Issue Comments

RPA.PR.A / RPB.PR.A / RPQ.PR.A Hit by FannieFreddieFiasco

The companies, which share a common manager/sponsor have announced:

On Sunday the US federal government announced its intention to place government sponsored entities (“GSEs”) Fannie Mae and Freddie Mac (both rated AAA by Standard & Poor’s) under conservatorship. The government’s actions, taken through the Federal Housing Finance Agency, the US Department of the Treasury and the Federal Reserve, are intended to reduce risk in the mortgage financing market.

The use of a conservatorship as the vehicle by which to carry out the changes, however, has potential consequences for ROC Pref II Corp.(“ROC II”), ROC Pref III Corp. (“ROC III”), and Connor, Clark & Lunn ROC Pref Corp. (“ROC IV” and collectively “the ROCs”) which have exposure to both Fannie Mae and Freddie Mac in their respective Reference Portfolios. As discussed in greater detail below, based on current information, we believe the impact on ROC II and ROC IV will be minimal. The impact on ROC III, however, could be more significant.

In the credit default swap (“CDS”) market, contracts are written using standardized language as set out by the International Swaps and Derivatives Association (ISDA). The ROCs apply this standard set of terms. Under ISDA terms, conservatorship is included as part of the definition of a credit event and therefore the government’s actions could be construed as a credit event that would impact the ROCs. Most large investment banks who are ISDA members have disclosed to ISDA that they interpret the conservatorship to be a credit event under the ISDA definitions. ISDA has announced that, after consultation with industry participants, it will launch a protocol to facilitate settlement of credit derivative trades involving Fannie Mae and Freddie Mac. ISDA will publish further details in due course.

The net economic impact of the government’s actions was to decrease the risk of default on the senior debt of the GSEs and there are some differences between this circumstance and the actions of a typical conservatorship, therefore we believe that there will be substantial on-going discussions regarding the impact of these actions on the CDS market in general and the fixed recovery rate swaps in particular. As of the time of this release the ROCs have not received a credit event notice.

If the dealers who issued the credit linked notes pertaining to the ROCs interpret this event as a credit event, ROC II and ROC IV would likely experience minimal impact given the recovery rate is expected to be in the 95% to 100% range. ROC III [RPB.PR.A] however, has a fixed recovery rate feature which, in the case of a typical credit event, would limit the recovery rate to the fixed level of 40%. Fixed recovery rates were a feature that was commonly used in the CDS marketplace at the time that ROC III shares were issued. The rating agencies preferred the additional level of certainty that fixed recovery rate swaps provided investors by taking away the risk of very low recovery levels.

CDS Recovery Locks have been discussed on PrefBlog.

RPA.PR.A was last discussed on PrefBlog when it sustained a credit event from Quebecor World.

RPB.PR.A was placed on Credit-Watch Negative in June. In a development not reported by PrefBlog, it was taken off credit watch and affirmed at P-2(low) in August.

RPQ.PR.A was downgraded in May.

None of these issues are tracked by HIMIPref™.

Miscellaneous News

DiversiCapital Pulls Split-Share Offering

DBRS has announced it:

has today discontinued its provisional rating on the Preferred Shares offered by DiversiCAPITAL Global Dividend Split Corp. (the Company) because the minimum offering of shares of the Company was not achieved.

According to the Confidential Information Memorandum:

This memorandum is confidential and for the use of selling group members only. The contents are not to be reproduced or distributed to the public or press.

Oops, I didn’t mean to quote that part of the confidential information memorandum I found on the web via google, I meant to quote this part:

Preferred Shares: Approximately $40 million. Class A Shares: Approximately $60 million.
…
The Company has been created to provide investors with an opportunity to gain exposure to an actively managed, globally-diversified portfolio comprised primarily of equity securities of dividend-paying issuers selected by the Manager. The Company will invest in dividend-paying equity securities (“Dividend-Paying Equities”) of issuers (“Dividend-Paying Issuers”) that the Manager believes are trading at a discount to their intrinsic value and have strong cash flows and the ability to grow their dividends. Investors in the Company’s Class A Shares will receive leveraged exposure to the performance of the Dividend-Paying Issuers, including increases or decreases in the value of their equity securities and increases or decreases in the dividends paid on such securities. Investors in the Company’s Preferred Shares will receive attractive quarterly distributions on a fixed, cumulative and preferential basis.

diversiCAPITAL is a wholly-owned subsidiary of DundeeWealth Inc.

