Market Action

February 19, 2008

A number of continuing stories today …

Accrued Interest reviewed a recent batch of Auction Rate Municipal auctions:

There was absolutely no rhyme or reason to what failed vs. succeeded and what rates resulted. The City of New York (rated Aa3/AA) had three issues auctioned, all three of which were fully tax-exempt. The rates were 5%, 5.25%, and 6%. Energy Northwest, a municipal power provider in Washington State, which is rated Aaa/AA-, had their ARS fail, and got a rate of 6.23%. Meanwhile, at one healthcare institution with a Baa3 rating and Radian insurance had their auction succeed with a 4.67% yield.

Meanwhile, I’ve received many e-mails from people interested in how one can play these ARS failures. One interesting idea is closed-end funds. Most closed-end bond funds are leveraged, usually in the 1.2-1.5x area, and they commonly use auction-rate preferred to create this leverage.

And yet closed-end muni funds are getting hammered, with several falling more than 5% today. I looked at the worst performers on the day, all of which had leverage created with auction-rate preferreds with 7-day auctions. The highest reset number I found was 3.3%. Excuse me if I don’t panic.

In times like these, the baby tends to go out with the bathwater! Naked Capitalism pours scorn over the entire idea of Auction Rates and notes:

The Wall Street Journal reports that organizations facing big funding cost increases are quickly trying to raise money at the longer maturities they should have borrowed at in the first place:
Turmoil in an obscure corner of the credit markets is expected to lead to a wave of refinancing by institutions that are in danger of finding themselves paying abnormally high interest rates on their bonds.

One of the first to queue up is the University of Pittsburgh Medical Center, which yesterday announced plans to refinance as much as $430 million of bonds. The medical center offered to buy back $92 million of bonds after market rates on some of its existing auction-rate debt topped 17% last week — threatening the center with extra weekly interest costs of as much as $605,000.

In the comments, Naked Capitalism goes even further and brands the issuers of Auction Rate Securities as speculators:

Municipalities get approval from taxpayers (either directly by approving bond issues or indirectly via who they elect) to enter into certain projects deemed useful for the community. They weren’t authorized to speculate with the public’s money, which is what this sort of thing is.

I cannot agree with such absolutism. Diversification of funding sources for an issuer is just as important as diversification of investments for an investor. I would have enormous reservations if it were suggested that all funding took place via Auction Rates, but I have no problem with a small piece being done that way.

A good example is floating rate mortgages and HELOCs in Canada. Many people have them and I’ve been asked many times about whether floating rate or fixed rate is better. It has been shown – and sorry, I don’t remember the reference – that, usually, floating rate is cheaper. This only makes sense; when you go floating rate then, ceteris paribus you should save money on the term premium. The risk you run is that rates will rise.

The advice I have given people to to imagine that they go for floating rate and immediately the rate doubles on them. If this is going to wipe them out and cost them their home … stick to fixed rate! On the other hand, if they will simply mutter to themselves and say ‘Oh, shoot, this investment didn’t work out’ … then go for floating rate because the odds are with them.

It’s the same with issuers. It would be most interesting to compare the overall cost of the funding over, say, a twenty-year period, and I’ll bet there are all kinds of graphs and figures in the brochures the treasurers get from their underwriters. Naked Capitalism is being more than just a little simplistic in this instance.

This issue is being raised on Bloomberg:

State officials, who are reviewing the $4 billion of auction bonds sold by six different authorities as well as by the state in 2002-2004, said the debt was the least expensive type of debt in the two years ended Sept. 30, according to a Dec. 12 report. Since then, it has become the most expensive.

The auction-rate turmoil represents a reversal for state fiscal officials. As recently as Jan. 22, Louis Raffaele, a chief budget examiner who helps manage New York’s borrowing, said higher rates on auction bonds across the country could benefit the state. “Because of our high ratings and unblemished record,” he said, the state could attract investors fleeing lower-rated issues.

I suggest that Mr. Raffaele’s remarks of Jan. 22 will ultimately be supported by the marketplace … albeit not without a period of dislocation of unknown length.

Another story that has crept back into the headlines is Structured Investment Vehicles, or SIVs. Standard Chartered’s USD 7-billion vehicle is close to default, while there has been an announcement that Bank of Montreal is committing 12.7-billion to prop up Links Finance.

