Category: Market Action

It was an interesting day, with a number of cross-currents resulting in a strong day for bonds at the expense of stocks.

The day started with a thump, as the Financial Post reported a gloomy sentiment from Edward Devlin of PIMCO:

The vast majority of about $35-billion of non-bank ABCP is backed by risky bets on credit default rates that are now so far underwater that investors could be looking at losses as high as 50 on the dollar

With all respect to Mr. Devlin, I’ll repeat my tired old refrain of “I wanna see more detail”! Readers will remember the sad story of Global DIGIT’s suspension of redemptions, which fits his story quite well – they’re leveraged to hell and gone on credit-default-swaps on the dreaded sub-prime (senior tranches only, so they claim). Global Digit issued a press release on August 28, stating:

The Trustee has now received from the Bank the indicative price which will be used to calculate the NAV as at August 31, 2007. If that indicative price, which was based on market conditions known on August 28, 2007, had been used to calculate the NAV as at July 31, 2007, the NAV would be $7.92, representing a reduction of about 12.5% from the NAV calculated based on the July 16, 2007 market conditions.

So, on the cheerful side, we can say that August 28 was pretty close to the height of the hysteria and the loss, while not likely to make the equity holders very happy, are not yet eating into the security of the ABCP holders. Now, there’s problems with this statement. In the first place, “indicative prices” don’t necessarily mean very much, as most rookie bond guys find to their consternation sometime before their tenth trade. And, of course, many many bad things can happen before those CDSs in the DG.UN portfolio unwind. And there’s no indication that DG.UN is representative of the kind of problem that Mr. Devlin refers to. Lots of uncertainty … but uncertainty with respect to Mr. Devlin’s statement as well. Details! Give me details!

This topic arose during a lunch I had today with a PrefLetter subscriber (He bought! I wish to take this opportunity, firstly to thank him, and secondly to encourage subscribers and others to buy me lunch at every opportunity!). We were talking about Tier 1 Capital Ratios, and the National Bank’s purchase of ABCP, preferred shares and how all those things related. My friend made the comment that ABCP buyers – buying assets that were levered 10+:1 – got everything they deserved. But, as I have now confirmed, such leverage is normal! Royal Bank’s financials reveal $537-billion in assets supported by $22-billion in equity, a gearing of 24:1.

They have a perfectly adequate Tier 1 Capital Ratio nonetheless, because not all assets are created equal. I’ve looked at a document from BIS that gives a few formulae and rules of thumb for calculating capital adequacy … on Page 160 of the document, for instance, we get the risk weights for various terms of bonds, while Page 156 gives the risks weights for various grades of issuer. As may be understood by comparing RBC’s asset-to-equity gearing with its Tier 1 Capital Ratio, the RBC assets have an average risk-weight of about-maybe 33%.

So – I’m not drawing any conclusions about the riskiness of ABCP or of RBC paper, but I’m just pointing out … there’s risk and then there’s risk; the leveraging factor in and of itself conveys some of the answer, but not all.

In news today with implications on the FedFunds rate, the Beige Book was released:

“Outside of real estate, reports that the turmoil in financial markets had affected economic activity during the survey period were limited,” the Fed said in the survey, which concluded before Aug. 27 and was released today in Washington. “Economic activity has continued to expand” nationwide, the Fed said in the Beige Book, named for the color of its cover.

Another perspective is available from the WSJ Economics Blog which also produced a summary by district. ADP is projecting a lousy jobs number for Friday’s release.

Longer term, the OECD released a report stating that in the US:

slower job creation, mortgage-rate resets and tighter credit standards will prompt a slowdown in the second half of the year that will drag annual growth down to 1.9%, from 2.1% forecast previously

The author does not believe a US recession is imminent.

A suggestion that banks pool and securitize their LBO debt caught Tom Graff’s attention, but another solution was implemented by AstroZeneca:

AstraZeneca Plc, the U.K.’s second- largest pharmaceutical company, sold $6.9 billion of bonds in the biggest U.S. debt offering in more than five years.

AstraZeneca will use proceeds from the sale to pay back commercial paper that financed the $15.2 billion purchase of U.S. biotechnology firm MedImmune Inc. in June

That’s the way to reduce liquidity risk on your balance sheet! Bite the bullet and extend term, even if it hurts.

The five-year 5.4 percent debt priced to yield 130 basis points more than Treasuries of similar maturity; the 10-year 5.9 percent securities have a yield premium of 145 basis points; and the 30-year 6.45 percent bonds paid a spread of 170 basis points.
…
AstraZeneca’s debt is rated A1 by Moody’s Investors Service, the fifth-highest investment grade and AA- by Standard & Poor’s, the fourth-highest ranking.

In this context, it’s worth noting that the Treasury 10-year to Baa spread, highlighted by James Hamilton a while ago, doesn’t appear to have moved much: the Fed is now showing Baa paper at 6.60%, which is actually less than each of the three most recent monthly observations. Granted, Treasury 10-years are down a lot but while spread-to-treasuries is important, spread-to-business risk is even more important. This looks like good insurance for the issuer.

Citigroup is closing a poorly performing hedge fund; it should be noted that while it underperformed its peers, it’s down only slightly on the year. It’s not all hedge funds that will blow up over the next few months … only some of them. Particularly those who are forced to sell their assets at whatever they will fetch in this environment.

The losers will be replaced:

The amount of debt in the Merrill Lynch distressed bond index tripled in July to $13.8 billion, and about doubled again in August to $24.8 billion. In addition to Residential Capital and WCI, the debt of New York-based amusement park operator Six Flags Inc., and pizza chain Uno Restaurant Corp. of West Roxbury, Massachusetts, is distressed based on their yields.