PrefLetter

Contest: Win a PrefLetter!

There’s a thread in Financial Webring Forum now titled Practically guaranteed to lose money that points out (as of September 8):

As I write, ACO.PR.A (TSX) is bid at 27.00.

Atco can call this issue at 26.00 plus 0.36 in dividends on 2008-12-01.

PrefInfo tells us the redemption schedule is:

  • Redemption 2008-12-01 2009-11-30 26.000000
  • Redemption 2009-12-01 2010-11-30 25.500000
  • Redemption 2010-12-01 INFINITE DATE 25.000000

and that the retraction schedule is

  • Retraction 2011-12-01 INFINITE DATE 26.040000

The annual dividend is 1.4375, paid quarterly, with the last ex-date 2008-8-1 according to tmxmoney.com.

So: here’s the question … how might a rational investor reason that paying $27.00 for this issue has enough chance of at least a half-way decent return to make it worth while? This investor knows that the yield to worst is negative and that he’s taking a chance … why might he buy it anyway?

The answer is buried in one of my articles (click on the green squares down the right-hand margin of this blog). Only casually referred to … but it is there.

The best answer (or the first one that precisely matches my answer!) in the comments will get a free copy of the PrefLetter that will be published this weekend. Judge’s decision is final. Everybody’s eligible, even those poor benighted souls who don’t live in Ontario, because I’m not going to charge the winner for it. Contest closes immediately prior to my sending out this month’s issue, which will probably be sometime Sunday afternoon … but it could be anytime between 4pm Friday and 9:30am Monday.

Programme Changes

HIMIPref™: New Build Available 2008-09-09

As mentioned previously, differences in spreads for Floating Rate issues require a new build every time there is a new spread defined. Very annoying; if this craze for Fixed-Resets continues, I’ll have to try the hypervariable-code-as-Web-Service solution previously noted.

The Royal Bank new issue, with its heretofore unheard-of +193bp spread, has required a new build. This build is available from the usual place.

Market Action

September 8, 2008

Assiduous Readers will remember that on September 5 I noted a paper regarding foreign exchange rate prediction – there is another paper on VoxEU today titled Where are commodity prices headed next? Look at exchange rates by Chen, Rogoff & Rossi:

Figure 2 shows the rate of growth of the IMF global commodity price index (the US dollar price index of over 40 exchange-traded primary commodities, weighted according to world export earnings) since 1994. It has indeed been highly positive in the past 5 years, resulting in the high price levels shown in Figure 1. Our forecast based on the exchange rates, labelled “Model Forecast”, is strikingly close to the actual realisation. Indeed, we find that such forecasts of future commodity prices are significantly better than forecasts that rely on traditional statistical models, such as an auto-regression or a random walk.
…
This forecasting success of commodity currencies is no deus ex machina but has a sound and intuitive economic basis. It follows naturally from the fact that exchange rates are asset prices that embody expectations of future movements in macroeconomic fundamentals, specifically ones that will directly affect the exchange rates. For commodity currencies, global commodity prices matter to their exchange rate values.

I am hesitant to criticize anything by Rogoff (for whom I have great respect) in the field of FX (his speciality) … but as stated in this very brief article, the mechanism sounds a little circular. ‘We can’t predict FX rates, but we can use them to predict commodity prices, because they’re moved by predictions of commodity prices which predict FX rates’.

The best stab I can make – as a complete non-specialist, understand, and looking at no actual numbers whatsoever – is that FX rates might be driven by foreign takeovers of producers by other producers (a mechanism often seen in Canada over the past few years) who might have a better handle on balance of risks (impending shortages and lengthy order books) than might the general public. But this mechanism is not investigated in the paper.

Top credit market story of the day was, of course, the fallout from the Fannie/Freddie takeover. Mortgage Backed Securities gapped in big-time which generated a lot of duration buying, which caused Treasuries to rally.

Fixed-Reset issues celebrated their ascension to respectability (by which I mean, of course, incorporation into the HIMIPref™ database) by losing money. PerpetualDiscounts had a good day.

