Category: Market Action

Thanks, Rebel Traders (via WSJ)! 

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

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

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

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

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

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

But – look at the situation: record foreclosures:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

James Hamilton of Econbrowser noted:

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

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

Well, US Core PPI looks OK anyway!

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

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

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

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

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

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

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

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

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

And, finally …

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

Treasuries pivoted:

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

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

Canadas pivoted.

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

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

Panic, thy name is retail:

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

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

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

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

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

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

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

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

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

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

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

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

And Credit Suisse is taking a hit on First Data:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

From the same paper, incidentally:

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

David Dodge is quoted in The Economist as saying:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Menzie Chinn has criticized Bernanke’s Savings Glut hypothesis:

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

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

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

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

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

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

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

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

David Dodge made an interesting speech in London, England. Of most immediate interest was his hawkish monetary stance:

I want to be absolutely clear on one point: The actions that we took to provide liquidity to support the smooth operation of financial markets did not in any way signal a change in our monetary policy. In fact, it was a step in maintaining our monetary policy stance by keeping our target for the overnight rate at 4 1/2 per cent, which we judged appropriate for keeping inflation on target over the medium term.

… but the theme of the speech was transparency:

In this complex process, transparency about the underlying credit was often lost. Because the originators of the loans intended to securitize them rather than leaving them on their balance sheets, they lacked the incentives to carefully assess the creditworthiness of the borrower. And investors often lacked the ability, or did not make the effort, to see through the complexity of the instrument. Thus, investors were unaware of the creditworthiness of the root asset and the potential difficulties with the liquidity of the instrument itself. Compounding the problems was the fact that the models upon which these structured products were valued assumed that they could be readily traded in a liquid market.

So far so good – especially the bit about liquidity. Liquidity killed portfolio insurance in 1987, but people never learn!

Moreover, the complexity and lack of transparency in many of the structured products added to the market dislocations. It was extremely difficult for investors to peel back the layers of these securities and derivatives to determine, with confidence, both the creditworthiness of the assets backing a particular security and the market value of the security itself. Even supposedly sophisticated investors became extremely uncertain and that, in turn, led to fear.

So far, so good. But now he skates over to an unrelated point:

In my view, there is a clear case for transparency more generally in the operation of all financial markets. In most countries there are fairly clear rules requiring transparency in the operation of mutual funds, so investors can tell what they are purchasing. Hedge funds, by their nature, are less transparent. But there is also, I believe, a clear case for increased transparency, at least with respect to their objectives, operating procedures, and governance.
…
Let me now say just a few words about the importance of transparency in government-sponsored institutions, whether domestic or international. I will begin with a few words about sovereign wealth funds, which control increasingly large amounts of money and are significant global financial forces. Some of these funds, such as the public pension funds in Canada, already adhere to very high standards of transparency. But in other cases, there is often insufficient transparency in the operation of these funds. Too often, the objectives behind these funds are not clearly defined, and this can lead to misconceptions about their motives, particularly those that have their origins in foreign exchange reserves. As is the case with private pools of capital, high standards of transparency for reporting and governance, as well as objectives, would be helpful for these public pools of capital.

So he begins with the idea that maybe it would be a good idea if PMs had some vague idea about what they’re buying … and ends with a desire to poke his nose into sovereign wealth funds? Mark my words … something’s up. We’re not being set up for the Bank of Canada to form the nucleus of a national securities regulator, are we? And not even Harper & Flaherty would politicize the Bank of Canada by influencing Dodge to help advance a political agenda?

Be afraid. Be very afraid.

The recession probability continues to be debated – with some amusing 1998 headlines:

• Market Watch: Bracing For Mortgage Losses
• Despite Late Rally, Dow Ends A Bad Week Lower
• Shift To Capital Markets From Banks Brings Tumult
• Crisis Goes Beyond The Balance Sheet
• Banks Tighten Some Loan Terms
• Commercial-Mortgage Issuers Are Locked In A Deep Freeze
• Recession Fears Dominate
• Market Turmoil Hits Luxury Home Sales
• Heavy Spenders Take A Break
• Decade of Moral Hazard
• Emerging-Market Investors Get Full-Fledged Drubbing

… which goes to show two things:

• Plus ça change, plus c’est la même chose
• You can always count on newspapers and markets to get extremely excited about things.