Investors specializing in distressed debt are gearing up for more opportunities. They raised $23 billion this year through Aug. 17, breaking 2006’s record of more than $16 billion, according to London-based Private Equity Intelligence Ltd.

There’s another good quote in that story too, that will help give some perspective on the Credit Rating Agency controversy:

Moody’s in January 2005 predicted the default rate would rise to 2.7 percent by the end of that year from 2.2 percent. Instead, it fell to 1.8 percent. Moody’s then forecast it would rise to 3.3 percent by the end of 2006. It fell again, to 1.7 percent, the lowest year-end level in a decade.

“The last couple of years we always used to say `Gee, isn’t it crazy, we’re seeing top of market behavior and this can’t be sustained,”’ Marshella said. “It did go on longer and we were wrong. You always thought there’d be an inflection point and, finally, an inflection point came,” he said, referring the increase in financing costs caused by the contamination of asset- backed securities by subprime mortgages.

US equities fell, as financials are now out of favour; Canadian stocks also fell on fears of a credit crunch. LIBOR just won’t go down!

Treasuries had a banner day; Canada didn’t do quite so well but there was a major steepening.

I wasn’t able to update the index values today, although I did update the index constituents. Tomorrow, I promise! 

Note: Somehow … don’t ask me how … I managed to screw up the input of the Volume and Price Change tables so completely that my software has given up. Sorry.

Update, 2007-09-07

Well, I’ll tell everybody straight off: there ain’t no indices being published today. I don’t have time; I’ll have to update tomorrow.

Bush’s profferred help for hapless homeowners is attracting considerable comment. Willem Buiter takes the view that “A rate cut is unnecessary. Congress will swiftly augment the Bush bail-out, adding a fiscal stimulus worth, say, 0.5% of GDP. The anticipation of relief on both the fiscal and monetary side is likely to be enough to normalise credit conditions.” Most importantly:

By subsidising excessive and imprudent borrowing, it reinforces the moral hazard faced in the future by low and middle income Americans pondering the size of the mortgage they can enforce (if the market-friendly President Bush is willing to bail us out today, would a more market-sceptical President Barack Obama or President Hilary Clinton not do so again tomorrow?)
…
There is a reasonable prospect that Federal legislation and Federal regulation and supervision of the housing finance industry will be changed in such a way as to reduce the likelihood of the excesses, the mis-selling and the misrepresentations that became rampant especially during the past 5 years or so.
…
It is, unfortunately, quite likely, that the legislative and regulatory changes we will get will amount to a Sarbanes-Oxley-style regulatory overshoot, that is, regulation of the ‘if it moves, stop it’ variety. This will discourage future lending to low-income or credit-impaired would-be homeowners even when such lending is fundamentally sound.

Tom Graff also worries about the moral hazard issues.

Meanwhile, at the Jackson Hole conference, sub-prime and related issues continued to be front and centre. Professor Hamilton of Econbrowser argues, in effect, that moral hazard has already happened; that the Government Sponsored Enterprises (GSEs) in the States that guarantee mortgages are woefully undercapitalized and are viable only due to an implicit government guarantee.

While I think that preserving the solvency of the GSEs is a legitimate goal for policy, it is equally clear to me that the correct instrument with which to achieve this goal is not the manipulation of short-term interest rates, but instead stronger regulatory supervision of the type sought by OFHEO Director James Lockhart, specifically, controlling the rate of growth of the GSEs’ assets and liabilities, and making sure the net equity is sufficient to ensure that it’s the owners, and not the rest of us, who are absorbing any risks. So here’s my key recommendation– any insitution that is deemed to be “too big to fail” should be subject to capital controls that assure an adequate net equity cushion.
…
It also might be useful to revisit whether Fed regulations themselves may be contributing to this misinformation. Frame and Scott (2007) report that U.S. depository institutions face a 4% capital-to-assets requirement for mortgages held outright but only a 1.6% requirement for AA-rated mortgage-backed securities, which seems to me to reflect the (in my opinion mistaken) assumption that cross-sectional heterogeneity is currently the principal source of risk for mortgage repayment.

A tax on GSE mortgages has been proposed, but I’ll need a bit more convincing on that matter! I like the regulation of capital better – it fits into the existing regulatory framework in a better way, allowing for more efficient use of capital. 

Professor Taylor – of Taylor-rule fame – argues instead that the culprit is loose Fed policy in the 2003-05 period. He was supported by Martin Feldstein, who feels the Fed should act more proactively on asset bubbles – such as, it is now clear, US housing – on the grounds that the rewards for correctly identifying an asset bubble in real time outweigh the risks of being wrong. This has very immediate implications for the correct Fed response to a housing-led slowdown: should the Fed assume the worst, and avoid a recession at the risk of easing too much, or should it react to data from the real economy as it arrives? After all, there has been minimal indication of damage in the manufacturing sector, but there are some indications consumers are running scared.

It certainly sounds as if the conference was fraught with interest! The basic debate can be cast as:

“Rick is basically saying, ‘We can’t lean, but we can clean up,”’ White said, referring to Mishkin by name and raising his voice to make his point. “I think we can make equally strong arguments for `You can lean and you may not be able to clean up.”’

For now, count me among the ‘wait for data to come in’ and ‘regulate capital usage of the GSEs’ camps. For now.

There has been plenty of damage to economic sectors closer to the epicentre of the financequake. Novastar is cutting back sharply on new loans and is desperately trying to survive on its servicing income. This role may achieve higher prominence (and fees, undoubtedly) now that regulators are urging loan workouts. First Data, a junk credit, is going to have to pay through the nose for loans.