Note that these indices are experimental; the absolute and relative daily values are expected to change in the final version. In this version, index values are based at 1,000.0 on 2006-6-30.
The Fixed-Reset index was added effective 2008-9-5 at that day’s closing value of 1,119.4 for the Fixed-Floater index.
Index Mean Current Yield (at bid) Mean YTW Mean Average Trading Value Mean Mod Dur (YTW) Issues Day’s Perf. Index Value
Ratchet N/A N/A N/A N/A 0 N/A N/A
Fixed-Floater 4.57% 4.57% 64,659 16.06 6 +0.0139% 1,119.6
Floater 4.36% 4.42% 51,462 16.48 2 +0.0000% 902.4
Op. Retract 4.94% 4.26% 127,057 3.32 14 -0.0841% 1,053.6
Split-Share 5.32% 5.78% 50,534 4.33 14 +0.2933% 1,048.2
Interest Bearing 6.38% 7.05% 53,453 5.21 2 -0.5162% 1,106.5
Perpetual-Premium 6.15% 5.41% 60,382 2.22 1 +0.3953% 1,008.9
Perpetual-Discount 6.02% 6.09% 187,474 13.75 70 +0.1113% 884.4
Fixed-Reset 5.05% 4.89% 865.717 13.59 6 -0.1650% 1,117.6
Major Price Changes
Issue Index Change Notes
IAG.PR.A PerpetualDiscount -1.5633% Now with a pre-tax bid-YTW of 6.32% based on a bid of 18.26 and a limitMaturity.
POW.PR.D PerpetualDiscount -1.2458% Now with a pre-tax bid-YTW of 6.18% based on a bid of 20.61 and a limitMaturity.
SLF.PR.A PerpetualDiscount +1.1364% Now with a pre-tax bid-YTW of 6.08% based on a bid of 19.58 and a limitMaturity.
PWF.PR.L PerpetualDiscount +1.2623% Now with a pre-tax bid-YTW of 5.96% based on a bid of 21.66 and a limitMaturity.
CM.PR.E PerpetualDiscount +1.2903% Now with a pre-tax bid-YTW of 6.46% based on a bid of 21.98 and a limitMaturity.
CM.PR.P PerpetualDiscount +1.3195% Now with a pre-tax bid-YTW of 6.50% based on a bid of 21.50 and a limitMaturity.
SLF.PR.C PerpetualDiscount +2.7778% Now with a pre-tax bid-YTW of 5.91% based on a bid of 18.87 and a limitMaturity.
Volume Highlights
Issue Index Volume Notes
L.PR.A Scraps (would be OpRet, but there are credit concerns) 112,275 CIBC bought 10,000 from RBC at 22.35, then another 25,000 from Scotia at the same price. Now with a pre-tax bid-YTW of 8.31% based on a bid of 22.35 and a softMaturity 2015-7-30 at 25.00. Assiduous Reader adrian2 gets his wish and the Loblaws issue – very poorly received when issued in June – makes it on the board (again!) despite its less-than-stellar credit. I’d say that, as above, after two-plus months of trying, the underwriters have found a level where this thing will sell … and that they’re under the gun to get it off the shelf well before bank year end in October.
TD.PR.S Fixed-Reset 33,305  
BAM.PR.O OpRet 25,650 Now with a pre-tax bid-YTW of 7.41% based on a bid of 22.90 and optionCertainty 2013-6-30 at 25.00. Compare with BAM.PR.H (6.27% to 2012-3-30), BAM.PR.I (5.48% TO 2013-12-30) and BAM.PR.J (6.44% to 2018-3-30) … well … looks to me like they finally found their level and this is the inventory blow-out special!
BMO.PR.M Fixed-Reset 24,220 Nesbitt bought 13,000 from anonymous at 24.94.
BNS.PR.Q Fixed-Reset 23,576  
TD.PR.Y Fixed-Reset 20,924  

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

Regulation

DBRS Responds to EU Commission on Credit Rating Agencies

DBRS has published its response to a European Union commssion with a mandate described by some in terms that make it sound as more of a lynching than an inquiry:

It is generally accepted that CRAs underestimated the credit risk of structured credit products and failed to reflect early enough in their ratings the worsening of market conditions thereby sharing a large responsibility for the current market turmoil.

The current crisis has shown that the existing framework for the operation of CRAs in the EU (mostly based on the IOSCO Code of Conduct for CRAs) needs to be significantly reinforced. The move to legislate in this area was initially welcomed by the Ecofin Council at its meeting in July.