The laissez-faire approach of the Bank of England has been compared to the more activist approach of the Fed:

The change in LIBOR is going to hurt bank profits, but the BoE is hanging tough:

“The provision of such liquidity support undermines the efficient pricing of risk by providing ex-post insurance for risky behavior,” King said today in written testimony to the U.K. Parliament’s Treasury Committee. “That encourages excessive risk-taking, and sows the seeds of a future financial crisis.”

Brad Setser has discussed Bernanke’s assertion that a savings glut will continue to keep interest rates low. He largely agrees, but puts more weight on official flows.

US Equities were flattish:

Analysts expect third-quarter earnings at S&P 500 companies to grow by 3.7 percent, down from an average estimate of 5.2 percent at the start of August, according to data compiled by Bloomberg. Growth at that rate would snap a streak of 20 straight quarters above 10 percent.

… but Canadian equities looked forward to higher oil prices.

Treasuries were off slightly and Canadas were downright boring.

Volume was fairly light in the preferred market, but Scotia pulled off a good sized cross. I was surprised to see that BAM.PR.M / BAM.PR.N did not exhibit ridiculous behavior on their ex-date … wow! Normal behavior from this pair!

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

There may be some spikes in commercial paper rates shortly as $700-billion in CP needs to be refinanced. There’s also a good chunk in Europe … so we may see some spectactular flame-outs.

We’re not over the hump yet, and won’t be for several months, as forecast by Ed Clark of TD. There are still lots of hedgies that haven’t blown up yet, although Y2K Fund has now halted redemptions:

The fund dropped 30 percent over June and July, according to data compiled by Bloomberg. It had been the best performing non- U.S. hedge fund investing in fixed income in the three years to the end of September 2006, according to Bloomberg data.

Maurice Salem, who founded Wharton in 1993 and runs the firm, didn’t answer calls to his mobile phone. Calls to the company’s offices in London weren’t returned. The Y2K fund was established in 1999.

Wharton’s Trio Finance Ltd. fund, which invests in real estate asset-backed securities, has fallen 46 percent this year, according to Bloomberg data.

Yesterday I mentioned Flaherty’s solution to the sub-prime crisis, namely: let the feds be in charge of capital market regulation. I was very pleased to see that there is at least one other person in Canada who noticed one vital thing about his remarks:

[Quebec Finance Minister] Ms. Jérôme-Forget said Mr. Flaherty has no business using the credit crisis to advance his campaign for a single regulator because there is “absolutely no link” between the subjects.

European Central Bank President Jean-Claude Trichet weighed in on regulatory reform:

Stressing the positive aspects of recent financial innovations to repackage and sell debt, Mr. Trichet nonetheless called the complexity of some debt products “overwhelming.” He said, “instruments and structures that cannot be fully understood even by those who bear the ultimate responsibility of the level of risk taken by financial institutions should not be acquired or set up by banks and investors who are lacking sufficient sophistication in the management of the risks.”

Mr. Trichet also called a dearth of ratings agencies problematic “for the present functioning of global finance” and suggested the agencies work out “benchmarks for improved behavior,” particularly on potential conflicts of interest. But he blamed investors equally: “An important lesson of the current risk re-pricing is that investors must never take the opinion of rating agencies as a substitute for their own credit analysis and due diligence.”

Well … I’d like to hear more about “benchmarks for improved [Rating Agency] behavior” … but three cheers for the rest of his comments! Who knows, if the hedgies take his advice they might last a little longer:

How often do hedge funds fail?
Lacking accurate data on the failure rate of hedge funds, most studies use the number of funds that stop reporting to the Lipper TASS database. According to this proxy, the average lifespan of a hedge fund is 40 months, with a median life of 31 months. Fewer than 15 per cent of hedge funds last longer than six years, while 60 per cent disappear within three years.

Meanwhile, US equities had a great day on hopes of a Fed easing and lots of consumer spending, aided by a Manpower report indicating jobs aren’t as scarce as all that. Canadian equities also rose on hopes that then we can sell them rocks and trees.

However, the Treasury market is now worried that it overshot but even with the rise in yields:

Yields on two-year notes, which are more sensitive to interest-rate changes than longer-term securities, are 131 basis points less than the Fed’s benchmark lending rate, near the biggest difference since January 2001.

Canadas followed.