Brad Setser continues his attempt to understand China’s USD holdings … an interesting and potentially lucrative specialty! The Chinese have not yet weighed in regarding Credit Rating Agency regulation, but Josh Rosner has. This last one is interesting because it’s the first balanced (which is to say, non-hysterical) approach to the topic I’ve seen. Mr. Rosner wants the following reforms (bolded; my comments in italics):

• ratings for structured securities use a different scale—say, numbers instead of letters—to differentiate them from ratings for corporate and municipal bonds. Cosmetic. Possibly useful if it can be shown that such securities have a genuinely different risk/reward profile than regular bonds, but it raises the spectre of different scales for each sector of the economy.
• He believes the agencies need to step up the training for analysts Training is a motherhood issue. Every time there’s a train wreck, we hear more calls for increased training of engine drivers. I’m OK with requiring some kind of registration for credit analysts, but (having fulfilled my regulatory educational requirements) I’m extremely dubious about the potential for this having much value.
• and should be compelled to re-rate transactions regularly rather than monitor them haphazardly. “Haphazardly” is rather a loaded word and I’d like to see more details about why it was chosen. This strikes me as micro-management.
• Furthermore, he thinks efforts should be made to distance the agencies from Wall Street. He proposes that any ­ratings-agency employee involved with a structured-finance deal for a Wall Street firm should have to wait a year before being able to join that firm. Such a waiting period already exists for auditors. No, no, a thousand times no! In the first place, acting as a credit analyst is simply an advisory function; there is no legal force to the analysts’ work. I definitely support such rules for employees of regulators – they have all the power of the State behind them when they exercise their function – but to extend this to credit analysts is going too far. They are advisors, only advisors, and should not be subject to employment restrictions that are any more stringent than those that exist for other advisors.

Redemption demands have led one fund to close, but the managers are now trying to put together a vulture fund. An internal Deutsche Bank unit is being shut down. And so the wheel spins…

US equities had a great day on speculation the Fed will cut two notches to 4.75% at their next meeting; Canadas were also strong on hopes fears that hurricanes in the Gulf will be destructive.

It was a quiet day for Treasuries, with some steepening; Canadas followed.

I hope to update the indices, performance and volume tables tomorrow.

Update, 2007-09-07

A rousing day in the markets to cap a tumultuous month!

There will be some kind of assistance – not a bailout, honest – for delinquent mortgagees:

Under Bush’s plan, the FHA during the fiscal year beginning Oct. 1 would help in 80,000 more refinancings than under current programs, FHA Commissioner Brian Montgomery said in a conference call with reporters. The agency plans to help 240,000 homeowners refinance during the period, compared to about 100,000 during the fiscal year ending Sept. 30, he said. FHA intends to increase refinancings to more than 600,000 within the next three years.
…
In the first quarter of this year, the FHA serviced about 3 million mortgages, 12 percent of which were delinquent or in foreclosure. Nationwide, the Washington-based Mortgage Bankers Association reported about 44 million mortgages in existence with an overall delinquency rate of 4.8 percent.

I’ll admit, I’m not entirely sure how much difference this will make … but one can be sure that the Democrats will find some way of trumping it as the Primary and Presidential cycle continues.

At the conference at Jackson Hole, Bernanke made it clear that the Fed would give some kind of assistance – not a bail-out, honest – to the financial system:

“The Federal Reserve stands ready to take additional actions as needed to provide liquidity and promote the orderly functioning of markets,” Bernanke said. He also made clear he won’t rescue investors from bad decisions.

Bloomberg has published the full text of the speech, complete with references. The WSJ has published some reactions to the remarks. In the meantime, inflation news is also good which may provide a veneer of respectability to a rate cut at the next FOMC meeting.

James Hamilton at Econbrowser has reported on the conference but, in my mind, was trumped by one of the commenters, a reader with the sobriquet “Constantine”:

If memory serves, the 1st edition of Shiller’s Irrational Exuberance came out in March 2000. The 2nd edition with expanded coverage of the housing market followed in 2005.

As soon I get word of a 3rd edition going to press, I’m going to fuckin’ liquidate everything I own.

Thanks, Constantine! It’s been a long month – I needed that.

The WSJ is reporting on the conference and has provided more detailed reviews of today’s papers: Should the Fed Target Housing; The Tension between Traditional Economics and Bubbles; and After the Mortgage Revolution the Terror – the last of which highlighting the authors’ view that:

the revolution has still been positive: “mortgage markets that are linked to capital markets are better for consumers and investors, than mortgage systems where the price and allocation of mortgages is determined by the government.”

Thank heavens … it hasn’t been often lately that I’ve seen an endorsement of the free market. I was also heartened to see that The Economist and I are in agreement:

But what look like incredibly sophisticated strategies on the surface can still be very simple at heart. Investors have been doing what banks have done over the centuries, borrowing short and lending long. Or, to put it another way, they have borrowed in liquid form and invested the proceeds in illiquid assets.

They also provide a link to what looks – at a very quick glance – to be a fascinating paper:Market Liquidity and Funding Liquidity, which I may review here … sometime …

Creative destruction in the mortgage business is continuing:

Citigroup Inc., the largest U.S. bank, agreed to buy the wholesale mortgage origination and servicing businesses of ACC Capital Holdings, operator of Ameriquest Mortgage Company and once the nation’s biggest subprime home lender.

Truly, one of the greatest pleasures in life must be access to cash in a buyers’ market!

US equities rose to the point where they were actually up on the month – which I will admit I find shocking. I’m glad, sometimes, that I’m not an equity guy. Canadian equities also rose but are down on the month.