However, even the official press release shows an intense desire to scapegoat the credit rating agencies, rather than those who actually made the investment decisions:

The main objective of the Commission proposal is to ensure that ratings are reliable and accurate pieces of information for investors.

“reliable and accurate”? This is just another way of saying that investments should only be recommended if they go up.

DBRS stated in its response:

A key lesson for DBRS from the crisis was the need for additional transparency of its practices, policies and procedures and for additional education and dialogue with investors, regulators and other market participants regarding the role of a CRA and the meaning of a credit rating.

Very nice, very desirable, very useless.

There is already much more information available about everything than can be used, and there is far more information that can be used that there is that is used.

Any regulator that wants to get serious about discouraging herd behavior and bad analysis in the future will start by enforcing publication of returns. If you have a license, that license will – at least in North America – be verifiable on a regulatory website. If that license is being used in any way in an advisory capacity with respect to real live money … your composite should be published.

Proficiency is the ability to generate superior returns. All too often, it is measured by regulatory authorities as the ability to parrot introductory textbooks that may – or may not – have relevence to how the advisor actually formulates his recommendations.

Update, 2008-9-15: I found a response to this, a piece in the Guardian by David Gow:

The plans will force agencies to register, subject themselves to pan-European regulators and improve their corporate governance to avoid conflicts of interest with their client customers, including plans to rotate analysts every four years.

Bell, S&P head of structured finance for Europe, Africa and Middle East, said the proposals seemed to treat the ratings process as scientific, whereas mistakes were inevitable. “The provisions of the draft regulation are for regulators to have a direct influence on a variety of aspects of our work … They can take powers to make us desist.”

… rotate analysts every four years? rotate analysts every four years???? I’ve never heard a more moronic idea in my life. Take a guy off his desk, just as soon as he’s accumulated some valuable experience, for no reason other than rotation? That’s a thoroughly bankerly approach, an approach guaranteen not just mediocrity, but bland mediocrity. Which is an excellent way to run a bank, but rather less well suited for excellence.

PrefLetter

PrefLetter: Two New Recommendation Classes

The September issue of PrefLetter will be prepared as of the close on September 12 and eMailed to subscribers prior to the opening on September 15.

Two new classes of recommendations will be included:

  • Fixed-Reset: My disdain for Fixed-Reset issues as currently priced is well known, but some people like them! Clearly, some of these issues will be better investment choices than others. Now that the asset class has been added to HIMIPref™, a recommendation from this class of preferred share will be included with the other recommendations.
  • Short-Term: I do not usually recommend short-term issues for preferred share portfolios, due in part to the fact that the relatively low level of price volatility gives little opportunity for trading; also due to the idea that the recommendations are for long-term buy-and-hold investors. However, there is public demand for short-term issues. While I will not create a specific asset class for these issues, I will henceforth recommend at least one issue from the combined OpRet / SplitShare indices that would otherwise be ineligible for recommendation due to shortness of term. Note that by “short-term”, I generally mean (as is usual in the bond world) “less than five years”.
Data Changes

Fixed-Reset Issues Added to HIMIPref™

As promised, Fixed-Reset issues have been added to the HIMIPref™ database.

Additionally, a new HIMIPref™ sub-index has been added, the Fixed-Reset Index.

Minor, but annoying programming changes were required in order to add these issues. Each Floating-Rate issue requires what is currently a hard-coded schedule, specifying the base index to be used for the issues and the calculations required to obtain the projected floating-rate. This has been an easy matter in the past, since there have not been many new floaters added and since those that have been added have fit comfortably into extant classifications (e.g., Ratchet Rate, Canada Prime, max 100% of index, min 50% of index). Fixed-Resets, however, have a spread specified in terms of basis points; in order to specify the future floating rate for the current ten issues, nine different spreads neede to be hard coded.

Therefore, HIMIPref™ users must download the new executable in the usual way. Don’t forget to back up user files prior to installation!

There is a possibility that I might isolate the hypervariable sections of code and place them in a new web-service, with calculations and descriptions to be downloaded on the fly. This would mean that the front-end could stay constant; to add a new floating rate specification I would simply recode and reinstall the service on server-side, invisibly to users. However, I have not yet determined that this concept is practically possible or, if possible, whether or not it will simply lead to spaghetti code making future enhancements possible. Until I’ve made a decision, users will simply have to re-download and re-install the front-end every time the issuers come up with a new spread!