More happily, Naked Capitalism has toned down the hysteria regarding negative non-borrowed reserves and is now focussing concern where it belongs: on the concept of the TAF itself:

We’ve called the TAF a discount window without stigma (and in fact, the Fed implemented the TAF because banks weren’t using the discount window even when they should have). Banks can post a wide range of collateral, borrow on a non-disclosed basis, and can hold on to the cash for a while (by contrast, the discount window is overnight)

But are things all that rosy? The Financial Times today raises some concerns, noting that banks are indeed using the TAF to use crappy collateral for borrowing,

And note that, with no announcement I can recall, the facility has been increased to $50 billion even though the year end crunch has passed. That too is not a good sign.

Naturally, we cannot let a day go by without a reference to the monolines! The Bank of America has forecast years of litigation if the monolines are split:

“Despite the regulatory interest in separating the exposures, the essential fact remains that all policy holders, whether municipal or structured finance, entered into contracts backed by the entire entity,” analysts led by Jeffrey Rosenberg in New York wrote in a note to investors dated Feb. 15. A breakup is “likely to lead to significant legal challenges holding up the resolution of the monoline issues for years.”…..

“The fact that one group of policy holders’ exposures has imperiled the policies of the other does not mean they should forfeit the value of their claims altogether,” the Bank of America analysts said.

Investors in credit-default swaps based on the bond insurers may also seek damages to compensate for losses, according to the research note.

 Accrued Interest has admitted to complete befuddlement over the question of what will happen to Credit Default Swaps on the pre-split companies. And again, Naked Capitalism provides a good round up of opinion (basically, everybody is saying that a monoline split will unleash the lawyers) and pours scorn on the idea:

Now, Ambac is seeking to raise money. It hopes to split up, but gee, we aren’t certain we can do that, and even if we can, we aren’t exactly sure yet how this will work.

Is any one with any sense going to invest in a proposition like that? You have absolutely no idea what you are getting into. This whole discussion of a breakup plan has increased uncertainty enormously and raised the specter of litigation risk. Those are not exactly comforting to investors.

Microsoft has long used FUD, Fear, Uncertainty, and Doubt, to paralyze its competitors. This bunch has managed to introduce a ton of FUD into something they want to move forward. Good luck.

Frankly, I don’t see how one can begin to consider a split ethical prior to bankruptcy and complete wipeout of the monoline’s shareholders. After all, preferential treatment of investors is generally considered a naughtiness. Never-the-less, there are rumours that MBIA is discussing joining the happy throngs.

VoxEU has an interesting article by Levich and Pojarliev on currency trading and the value of active management:

In the last year, both Deutsche Bank and Citibank have introduced several indices that track returns from several well-defined trading strategies.

  • Carry – To reflect the returns on the well-known strategy of borrowing a low interest rate currency and investing in a higher interest rate currency
  • Trend following – To reflect the returns of strategies related to identifiable patterns in currency movements
  • Value – To reflect the returns on taking short positions in overvalued currencies and using the proceeds for long positions in undervalued currencies


While theoreticians may argue over whether currency risk, like equity risk, always deserves a risk-premium, as a practical matter, institutional investors willing to hold currency risk can do so using a variety of simple trading strategies. Many of these strategies have been profitable recently and exchange-traded funds built on those strategies have been launched for the retail market. It is questionable whether professional currency managers can continue to charge higher management and performance fees while delivering cheaper-to-obtain beta returns. However, our results show that even when evaluated against the higher standard, some currency managers show superior performance, and true alpha. How they achieve this may in part be due to superior market-timing ability, trading in emerging market currencies, or some other factors. Whatever their formula, their returns appear unrelated to some conventional simple trading strategies. These true “alpha generators” may deserve their fees after all.

The actual paper costs money and I’m not really that interested … but if anybody does buy the paper, I’d be very interested in learning how the authors corrected for survivor bias. I will also note the critical sentence of the authors’ conclusion:How they achieve this may in part be due to superior market-timing ability, trading in emerging market currencies, or some other factors. Until this question is resolved, any analysis is of the “Look, Mummy, I got a spreadsheet!” variety.

Assiduous Readers will be aware that Naked Capitalism‘s opinions often meet a severe reception on PrefBlog, but as a clipping service, it’s excellent! Northern Rock has been nationalized by the UK government, generating a lot of discussion.

