS.

LCFIs had the incomprehensible total of USD 23-trillion in assets in 2006, according to Chart 10 of the Bank of England’s April 2007 Financial Stability Report. The Financial Times had a very good report on this at the time.

The next section of Portes’ essay deals with the somewhat related issue of new financial instruments:

Given all the benefits from innovative financial instruments, the appropriate question is how to make these instruments safer. First, market-driven, but regulatory- and supervisory-authority-guided, approaches are necessary for successful financial risk management. As new instruments are designed, regulation must keep pace. Second, financial risk-management solutions must be global.

Finally, having prepared the ground by addressing LCFI regulation and financial novelty regulation, we get to the heart of the matter (and without this section my review of the essay would have been much more cursory!):

Transactions that do not transfer risk should not be treated by regulators as if they do
…
Many of the new instruments are illiquid, and the role of ratings firms in evaluating them is highly controversial. There has been a transfer of activity from regulated to unregulated investors.
…
The shift from ‘buy and hold’ to the ‘originate to distribute’ model should not (and probably cannot) be reversed. Policy-makers and industry bodies can try to make it work better, to push it towards a more balanced, market-based model through reforms that include:

• Regulators and market participants should pay particular attention to “tail risk”
• New regulations could require originators to retain equity pieces of their structured finance products.
• Regulators need aggregate information on structured finance instrument holdings and on the concentration of risk to assist in the regulatory process.
• Industry bodies should promote product standardisation and accurate pricing in the structured finance market.
• Credit market transactions that do not definitively transfer risk should not be treated by regulators or risk managers as if they do.
• Ratings firms should provide a range for the risk of each instrument rather than a point estimate, or should develop a distinct rating scale for structured finance products.

I consider these recommendations rather breathtaking – but there is doubtless argument to support the conclusions in the full report. I will merely point out that:

• the industry, to at least some extent, likes non-standardized products and inaccurate pricing. They can make more money trading that stuff against players who have no idea what they’re doing.
• how is the requirement that originators hold equity pieces of their transactions to be enforced? If I have some kind of risky revenue stream that I want to monetize, are the regulators really going to stop me? My instinct is to leave this kind of thing with the market and make the ability to say ‘We’ve got skin in this game’ a competitive advantage.
• the ‘new credit ratings scale’ recommendation has been floated so many times it is acquiring a veneer of inevitability. But Joe Broker does not want a new ratings scale. He wants something easy to explain to his client and his client just wants his hand held. I don’t know what kind of practical effect this cosmetic measure will have.
• all these recommendations will come to nothing for as long as investors don’t care about their returns – that is, forever.

My last point deserves at least a little elucidation. I have never talked to an investor who didn’t claim he was after performance … sometimes with less risk, sometimes with more risk, but all these guys have been pretty tough cookies, you know, and want good performance … or so they say.

The OSC issued a press release today regarding their review of ICPM marketting practices. I was on the long-list for their preliminary review – I believe every ICPM was. I had to provide them with a list of my websites and a copy of all printed marketting material; after submitting it, I never heard from them again.

Have a look at their summary of results … and bear in mind that these are Investment Counsel / Portfolio Managers that are being looked at, not mere stockbrokers:

Most of the deficiencies fall into one of the following areas:

1. preparation and use of hypothetical performance data
2. linking actual performance of the ICPM’s investment fund or investment strategy with the performance of another fund or investment strategy
3. construction and marketing of performance composites
4. construction and use of benchmarks in marketing materials
5. use of exaggerated and unsubstantiated claims in marketing materials

In the absence of actual deceit, not a single one of the sharp practices listed will withstand two minutes of questioning by a client who is concerned about performance. While the OSC’s efforts in this area are to be applauded, you cannot regulate common sense.

And, briefly, the bond-insurer saga continues, with fears of a USD 200-billion hit to markets if the insurers are downgraded … but the math looks bad enough without being as pessimistic as the very gloomy assumption required to get that high:

Then there is the $1 trillion market for insured securities backed by assets such as home-equity and consumer loans. Concerns about the underlying quality of the assets and the viability of the guarantors have caused investors to price some securities relative to the credit-default swaps of the insurers, according to David Land, a mortgage-bond fund manager at Advantus Capital Management. Advantus, based in St. Paul, Minnesota, oversees about $18 billion.

Insured securities backed by home equity-lines of credit have fallen by 15 percent, based on the rise in credit-default swap rates this year on Ambac’s insurance company. If the entire insured market were to drop that far, it would reduce the value of the securities by $150 billion.

There are some reports of a change in accounting treatment of credit losses by Fannie Mae – which readers will remember is a grossly undercapitalized Government Sponsored Enterprise. As I mentioned on September 20, the GSEs are helping to bail out the mortgage sector, to the condemnation of all right-thinking individuals and cheers from Congress.

As far as I can make out from the FDIC supervision manual, the change in accounting treatment relates to the discounts at which loans are purchased from a third party. If a $100,000 loan is purchased at $60,000 (due to credit concerns), it is no longer booked as a $100,000 loan with a $40,000 credit reserve; it’s booked as a $60,000 loan.

Given that the GSEs are now purchasing impaired loans (at least, to a far greater extent than they have in the past), one would definitely expect there to be a large difference between results from the old and new calculation methodologies. In other words, the issue sounds like a lot of fuss over nothing – but to confirm that I’d have to look very carefully at the source documents and I don’t have time. I’ll leave it as an exercise for the student.

A busy day in the preferred market, with prices falling amidst the now usual amount of completely strange relative pricing.

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