Treasuries finished August’s wild ride with an upwards shift of 4-5 bp, but the big story is the month’s massive steepening of about 18bp.  Will it continue or reverse? Place yer bets, gents, place yer bets … the wheel spins again starting Tuesday.

Mutual funds’ retail cash flows show a move into junk bonds and a slackening of the move out of investment-grade. together with the equity data, it would appear that greed is beginning to triumph over fear!

It was another light day for preferreds – there seems to be some interest in BAM.PR.N at the current price, since it has been in the volume leaders table very often lately.

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

A relatively quiet day!

The Fed’s discount window is less dusty nowadays, averaging $1.3-billion in loans – but $1.3-billion isn’t a lot in the great scheme of things.

“There are very few people in the money markets that I talk to who think it is providing any relief beyond psychological relief,” said Christopher Low, chief economist at FTN Financial in New York. “It is too expensive. If a bank has decent credit, they can get a much lower rate in the market” than the discount rate.

True enough … but I’d hate to see what the market would look like if it didn’t have some psychological relief!

In a somewhat-sort-of related post, Tom Graff looked at Fed Funds today, as did the WSJ.

A reporter joined in the ‘blame the rating agency’ chorus today:

Moody’s recently added some new phrases to its lexicon of code words. When the rating company refers to “updating its methodology” or “refining its risk assessments,” what it really means is that its historical models say absolutely nothing about how the future might turn out.

Last week, for example, Moody’s summarized “the most recent refinements” to how it treats bonds backed by so-called Alternative-A mortgages. “In aggregate, the change in our loss estimates is projected to range from an increase of approximately 10 percent for strong Alt-A pools to an increase of more than 100 percent for weak Alt-A pools,” Moody’s said.

So a mortgage-backed security with a rating based on, say, a 1.5 percent loss rate might now suffer 3 percent losses in its collateral, Moody’s said. How’s that for missing something the first time?

The reporter did not disclose his track record; nor did he provide an indication of what it is he thought that Moody’s missed. The story was about the Solent & Avendis meltdown – the structures have been forced to sell assets for anything they would fetch after failing to refinance their ABCP. Quite a few shops haven’t refinanced! Commercial Paper outstanding continued to decline and is now down $244-billion in three weeks:

The total fall in the commercial paper may end up at $300 billion, the amount of mortgages funded by asset-backed commercial paper, wrote Tony Crescenzi, chief bond market strategist for New York-based Miller Tabak & Co. LLC, in a note today.

Poor Bernanke! Despite plaudits from Barrington Research (and me, by the way), he’s going to get an earful at the Jacksons Hole conference this weekend: 

The “big debate” will be about how subprime mortgages were turned into gold-plated securities, especially the collateralized debt obligations that have caused the headaches, said Hale, president of Hale Advisors LLC in Chicago.

Headaches is definitely the word, as investors and principals of Basis Capital can tell you:

The Yield Alpha Fund has assets of $100 million. That’s down from $436 million at Jan. 31, according to Bloomberg data. 
…
Basis Capital asked a Cayman Islands court for permission to liquidate the fund, according to a petition filed in New York yesterday

There is a growing school of thought that feels the problem is asymmetric information but, frankly, I’m not sure if any regulatory regime that addressed that issue in particular will have the desired effect. In order for information to be useful, the purchasing portfolio manager must

• be able to get the information
• analyze the information
• draw logical conclusions from the information

I’m not convinced that a regulatory solution to step one will necessarily lead to steps two and three. And I suspect that it’s impossible to enforce due diligence in a broad and consistent manner. “Due Diligence” means “Having a bunch of binders in your office somewhere”.

The investment business is more about sales than performance and diligence. And to the extent that performance does matter:

Pushed by fierce competition to make it to the “funds-of-the week” top-ten list of pseudo-specialised financial reviews, with the comfortable belief that one will be handsomely compensated in the case of success and allured by the possibility of diversifying much of the risk away, many funds’ managers have probably taken up an increasingly inefficient amount of risk. A correct assessment of risk should instead consist in compensating funds managers just slightly less if the fund is listed, e.g., eleventh in the ranking (if only such an ideal ranking existed!)³. To be sure, this potential source of inefficiency does not lie in the funding of subprime loans per se, but in the excess funding of risky projects due to a perverse/distorted assessment of risk.

And it’s not just sub-prime:

Freddie Mac, the second-biggest U.S. mortgage finance company, reported quarterly profit fell 45 percent after setting aside $320 million for losses as the housing slump deepened.

as a lot of mortgage defaults are investments. However, there’s still plenty of money for good credits:

Rio Tinto Group, the world’s third- largest mining company, raised $40 billion in loans for the purchase of aluminum producer Alcan Inc., a record for a U.K. borrower.

…even for American companies:

General Electric Capital Corp., the financing arm of the world’s second-biggest company by market value, sold $3.2 billion of hybrid bonds in pounds and euros.

US Equities were off a bit, led by financials:

Lehman reduced its earnings estimates for investment banks two days after Merrill Lynch analysts slashed their projections. Financial shares in the S&P 500, which comprise about one-fifth of the index’s value, are headed for their worst quarter in five years amid concern that higher borrowing costs spurred by mortgage defaults by the riskiest borrowers will erode earnings.

It’s not just cost of funds that will have the investment banks worried – it’s possible wind-up or delevering of their best customers that is causing concern:

“The recent expansion of hedge-fund positions and trading activity has been so rapid and consistent that it is now no exaggeration to say that hedge funds are no longer just an important part of the market in some fixed-income products; they are the market,” according to the report, which covered the 12 months ended in April.

Hedge funds accounted for more than 80 percent of trading in the debt of financially distressed companies and high-yield derivatives such as credit-default swaps, the Greenwich, Connecticut-based consulting and research firm said. The loosely regulated investment pools generated almost half of U.S. trading volume in structured credit.