However, the article that most caught my eye on the weekend was a long piece on the Credit Default Swaps market and the fact that it may, ultimately, be dragged down by operational inefficiency:

In a credit default swap, two parties enter a private contract in which the buyer of protection agrees to pay the seller premiums over a set period of time; the seller pays only if a particular credit crisis occurs, like a default. These instruments can be sold, on either end of the contract, by the insurer or the insured.

But during the credit market upheaval in August, 14 percent of trades in these contracts were unconfirmed, meaning one of the parties in the resale transaction was unidentified in trade documents and remained unknown 30 days later. In December, that number stood at 13 percent. Because these trades are unregulated, there is no requirement that all parties to a contract be told when it is sold.

As investors who have purchased such swaps try to cash them in, they may have trouble tracking down who is supposed to pay their claims.

“This is just a giant insurance industry that is underregulated and not very well reserved for and does not have very good standards as a result,” said Michael A. J. Farrell, chief executive of Annaly Capital Management in New York. “I think unregulated markets that overshadow, in terms of size, the regulated ones are a real question mark.”

I dispute the notion that the lack of attention to the most basic detail is due to under-regulation … I claim that it is due to the practice of putting know-nothings on the the trading desks; and, what’s worse, promoting these know-nothings to managerial roles. Lack of knowledgeable supervision can, I suspect, also be fingered as the cause of mark-to-market “errors”.

I mentioned on February 13 my distaste for a system in which traders in securities not only boasted of their ignorance of operations, but made such ignorance a condition of entry to the elect. These operational issues with CDSs illustrate the first logical consequence of such ignorance … and I will admit, there is a large part of me that wants to see a big House go bankrupt over these issues, throwing those effete cowboys on welfare where they belong!

BMO has announced another writedown involving preferred shares – I have updated the post regarding preferred performance in 2007. In another update to an old post, I’ve added some information to Seniority of Bankers’ Acceptances … which I find particularly interesting in view of concerns over the monoline business model. Finally, the most recent post re ABK.PR.C has been updated … everything is proceeding as anticipated.

As noted in the comments to Feb 15, bonds got nailed today:

Treasuries fell, pushing the 10-year note’s yield to the highest level in more than a month, on speculation accelerating inflation will prompt the Federal Reserve to be less aggressive in cutting borrowing costs.

The yield on the benchmark 10-year note, more sensitive to inflation than shorter-term debt, was 1.84 percentage points higher than two-year rates. The spread was 1.93 percentage points on Feb. 14, the most since July 2004, reflecting a steepened yield curve.

Consumer prices rose at an annual rate of 4.2 percent in the 12 months through January after a 4.1 percent pace through the previous month, according to the median forecast of 31 economists surveyed by Bloomberg News. Excluding food and energy, prices rose 2.4 percent in the year through January, economists forecast. The Labor Department will release the report tomorrow.

…  and the Fed Funds contract backed off its more dramatic predictions.

Fed funds futures on the Chicago Board of Trade indicated a 100 percent chance policy makers will cut the 3 percent target rate for overnight loans by a half-percentage point at the March 18 meeting, compared with 66 percent odds on Feb. 15. The chance of a three-quarter-point reduction was 34 percent on Feb. 15.

Another good, solid day for the preferred share market, although volume continued light.