Miscellaneous News

Critchley Sounds Cautionary Note on Fixed-Resets

As noted by Assiduous Reader Tobyone in the comments to a prior post, Barry Critchley of the Financial Post has published a column with a cautionary note regarding this structure: Banks Big on Reset Preferred Shares:

Over the past six months, five of the chartered banks — the Big Six less the Royal Bank–have raised more than $2-billion by way of reset preferred shares, a security they hadn’t previously sold to the public.

But the security has been around for a long time, given that BCE, for example, issued a pile of them.

The Royal Bank announced a new issue today just to ruin his column.

However, it is not strictly correct that BCE issued a pile of them. The BCE issues were reset at a proportion of five year Canadas determined by the board; the floating-rate side were ratchet-rate preferreds that could (and currently are) paying 100% of prime.

Critchley notes the inflation-mitigating effect of this structure:

In a high-inflation world, that new feature allows investors to be offered market-type rates. That feature is better than what existed with the fixed-rate perpetuals where there was no ability in a high-inflation world for investors to receive market rates.

I noted the inflation-mitigating effect of this structure in the previous post on this topic, Harry Koza Likes Fixed-Resets. Naturally, I will grant “that feature is better”. Of course it is. What else am I gonna say? The question is not whether the feature is good or not, but how good is it and how much are we paying for it?

Mr. Critchley continues:

Investors giving up yield compared with buying a fixed-rate non-reset pref share: “In essence, you are paying a premium (in terms of a lower current yield) in exchange for inflation protection down the road that won’t likely materialize unless it is clearly in favour of the issuer,” he noted. “The only thing you know for sure is that you are taking long-term credit risk with a very uncertain compensation that is currently well below fixed-rate issues.”

Exactly my point.

Update, 2008-9-9: The source for the quotations in the column was the screen-name scomac, writing in Financial WebRing Forum.

New Issues

New Issue: RY Fixed-Reset 500+193

Royal Bank has announced:

a domestic public offering of $225 million of Non-Cumulative, 5 year rate reset Preferred Shares Series AJ.

The bank will issue 9 million Preferred Shares Series AJ priced at $25 per share and holders will be entitled to receive non-cumulative quarterly fixed dividends for the initial period ending February 24, 2014 in the amount of $1.25 per share, to yield 5.0 per cent annually. The bank has granted the Underwriters an option, exercisable in whole or in part, to purchase up to an additional 3 million Preferred Shares at the same offering price.

Subject to regulatory approval, on or after February 24, 2014, the bank may redeem the Preferred Shares Series AJ in whole or in part at par. Thereafter, the dividend rate will reset every five years at a rate equal to 1.93% over the 5-year Government of Canada bond yield. Holders of Preferred Shares Series AJ will, subject to certain conditions, have the right to convert all or any part of their shares to non-cumulative floating rate preferred shares Series AK (the “Preferred Shares Series AK”) on February 24, 2014 and on February 24 every five years thereafter.

Holders of the Preferred Shares Series AK will be entitled to receive a non-cumulative quarterly floating dividend at a rate equal to the 3-month Government of Canada Treasury Bill yield plus 1.93%. Holders of Preferred Shares Series AK will, subject to certain conditions, have the right to convert all or any part of their shares to Preferred Shares Series AJ on February 24, 2019 and on February 24 every five years thereafter.

The offering will be underwritten by a syndicate led by RBC Capital Markets. The expected closing date is September 16, 2008.

Issue: Royal Bank of Canada Non-Cumulative 5-Year Rate Reset Preferred Shares, Series AJ

Size: 9-million shares (=$225-million) + greenshoe 3-million shares (=$75-million) exercisable before closing.

Dividend: 5.00% until first exchange date; 5-year Canadas +193bp thereafter, reset every exchange date. Series AK (the floater) pays 90-day bills +193bp, reset quarterly.

Exchange Date: 2014-2-24 and every five years thereafter.

Redemption: Series AJ (the reset) redeemable every exchange date at $25.00. Floater redeemable every exchange date at $25.00 and at $25.50 at all other times.

Closing: 2008-9-16