Canadian equities fell too, on growth concerns. Silly traders! John Tory’s election platform calls for continued normal growth and we all know what superstars of fiscal acumen the Ontario PCs are!

With all these scares US T-Bills continued their amazing journey and yield less than 4% again. Treasuries had another good day, with a parallel shift 5bp downwards. Canadas underperformed quietly.

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

OK, everybody! The end of the world, previously scheduled for Friday, has been cancelled. You are encouraged to make plans for the long weekend.

Loyal readers will know that I’ve become sufficiently irritated by calls for increased regulation to write a post on the topic (well, it’s really just a commentary on another essay) and even to initiate a category for what promises to be a series of posts. I don’t think the issue is going to go away any time soon … the New York Times has published an article with many interesting statements:

“In a globalized economy with hedge funds, leveraged buyouts and all these investment funds, we have to ask the question about more transparency,” said Claude Bébéar, the chairman of the supervisory board of the insurance company AXA

I have some free advice for M. Bébéar: ask these questions before investing.

Washington and London rebuffed the German government earlier when it pushed for an international code of conduct for hedge funds. Now some economic advisers to the German government are going further, suggesting that rating agencies should be nationalized, that large-scale loans be registered publicly and that minimum standards be developed for complex debt securities.

Super. “We’re from the German Government and we’re here to help you”. Can’t wait for that. Trouble is, the US national debt, fiscal deficit and trade deficit are all in such lousy shape that the US is not in a strong position to tell its creditors where to stuff their nationalized credit rating agencies. We shall see!

Christian de Boissieu, president of the group and a member of the Committee for Credit and Investment Institutions, which helps regulate French banks, is calling for a global register of hedge funds. In addition, he said, complex securities should be scrutinized before being sold to bank portfolios.

Is M. de Boissieu claiming that complex securities were not scrutinized before being bought by bank portfolios? Quick, tell me which banks! I want to buy a lot of puts on such poorly run stocks … except … um … French banks are halfway nationalized already aren’t they? And thoroughly scrutinized by … um … M. de Boissieu?

“It’s not just the U.S. regulators that failed, though they did fail,” Mr. Rosner said. International regulators have “thrown the keys to the rating agencies,” which have been left in charge of the safety and soundness of bank capital, insurance and pension money.

The article did not specify where the regulators are alleged to have failed. Pension money? Sorry, Mr. Rosner. Responsibility for pension money rests with the pension fund board. If they’ve been sleeping there are lots and lots of regulations on the books about that already.

Oooh, all this jockeying for regulatory power and salaries makes me angry! I do want to stress again, however, that my defense of the ratings agencies does not have an origin in any thought that they’re perfect. They’re not: Credit Anticipation is a perfectly good fixed income management strategy, one that Deutsche Bank has done very well with recently, although maybe that’s just because they’re German and have good connections with the German Government Credit Ratings Analysis Department.

However … in the first place, they offer investment advice. See that word? I’ll bold it. advice. If you don’t trust their advice, don’t take it. If you think their advice is sort-of usually OK but not perfect, then listen to it while checking it and staying diversified. If you believe so completely in their advice that you’re willing to lever up 15:1 (with all your money, not just a small chunk of it as your ‘hedge fund flutter’), on the basis that not only is it perfect but that everybody else will also always believe it’s perfect … then go home and play with your dollies.

In the second place, they major agencies have extremely good track records. Better than virtually all of their critics are willing to disclose, anyway.

And in the third place, I have yet to see any actual evidence that they’ve made any mistakes other than, possibly, the defaults on some ABCP issues. This is a black eye, definitely, but are due to market convulsions rather than actual deterioration of the underlying; market convulsions are very hard to predict. Shall we fault them, for instance, for the fact that 100-year floaters (e.g. Royal Bank) are now almost impossible to sell at a decent price [CUSIP# 780087AK8. Indicated at $94.50]? If recovery is (eventually) 100% it’s not the worst catastrophe finance has ever seen.

So there.

Return to my usual boring drone about economics, there is renewed discussion of the efficiacy of the yield curve in predicting recessions. Some of the data looks a little dated already:

The spread has turned negative with the 10-year rate at 4.79 percent and the 3-month rate at 4.83 percent (both for the week ending August 10).

With luck, however, the German government will soon regulate yield curve slopes and then we’ll never have a recession again. Econbrowser notes that the Fed Funds market is starting to look almost normal again. Tomorrow the US Treasury will release statistics on Commercial Paper Outstandings, which should be quite interesting. RAMS is liquidating as well as Cheyne, to name but two.

The US mortgage market is tightening, with banks both having less money to lend AND not being able to securitize as efficiently as they used to. The mortgage curve is now inverted, which seems very strange. All the short money has been sucked up by distressed ABCP issuers. Bernanke has opined that US Agencies should stick to securitization and not increase their leverage for the time being, which probably disappoints many.

US Equities roared back from the horror of yesterday and were accompanied by their Canadian cousins. Three-Month US T-Bills continued their wild ride (this is really strange, by the way) even as Treasury notes got whacked. Canadas were hurt as well, in what may be dubbed a Flight to Equity.

There has as yet been no comment from the German Government concerning the correct level of bond yields.

It took nine straight days of gains, but the PerpetualDiscount index is now up on the month, albeit marginally. Only floaters and splitShares are still under water.

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

Whoosh!