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
Index Mean Current Yield (at bid) Mean YTW Mean Average Trading Value Mean Mod Dur (YTW) Issues Day’s Perf. Index Value
Ratchet 5.56% 5.61% 42,778 14.5 2 -0.0617% 1,071.5
Fixed-Floater 5.00% 5.66% 76,078 14.70 7 +0.0032% 1,025.3
Floater 4.95% 5.01% 71,830 15.44 3 -0.0763% 853.7
Op. Retract 4.81% 2.51% 78,237 2.79 15 -0.1482% 1,045.8
Split-Share 5.27% 5.41% 99,208 4.09 15 +0.0584% 1,044.7
Interest Bearing 6.24% 6.45% 59,528 3.56 4 +0.5350% 1,081.5
Perpetual-Premium 5.73% 4.44% 369,713 4.34 16 -0.0522% 1,029.5
Perpetual-Discount 5.35% 5.39% 284,212 14.83 52 +0.1689% 960.6
Major Price Changes
Issue Index Change Notes
DFN.PR.A SplitShare -1.8095% Asset coverage of just under 2.5:1 as of January 31, according to the company. Now with a pre-tax bid-YTW of 4.79% based on a bid of 10.31 and a hardMaturity 2014-12-1 at 10.00.
PWF.PR.J OpRet -1.7918% Now with a pre-tax bid-YTW of 4.15% based on a bid of 25.76 and a softMaturity 2013-7-30 at 25.00. 
GWO.PR.F PerpetualPremium -1.6406% Now with a pre-tax bid-YTW of 5.37% based on a bid of 25.78 and a call 2012-10-30 at 25.00.
MFC.PR.C PerpetualDiscount -1.5473% Now with a pre-tax bid-YTW of 5.13% based on a bid of 22.27 and a limitMaturity.
SBN.PR.A SplitShare -1.4493% Asset coverage of just under 2.2:1 as of February 7 according to the company. Now with a pre-tax bid-YTW of 4.93% based on a bid of 10.20 and a hardMaturity 2014-12-1 at 10.00.
BAM.PR.I OpRet -1.4122% Now with a pre-tax bid-YTW of 5.02% based on a bid of 25.83 and a softMaturity 2013-12-30 at 25.00.
BAM.PR.B Floater -1.0989%
PWF.PR.I PerpetualPremium +1.0081% Now with a pre-tax bid-YTW of 5.02% based on a bid of 26.05 and a call at either 25.25 on 2011-5-30, or 25.00 on 2012-5-30 … take your pick.
SLF.PR.D PerpetualDiscount +1.1253% Now with a pre-tax bid-YTW of 5.04% based on a bid of 22.02 and a limitMaturity.
SLF.PR.A PerpetualDiscount +1.1898% Now with a pre-tax bid-YTW of 5.09% based on a bid of 23.25 and a limitMaturity.
BSD.PR.A InterestBearing +1.3800% Asset coverage of 1.6+:1 as of February 15, according to Brookfield Funds. Now with a pre-tax bid-YTW of 7.07% (mostly as interest) based on a bid of 9.55 and a hardMaturity 2015-3-31 at 10.00.
MFC.PR.A OpRet +1.4112% Now with a pre-tax bid-YTW of 3.71% based on a bid of 25.87 and a softMaturity 2015-12-18 at 25.00.
SLF.PR.B PerpetualDiscount +1.4175% Now with a pre-tax bid-YTW of 5.13% based on a bid of 23.31 and a limitMaturity.
SLF.PR.C PerpetualDiscount +1.4847% Now with a pre-tax bid-YTW of 5.01% based on a bid of 22.15 and a limitMaturity.
FBS.PR.B SplitShare +1.6461% Asset coverage of 1.6+:1 as of February 14, according to TD Securities. Now with a pre-tax bid-YTW of 5.39% based on a bid of 9.88 and a hardMaturity 2011-12-15 at 10.00.
SLF.PR.E PerpetualDiscount +2.0871% Now with a pre-tax bid-YTW of 5.04% based on a bid of 22.28 and a limitMaturity.
Volume Highlights
Issue Index Volume Notes
SLF.PR.D PerpetualDiscount 102,766 Nesbitt crossed 100,000 at 22.10. Now with a pre-tax bid-YTW of 5.04% based on a bid of 22.02 and a limitMaturity.
BNS.PR.L PerpetualDiscount 47,475 Now with a pre-tax bid-YTW of 5.19% based on a bid of 21.88 and a limitMaturity.
BAM.PR.N PerpetualDiscount 35,710 Now with a pre-tax bid-YTW of 6.47% based on a bid of 18.68 and a limitMaturity.
BNS.PR.0 PerpetualPremium 32,620 Now with a pre-tax bid-YTW of 5.53% based on a bid of 25.44 and a call 2017-5-26 at 25.00.
BNS.PR.M PerpetualDiscount 22,435 Now with a pre-tax bid-YTW of 5.20% based on a bid of 21.83 and a limitMaturity.

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

HIMI Preferred Indices

HIMIPref™ Preferred Indices : March 2006

All indices were assigned a value of 1000.0 as of December 31, 1993.