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

The Economist points out that mark-to-market accounting (which is a hallmark of securitization) can be destabilizing; it can turn bankers from rather dry borrow-short-lend-long types into market speculators. I believe we are seeing this effect in the CPDO market where the deleterious effects of spread widening on capital have been observed, but the benefits of realizing on those spreads over the mid-term have not yet materialized.

It is also possible that cooler heads will prevail and avoid rushing for the exits – a possible example is:

Washington Mutual plans to hold more loans for investment, citing potential for strong risk-adjusted returns.

And it would appear that some shops have resolved their funding issues:

Thornburg Mortgage Inc., the home lender that sold $20.5 billion of mortgage bonds at a loss last month to ease a cash shortage, now plans $3 billion to $4 billion of purchases to take advantage of low prices.

The AAA-rated securities could yield 1.25 to 2.25 percentage points over Thornburg’s cost of funds, President Larry Goldstone said in an interview. That compares with an average of 0.5 points for securities now in the Santa Fe, New Mexico-based company’s portfolio. The purchases will occur “over the next month or two,” presuming mortgage markets begin to stabilize, he said.
…
Goldstone said $546 million of fresh capital from a preferred-stock sale last week will help the company pounce on opportunities that cash-starved rivals can’t afford.

Some of my more fanatical readers may remember my post about BSABST 2005-1, in which I attempted to demonstrate that the S&P downgrade of one particular ABS wasn’t as scary as it sounded when one looked at the actual dollar values. I’m a little late reporting this, but I’ve found a S&P press release about subprime that puts a little meat on those bones:

Our July 2007 downgrades affect around 1% (by value) of the US subprime first lien mortgage tranches we rate:
• 85% of the ratings downgraded were BBB and below (ie, the weakest quality subprime securities)
• no AAA ratings on these securities were downgraded
• between July 1 and August 24, 2007, S&P received reports of only three defaults from approximately 15,000 current first lien subprime mortgage tranches rated by S&P globally (two of the defaulted tranches were issued in 2002, the other was issued in 2004).

We’ll see how it all turns out. We’ll probably find that the ratings agencies acted in a less than perfect way – I haven’t yet found an analytical system or an analyst who’s perfect. But I’ll bet a nickel that in ten years we’ll be saying that the pendulum of sentiment swung from “Everything is perfect” to “The world is about to end” and that hedgies as a group are attempting to deflect criticism of their own performance towards the agencies; aided by the regulators, who can’t stand to see anything happen in the capital markets that doesn’t involve a kow-tow to the regulators; abetted by the reporters, who don’t care what they say as long as it sells papers; and encouraged by the politicians, who need to show Concern and Judicious Thought.

Like, for instance, Flaherty:

Finance Minister Jim Flaherty says the summer credit crunch is indisputable proof of the need for a single Canadian securities regulator: one that could better guard against, and fend off, shocks buffeting this country’s capital markets.

Such nonsense – and Flaherty doesn’t do anything but wring his hands at the horrifying idea that something might happen in this country without federal regulation.

Regulation of the securities markets in Canada can clearly be improved – see my summary of sales restrictions applying to my firm, for instance – but not, I believe, in terms of the end product. There will be the same good points and bad points about the effects of the application of regulation whether we have one regulator or five hundred. The effects of regulatory unification will be noticable only in the cost – in terms of actual dollars, time and elimination of basically arbitrary selling restrictions – and should be pursued for that end alone.

There is considerable debate regarding what the Fed should be doing at their September 18 meeting. James Hamilton view is:

They can clearly communicate they’re not panicked by the market or bullied by the politicians by waiting until the scheduled September 18 meeting before announcing a cut, and even then one or two members could cast a dissenting vote. Markets would see a 25-basis-point cut delivered in that manner as a splash of pretty cold water. If next month’s data show the same trends as last week (some comforting and some alarming numbers), the Fed could cut another 25 basis points at the end-of-October meeting, adding another dissenting vote. That would leave them free to move any way they want, up or down, in December.

If we get stronger confirmation that the August employment and LA home sales numbers are not an anomaly, the Fed should be prepared to make that a 50-basis-point cut for October.

I agree; I’d like to see some language in the statement that they’re still worried about inflation, jobs number or no jobs number … monthly data can vary significantly. As JDH notes, the increase in LIBOR has done a lot of the anti-inflation heavy lifting on the Fed’s behalf.