Just when you thought you were safe …

I was most impressed today by the DG.UN suspension of redemptions, a made-in-Canada $1.4-billion whoopsee, when in comes news of S&P’s downgrade of Cheyne, a $6-billion oopsy-daisy. According to S&P’s actual release (emphasis added):

Cheyne Finance is a SIV structure managed by Cheyne Capital Management Ltd. who has responsibility for purchasing assets, managing the portfolio, and overseeing the issuance of CP and medium-term notes.
 
Current pressure on market prices and the associated recent deterioration in the net asset value (NAV) of this vehicle have reached a level where the ratings have come under pressure.
…
The portfolio is predominantly invested in real estate securitizations, and we note that the portfolio has not suffered any downgrades to these underlying assets.
 
We have been notified today that the vehicle breached its major capital loss
test and so an enforcement event has occurred. In accordance with the program documents, the portfolio manager upon consultation with the security trustee may begin an orderly liquidation of assets and by Aug. 30 it will estimate the expected proceeds from future liquidations.

Both the “Issuer Credit Rating” and the rating on the Senior Notes has been downgraded from AAA to A-[Watch Negative]. Those of you who are in furious disagreement with my defense of the ratings agencies and eager to see me with egg all over my face (which I know is practically all of you, you’re not fooling anybody) will be most pleased!

What makes this event notable is the bolded disclosure above that this event results from a decline in market prices of the underlying security, not simply an inability to roll the paper at sensible prices. I eagerly await more information regarding Euromoney’s Best CDO Manager of 2006.

The good part about these events with Cheyne is that some actual liquidation of the underlying portfolio will take place. This will lead to at least some delevering of the financial system – this calling on bank lines stuff merely transfers debt. Some equity guys will be wiped out, but that’s what equity guys are for.

There’s more ghoulish news about liquidity exposures, this time from the Times:

State Street, the American bank, has been identified as having $22 billion (£10.9 billion) of exposure to asset-backed commercial paper conduits, the off-balance sheet vehicles that have caused severe problems for rivals in recent weeks amid turmoil in credit markets.

According to regulatory filings, the Boston-based bank has credit lines to at least six conduits, which account for 17 per cent of its total assets. That proportion makes State Street the most highly exposed bank to conduits among its European and American peers.

17% of assets is a very lot. On a positive note, their most recent 10-Q filing discloses that the bank had a Tier 1 Capital ratio of 12%, which is quite good, equal to TD Bank’s ratio as of last year-end, which was the best of the big 5. Even if we divide their 12% by 1.17 to get a ballpark idea of capital adequacy in the event all their lines get called on, we’re still in excess of 10%, which is still quite reasonable. But holy smokes, that’s a lot of lines!

Meanwhile, credit card delinquencies are rising while housing prices are falling, not a great combination.

The Fed’s trying to help! More banks got an exemption allowing them to lend discount money to their broker subsidiaries and I think we can count on this sort of thing being earnestly debated at this weekend’s Jackson Hole conference.

However, I can now provide links to another panic: the Panic of ’07 (not this ’07, the last one), brought to my attention by the WSJ Economics blog, which has some interesting-sounding links to papers I haven’t yet read. If I do read them and they’re good, I’ll post again. Panics, panics panics! Collect them all at PrefBlog!

In other news, some brave Australians are putting together a $1.9-billion LBO, Brad Setser discusses a claim that sub-prime was dumped on the Chinese, jumbo mortgages have become much less available, which is hitting Californial real-estate where the average house needs a jumbo loan and European politicians are planning to do some credit-crunch grandstanding.

Given the gloomy tone of today’s post, nobody will be surprised that US Equities got hammered, mainly financials. Canadian equities got pasted as well, but here it was mainly commodity-related stocks. Treasuries steepened on a banner day with more of the same for Canadas.

Preferreds had quite a good day, ignoring the stock market and the credit concerns. But it’s always the way! No sooner do I point out what a lousy month the splitShares are having than they have a great day and make up half the difference between their returns and OpRet’s. It’s nice to see, but maybe I should just keep my mouth shut from now on.

BAM.PR.N had very high volume today, courtesy of two large blocks crossed by Scotia. I have no idea whether that’s cleaned out their inventory or not, but it’s about time we saw some big-time crosses! Volume in general picked up, which is good to see … equity refugees?

BMO.PR.G has been removed from the OpRet index because it no longer exists. It’s the end of an era … the world was different at the time of its first month-end in the index, February, 1998.

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

Another reasonably normal day, bearing in mind that we’re talking about financial markets here and the word “normal” needs to be taken with a grain of salt.

Of great interest to me (I dare not say, “Of prime interest”, for fear of being misunderstood) was the Bank of Canada’s cash management bill, $2.5-billion of one-month bills to be auctioned tomorrow morning. They had to do something! The spread between 1-month bills and one-month CP as of the 24th had widened to 137bp (out 40bp just on the week) which I find just incredible … I mentioned on the 21st that I thought a 60bp three-month Bill/BA spread was amazing.”Cash Management Bill” is simply what they’re calling it – I’m not even sure if they can call it anything else, given that it’s not part of the regular auction routine.

I suspect that all the actual cash will be pushed right back into the money supply as loans against ABCP (maybe indirectly, e.g., National finances all the ABCP it suddenly owns by repo-ing more of its Canada holdings) … but I’m sure only a few people know that for sure at this point.

Bank of Canada deputy governor Pierre Duguay stated:

“Specifically, we are asking ourselves two questions: First, how much greater is the risk to the Canadian economy now posed by developments in the U.S. economy? And second, to what extent would the re-pricing of credit risk lead to a sustained tightening of credit conditions in Canada?”

In other words, they may have to ease considerably just to keep the commercial paper market (and the rest of the corporate curve) where they want it to be. We’ll see! The money-market quality spread has, maybe, stabilized in the US.