HIMI Index Values 2006-03-31
Index Closing Value (Total Return) Issues Mean Credit Quality Median YTW Median DTW Median Daily Trading Mean Current Yield
Ratchet 1,358.5 1 2.00 3.81% 17.9 58M 3.81%
FixedFloater 2,296.0 6 2.00 3.28% 1.9 114M 5.13%
Floater 2,086.7 4 2.00 -14.01% 0.1 41M 4.30%
OpRet 1,894.2 18 1.56 2.43% 2.9 80M 4.63%
SplitShare 1,965.3 18 1.84 3.29% 2.2 53M 4.99%
Interest-Bearing 2,327.4 8 2.00 4.65% 1.3 50M 6.74%
Perpetual-Premium 1,487.8 47 1.64 4.35% 5.6 111M 5.15%
Perpetual-Discount 1,622.5 3 1.34 4.55% 16.3 860M 4.55%

Index Constitution, 2006-03-31, Pre-rebalancing

Index Constitution, 2006-03-31, Post-rebalancing

Issue Comments

BCA.PR.A : Ticker Change to BRN.PR.A

We can always count on this company to fiddle with its corporate names and structure!

Brookfield Investments Corporation has announced:

that the company’s name has been changed from Brascade Corporation (TSX:BCA.PR.A) to reflect its emerging role as an investment company within the Brookfield Asset Management group. Brookfield Investments currently holds common share interests in the following Brookfield group companies, Brookfield Properties Corporation, Canary Wharf plc, Fraser Papers Inc. and Norbord Inc., as well as a portfolio of preferred shares issued by companies in Brookfield group.

Brookfield Investments also announced that its Class 1 Senior Preferred Shares, Series A, will commence trading on the Toronto Stock Exchange under the company’s new name and new stock symbol, BRN.PR.A at the commencement of trading on Thursday, February 21, 2008.

In conjunction with this name change, the CUSIP number of the company’s Series A Senior Preferred Shares has been changed from 10549T 301 to 112741 202.

Information on Brookfield Investments and its Series A Senior Preferred Shares can be found on its website, www.brookfieldinvestments.com.

For those keeping track, I will remind Assiduous Readers of last year’s press release:

As previously announced, Brascade amalgamated with Diversified Canadian Financial II Corp. and Diversified Canadian Holdings Inc. on January 1, 2007, and continues under the name Brascade Corporation. The financial impact of this amalgamation will be reflected in Brascade’s results for the first quarter of 2007.

Sub-Prime!

Canadian ABCP : Planet Trust Downgraded

DBRS has now downgraded Planet Trust Series E notes, which join Apsley Trust in the doghouse:

DBRS has today downgraded the Series E ratings of Planet Trust (Planet) to R-2 (high) from R-1 (high). The ratings remain Under Review with Developing Implications.

Approximately $2.7 billion of the collateralized debt obligation (CDO) transactions funded in Canadian ABCP directly have full or partial exposure to U.S. residential mortgage-backed securities (RMBS). This total includes about $143 million held by Planet Series E, consisting of a $85 million transaction representing approximately 14% of the assets of Series E (the Transaction) and a $59 million transaction representing approximately 10% of the assets of Series E, each fully funded (unleveraged).

The Transaction is exposed to pools of U.S. non-prime residential mortgages, as well as other CDOs backed by residential mortgages, among other assets. In accordance with its CDO rating methodology, DBRS has relied in the past on ratings from other major rating agencies as inputs to its CDO model. Since the Transaction’s inception, the Transaction has met all of the minimum requirements for a AAA rating. Recently, however, one rating agency took its largest single-day rating action with respect to the U.S. non-prime residential mortgage market when it downgraded or put on negative watch US$270 billion of U.S. RMBS bonds and US$264 billion of CDOs. As a result, the Transaction now has about 12% of its portfolio ratings on negative watch by other rating agencies (weighted by notional amount).

As noted in a commentary released simultaneously with this press release, DBRS has revised its surveillance methodology in regard to the use of other agencies’ ratings of U.S. RMBS referenced by Canadian CDOs. As a result, notching assumptions were applied to 2006 and 2007 vintage U.S. RMBS currently on negative credit watch by other rating agencies. Also, CDOs with exposure to 2006 and 2007 vintage U.S. RMBS were notched based on factors such as subordination, vintage concentration and underlying ratings.

As a result of the application of the revised methodology, a long-term rating of BBB (high) has been assigned to the Transaction by DBRS.