Brad Setser notes that:

At least part of the dollar’s August rally seems – at least to me – to have been tied to deleveraging (including deleveraging by European banks) rather than safe haven flows.  Selling rubles and Asian equities to pay back borrowed dollars isn’t quite the same as seeking out the dollar because you expect it to rally in times of stress.

… and sees interesting times ahead for countries with currencies tied – explicitly or implicitly – to the dollar.

US equities looked like they were going to have a horrible day until Thornburg announced its plans to rebuild a position in some high-grade sub-prime tranches. Then they recovered, followed by Canadian equities.

Treasuries continued to roar, yields falling 6bp in a parallel shift, but it’s not doing the dealers much good and reports of foreign selling into the rally continue to accumulate. Canadas were listless.

There were a few good sized crosses in the preferred market today, but the increase in volume wasn’t very broadly based. PerpetualDiscounts continued to recover; they have had only one (minor) down day since August 16 and are up 2.05% since that date.

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

Well – a short week, but not entirely devoid of interest!

Today’s big news was that the US Jobs number was negative, which hasn’t happened in a while. Politicians reacted according to their stripe; economists hastily revised downwards their expectations for both growth and rates. Greenspan sounds very happy it’s not his problem. There is general agreement chances of a recession have increased.

I’ve previously mentioned Deutsche Bank’s success at Credit Anticipation in betting against sub-prime. Another winner emerged today:

The $4.5 billion Credit Opportunities fund, started last year, gained 26.7 percent in August, according to a Paulson investor. Credit Opportunities II, a newer $2.3 billion fund, is up more than threefold after a 32 percent return last month.

I feel quite sure that a lot of these massive losses we’re reading about are just hedge funds transferring money back and forth … when you share 20% of winnings and 0% of losses, why not bet the firm?

The Canadian bank-operated ABCP market is having major problems. Three-month BAs are yielding about 5% … ABCP is yielding about about 5.60% … when three-month bills are at 4.04%. That kind of spread is … well, let’s just say that banks are not having a nice time. Mind you, it’s even worse in the States, with bills at 4.07% and financial paper at 5.48% (US ABCP at 6.18%). While we’re on the topic of ABCP, the outstandings in America continue to shrivel, which indicates a ferocious combination of deleveraging and transfer to bank lines. The ‘transfer to bank lines’ part is dangerous – there is some concern regarding the banks’ committments and whether regulators need to step in. I don’t know, frankly, if line committments are added in any way to risk-adjusted capital. They should be! Especially since laying off risk is, to an extent, boomeranging.

Countrywide Credit is having a mass layoff, trying to survive in environment where it’s difficult, to say the least, to securitize mortgages that it originates. Citigroup is reportedly refusing to accept new mortgage clients. But maybe they’re just providing bigger lines to fewer clients.

Centex Corp., a Dallas-based homebuilder and lender, said in a regulatory filing today it replaced a warehouse credit line with a larger one arranged by JPMorgan Chase & Co. that may provide as much as $1 billion. Centex increased the credit line because the global credit crunch made it hard to rely on selling short-term notes to finance mortgages, the filing said.

US equities went splat on the jobs number. Recessions aren’t generally good for profits! Canadian equities also fell.

Treasuries had such a good day on the back of the jobs number it has to be referred to as panic-buying (possibly sending a lot of profit to foreign central banks, since boneheaded fiscal policies have sent a lot of money abroad). Why not, when Fed Fund Futures are predicting a rate of 4.5% by December? Well, perhaps because Fed officials are watching the economy, not markets. Canadas had a super day, with the ten-years’ yield declining about 13bp.

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

Month-end is taking its dreaded toll … there will be no indices AGAIN today and precious little commentary.

My sole comment for today is that DBRS is sounding very defensive! They have released a “commentary” titled Rating Volatility in Structured Credit and a press release titled DBRS Approach to Canadian ABCP Surveillance – neither of which I can link to because ratings agencies, for all their good points, are complete dorks when it comes to public relations. So visit their web site and poke around for a few hours until you find their precious commentary.

If we do manage to avoid government regulation and control of the credit ratings process – the prospect that fills me with dread – it won’t be because of the slick publicity campaign managed by the agencies, that’s for sure.

The S&P equivalent was published August 23 and titled Structured Finance Commentary.

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

Update, 2007-09-07