Speaking of the US, Brad Setser continues his probing of the current account deficit, Menzie Chinn highlights risks to the US deficit projections and Stephen Cecchetti reviews the Fed reaction to the crisis. He also includes the sentence

The sub-prime crisis made it clear that the rating agencies were doing a poor job of evaluating risks in securities that were backed by sub-prime mortgages.

but does not substantiate the charge that they’re doing a poor job. But that’s another post … and doubtless many more, as actual data start to come in to replace all this guessing.

I hope nobody thinks I’m totally indifferent to the situation, or that I’m carrying a torch for the ratings agencies. It’s just that … I’m not the oldest guy in the business, not by a long shot, but I’ve been around the block. If I had a nickel for every time I’ve been told the world’s about to end (and a dime for each time it was the result of a conspiracy or massive negligence by big institutions) … I’d be too busy with my troupe of dancing girls to bother writing this blog.

A lot of hedgies are going to get wiped out and the sooner the better; a few pension funds are going to play blame the manager; credit squeezes and the sudden conversion of Money Market instruments to term debt a la Coventree may give a recessionary cast to the economy; the US may well enter a recession, since a lot of their deficit-fuelled growth in the past few years has been housing-related and there ain’t gonna be much more of that; a few real companies will probably get weak enough that they get taken over at prices that don’t make long-term shareholders very happy (like just happened to Sachsen, mentioned here on August 20); and we might even see a spectacular flame-out if a big institution’s risk-controls are found wanting  … but I’m not so sure that the solidly investment-grade tranches of sub-prime debt are as bad as they’re made out to be.

What I am sure of, is that if I was a hedgie myself, I’d be bidding … low. And telling the newspapers how awful everything is.

US Equities fell a bit, as did those in Canada. There is concern that the de facto easing will be bad for Treasuries; the Fed Fund Futures are pricing in an immediate ease to 5.00% (the current de facto rate) and another ease to the 4.75% area – and beyond – by November. Canadas had a good day, with a basically parallel shift.

Another quiet, directionless day in pref land. Split shares are getting hit this month … people appear to want direct investments in companies with recognizable names!

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

Another normal day! At this rate, I’m going to have to make notes when preparing remarks about ‘What happened in August’!

The Fed made it clear that it will accept ABCP at the discount window. This will aid in delevering the financial system since it makes it easier for the banks to buy, or to lend against, the ABCP that has been issued in an attempt to avoid the banks. The latter process is referred to as disintermediation; I’m not sure what to call the process of reversal.

In related news, two Canadian sub-prime lenders have tightened their standards, citing inability to fund the loans at a decent price.

There was good economic news in the US (especially durable goods orders) … but that was for July! Considerable uncertainty remains over how the recent events will affect the real economy.

Brad Setser speculates, based on foreign official reserves held in custody at the Fed, that private investment in emerging economies is being reduced – funds reducing risk, funds meeting margin calls.

On the other hand … US equities capped a fine week with a good gain and Canadian equities did even better. So who knows? Markets will do what markets want to do when they want to do it.

But in signs that many, anyway, are calming down after the panic the US bond curve flattened and

Benchmark 10-year notes rose as traders said corporate bond sales created demand for long-term products sold earlier as hedges.

So in general, it would appear that term is being extended (even if merely via intermediaries), which is a Good Thing. Canadas flattened a lot with the 2-10 spread moving to 12.1bp from 19.1bp.

A quiet, directionless day in pref land.

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

At last, a normal, quiet day in the summer! I had almost forgotten what those were like!

The big news, as far as I’m concerned, is the release of Fed statistics that illustrate the continued delevering of the financial system; the amount of outstanding US ABCP down over 4% on the week:

More than half of the $1.1 trillion in outstanding asset- backed paper comes due in the next 90 days, according to the Federal Reserve. Unless they find new buyers, hundreds of hedge funds and home-loan companies will be forced to sell $75 billion of debt, according to Zurich-based UBS AG, Europe’s largest bank.  

Those sales would drive down prices in a market where investors have already lost $57 billion, based on Merrill Lynch & Co.’s broadest index of floating-rate securities backed by home- equity loans. That may hurt the 38.4 million individual and institutional investors in money market funds, the biggest owners of commercial paper. Top-rated commercial paper is one of the world’s safest assets.

In Europe, the asset-backed commercial paper market is almost closed, Reynold Leegerstee, team managing director for Moody’s Investors Service, said on a conference call today.

My guess is that we’re going to see some more blow-ups, perhaps even large and exciting blow-ups. Paribas is re-opening the redemption window for the famous three funds that accellerated the panic; but there will be redemptions on the order books now for many funds and more to come when investors get their statements.

The lock-up in the ABCP markets is going to lead to exciting times (and bargains!) as financing intermediaries are forced to dump their holdings on the market for whatever they can get; such are the perils of leverage and term mismatching and the Fed’s pushing of the discount window (and other techniques, such as a lifting of the cap on Citigroup’s loans to customers via Citigroup Global Markets) is intended only to ensure that there is a market; they don’t care whether or not it’s a good and friendly market.

But so far, I’d say, so good. The damage has largely been confined not just to the financial system, as opposed to the real economy, but to hedge funds – and it is their function to absorb risk and trade it for return. It’s far too early to celebrate – assuming that the worst is over, effects won’t show up until Christmas – but right now we’re hearing of hedge fund redemptions being stopped and large financial institutions taking write-downs; we’re not learning of huge corporations bouncing their payroll cheques. But we’ll see! Things can always get worse and there’s still a lot of tension in the corporate bond market.