Interesting External Papers

IMF: Canadian Financial System is Well-Capitalized

The International Monetary Fund Country Report on Canada (2008) has been released. Here are some highlights:

Canadian banks appear to be sound and resilient. The stress tests indicate that the five largest banks would be capable of weathering a shock about one-third larger than the 1990–91 recession, involving a contraction of the North American economy, an increase in interest rate risk premia, and lower commodity prices. This resiliency may in part reflect the fact that the Canadian banks are national in scope and thus able to benefit from regional and sectoral diversification.

There’s more detail available on this. Credit risk is the major risk factor; market risk and liquidity risk were determined to be less important risk factors.

Until recently, most Canadian liquidity protection could only be drawn in the event of a GMD, whereas conduits in Europe and the United States enjoy virtually unconditional “global-style” liquidity protection.12 This may have been, in part, an unintended consequence of OSFI’s Regulation B-5, which exempted only GMD-conditional liquidity support from bank regulatory capital requirements. For unconditional facilities up to one year, OSFI and the United States used national discretion (consistent with Basel rules) to apply a 10 percent credit conversion factor (CCF), whereas most European countries applied a zero CCF. Basel II will apply a zero CCF to GMD-conditional support, and 20 percent to unconditional facilities with maturities up to one year.

Note: The required regulatory capital on a liquidity facility is calculated on the product of the CCF and the highest risk weight assigned to any of the underlying individual exposures covered by the facility.

I hadn’t known that about the European banks’ zero CCF on unconditional liquidity support! No wonder they’re in so much trouble! The Fed Policy, and its change to match stricter Canadian standards, has been previously discussed.

The situation in the ABCP market is still evolving and continues to pose a risk to investor confidence. Stress tests performed by OSFI indicate that if banks were to put the assets in their sponsored conduits on their balance sheets, this would leave them with capital above the regulatory targets. While the problems in the third-party conduits may result in losses to some of the parties involved, it is not clear that the stability of the broader financial system will be materially affected. There is, however, the risk that continuing problems in the ABCP and money markets could lead to a wider loss of confidence. The precise form such an event would take is of course difficult to predict, as are its possible consequences.

Note: However, these stress tests do not seem to consider an interruption of financing, a decline in asset prices, or the cost of holding “bridge loans” that would have otherwise been financed in the money markets.

…which leaves one wondering just what was modeled by the OSFI stress tests!

The banking system also appears to remain fairly stable in terms of marketbased measures. The two-year probability of default of a single Canadian bank implied by Moody’s KMV data has increased to about 7 percent in mid-December, compared with 2 percent before the market turbulence began in August 2007, and remains well below the 14 percent seen in the United States. A banking stability index (BSI) defined in terms of the joint probability of default of the largest banks in the system has also increased commensurately.

I’m surprised that this paragraph didn’t draw more headlines! KMV is a Merton-style structural model of defaults – as such, if may be expected to overestimate default probability at times when the equity cowboys are panicky.

Market Action

February 15, 2008

I will admit to having felt a certain amount of schadenfreude when Accrued Interest brought to my attention what has to be one of the world’s worst bond funds. A loss of over 50% in a year in what was touted as a fund that would seek:

a high level of income by investing in intermediate maturity, investment grade bonds. The fund seeks capital growth as a secondary objective when consistent with the fund’s primary objective.

… must be something of a record. But this is the modern age! Faster, Stronger, Better! Citigroup’s Alternative Investments unit has brought new meaning to the word “Alternative”:

Falcon Plus Strategies, launched Sept. 30, lost 52 per cent in the fourth quarter, after betting on mortgage-backed and preferred securities and making trades based on the relative values of municipal bonds and U.S. Treasuries. Some collateralized debt obligations in the fund trade at 25 per cent of their original worth, the newspaper said.

OK, well, I think it’s funny! The WSJ had some more detail about the excellence of Citigroup’s risk-control procedures:

Mr. Pickett’s big order last June was for several hundred million dollars of leveraged loans that a group of banks was selling in a private auction on behalf of a German media company, according to people involved in the transaction. At the time, CSO had roughly $700 million in assets, meaning that Mr. Pickett wanted to commit more than half of the hedge fund’s assets.

Some investors in the fund contend that executives at Citigroup didn’t supervise Mr. Pickett closely enough. “I don’t understand…how it would have been possible for him to take on a position that was disproportionately large,” says one investor in CSO.