TD Bank released its results today and claimed that its underwriting of the BCE / Teachers deal is a really good piece of business. Well gee, if the salesman says it’s good, maybe we should all rush out and buy some, eh? There’s another one that we’ll just have wait and see about … at today’s close of 39.67, BCE common is still 7.2% below deal price, so those who are confident the deal will get done as described still have lots of chance to make some good money … at a higher yield than ABCP paper!

In other news we have another argument that it’s all Greenspan’s fault; an explanation of Countrywide’s financing requirements; and a discussion of Treasury’s problems with the IMF.

US equities were quiet, as were their Canadian counterparts. Treasuries barely moved and Canadas were boring, although some flattening was seen, reversing some recent trends. A quiet summer day, in fact.

Things were just as quiet in the preferred share market at it drifted up in lazy trading. Just how much up and how lazy is, however, something you’re going to have to wait for, since I’ve run out of time and will have to update the tables tomorrow.

Update, 2007-08-24

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

Well, the press is certainly champing at the bit to announce a return to normalcy!

In the best news of the day HSBC Canada issued a press release that included the paragraph:

HSBC Investment Funds (Canada) Inc., manager of the HSBC Mutual Funds, and HSBC Investments (Canada) Limited, manager of the HSBC Pooled Funds, confirm that there is no exposure to third party asset backed commercial paper within any of these Funds.

Finally! Some explicit recognition in all this mess that there is a difference between the corporation’s interest and the subsidiaries fiduciary function. It isn’t much and it isn’t any kind of proof that all is well with separation of function at HSBC Canada (any more than the press releases that aroused my ire in the past two days are any kind of proof that there’s anything wrong at National Bank and Industrial Alliance) … but the more that such a distinction is mentioned in public, the more willing I am to believe that the distinction is part of corporate culture.

All this Independent Review Committee stuff has to be good for something, right?

In Canadian ABCP news, NAV Canada (beloved of all those who pay for airline tickets) announced that it:

holds approximately $368 million of non-bank R-1 (high) rated ABCP allocated among its reserve funds and accounts required by its debt indentures.  The Company has approximately $130 million of cash and cash equivalents not affected by the problems in the non-bank ABCP market.

It is, of course, cheap and easy to point out investment mistakes in hindsight, so I’ll try to show a little restraint … but that means about three-quarters of their cash is held in non-bank Canadian ABCP. They may wish to review their diversification policies.

Amidst fears that liquidity infusions are being hoarded by the top-tier banks four major banks were jawboned by the Fed into using the discount window and letting the credit trickle down. Bernanke is using a more targetted approach than Greenspan used for the 1998 LTCM crisis … we shall see how it all turns out! If he can get away with it, there will be less bleeding of easy credit into the real economy and less chance of a renewed asset bubble. At present, the Fed appears to be defending a 5% Fed Funds rate but Bernanke’s got lots of time to decide whether or not to make the de facto easing de jure. The futures traders appear to believe in a three month ease, then back to the anti-inflation grind.

There is still a lot of stress in the global system despite a pause for breath in US markets. Investors should remember the Fed doesn’t really care about them. We can only hope that the politicians do not succeed in getting the Fed to bail out mortgagors, but it is election time in the US, after all, so there’s bound to be a lot of showboating.

Meanwhile, the default statistics on securitized loans mentioned yesterday are being confirmed by statistics on mortgages held directly. Lenders are reacting ruthlessly to the changed climate, with three lenders firing 3,700 employees. Remember “creative destruction”? This is the nasty second part, and we’ve only just begun:

two European mortgage-securities funds had their credit ratings slashed to junk from AAA by Standard & Poor’s because debt market turmoil curbed access to short-term financing.

Even more seriously, Wall Street bonuses are threatened. On the other hand, in late-breaking news it was announced that Bank of America’s putting $2-billion into Countrywide. So things are – very slowly and jerkily – working as they should.

At least one hedge fund is experiencing knock-on effects of the credit crunch. Stratus has 25% of its assets in Sentinel, which suspended client redemptions on August 14 – which may, in fact, have more to do with fraud than liquidity.

The Chinese have bought up a huge amount of high-quality housing debt over the past few years.

Here’s a good question to ask your friendly neighborhood US Equity Quant: “how do you distinguish between the various levels of financial instrument valuation“? Without having to gain access to the quantitative code and other trade secrets, you should be able to come to a reasonable judgement of skill level by the answer to that question!

US Equities had a very good day as traders decided the world might still exist at the time today’s trades settle. Canadian equity roared upwards, but is still down a bit more than 7% from the July peak. We shall see what happens if Tom Graff’s musings on the potential for re-pricing of as-yet unsettled private equity takeovers should prove to be prophetic with respect to the Teachers’ / BCE deal.

Treasuries fell, with the 2-10 spread flattening 6bp. Some investment grade issuers raised funds, reducing reliance on short term credit, for instance:

XTO Energy Inc. reopened a bond sale yesterday, raising $1 billion to pay down commercial paper, according to a regulatory filing. Fort Worth, Texas-based XTO yesterday sold five-year, 10- year and 30-year bonds.

After all … look at the alternative:

Asset-backed commercial paper yields rose to the highest in almost seven years after H&R Block Inc., the biggest U.S. tax preparer, said a unit tapped $850 million in credit lines because it couldn’t sell the short-term debt.

Canadas fell, with the 2-10 spread flattening by 7.4bp, in what was hailed as an indication that the market has been pricing in too catastrophic a disaster.

It was a quiet and calm, but none-the-less positive day for Canadian preferreds. There was good volume and a confluence of prices with BAM.PR.M / BAM.PR.N, so it may be that those issues are normalizing after recent wild oscillations … subject to “normalizing” being a meaningful word, that is!

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