Citigroup defends its handling of the situation. Spokesman Jon Diat said CSO and similar funds “are subject to comprehensive internal fiduciary risk oversight, risk management practices and senior-level management supervision.”

The mention of collateralized debt obligations continues to resonate, since UBS says there’s a good chance of huge write-downs to come:

Writedowns for collateralized debt obligations and subprime related losses already total $150 billion, [UBS analyst Philip] Finch estimated. That could rise by a further $120 billion for CDOs, $50 billion for structured investment vehicles, $18 billion for commercial mortgage-backed securities and $15 billion for leveraged buyouts, UBS said. “Risks are rising and spreading and liquidity conditions are still far from normal,” the note said…..

And you’ve got to figure … a UBS analyst would know!

Monolines, monolines … Elliot Spitzer, best known for his efforts in singlehandedly saving the world from the horrors of a NY state governor who was not Elliot Spitzer, has made a bald threat to take over the monolines (well … MBIA, anyway) and split them:

During a recess, Mr. Spitzer told reporters that splitting the bond insurers’ businesses was a last resort. “The clear preference is a recapitalization of the companies,” he said. “Even if the deals don’t close, the sort of market comfort that would be needed to stabilize the marketplace could get there pretty quickly. We just have to wait and see what happens.”….

Turning up the heat yesterday on the banks’ discussions, he said in an interview that there are “some mechanisms” in the law that allow regulators to “force [the bond insurers] into what’s called ‘rehabilitation.'” During his testimony before the panel, he asked Congress for a $10 billion line of credit for the bond insurers, which he said could encourage banks to contribute capital.

There are claims that FGIC wants to be split up:

FGIC Corp., the bond insurer stripped of its Aaa rating by Moody’s Investors Service, asked to be split in two to protect the municipal bonds it covers, according to the New York Insurance Department.

FGIC, owned by Blackstone Group LP and PMI Group Inc., applied for a new license so it can separate its municipal insurance unit from its guarantees on subprime-mortgages, David Neustadt, a department spokesman, said in a telephone interview.

And was the regulator holding a gun to FGIC’s head at the time, or what? What’s the whole story? 

How can this possibly be legal? More to the point, how can it possibly be ethical? Those who purchased credit protection on sub-prime did so based on the strength of the whole company, not simply the post hoc selection of bad bits. Accrued Interest speculates that the so-called crisis might simply be political embarrassment:

But the refinancing won’t erase the embarrassment of having an auction failure. Governmental agencies, including the Port Authority, will start putting increasing pressure on the New York insurance regulators to resolve this matter once and for all.

But the combination of heavy political pressure and a viable private sector solution will be too difficult to ignore. A deal will be worked out to insulate the municipal bond market.

Perhaps more to the point, there is at least a little concern that the so-called crisis in Auction Rate Municipals is largely self-inflicted:

Banks including Goldman Sachs Group Inc. and Citigroup Inc. allowed hundreds of auctions to fail this week after they were unable to attract bidders and decided to stop buying unwanted securities. A failed auction nearly doubled seven-day borrowing costs on $15 million of bonds sold by Harrisburg International Airport in Pennsylvania to 14 percent while a $100 million Port Authority of New York & New Jersey bond reset at 20 percent, up from 4.3 percent a week earlier.

“The problem with most auction bonds isn’t the bonds’ credit quality or default risk,” said Joseph Fichera, chief executive at Saber Partners, a New York-based financial adviser to local governments. “The problem is that there isn’t enough demand for the bonds because some issuers gave monopolies on the distribution to a few banks.”

Just to think … there are still some people in the world who believe that increased political involvement via regulation will save the world!

There has been an amusing twist to the increase in the allowed size of GSE mortgages, which was discussed on January 29. The effective infusion of new money into the jumbo mortgage sector will, in the absence of other factors, affect prices of existing securities:

If larger loans can be packaged into guaranteed securities that can trade in the TBA market, the difference between their rates and those on other prime mortgages would probably fall to between 4 basis points and 19 basis points, from more than 80 basis points today, New York-based Credit Suisse analysts Mukul Chhabra, Chandrajit Bhattacharya, and Mahesh Swaminathan wrote in a report last week. The rates offered on other prime mortgages would climb by a similar amount, they said.

So the trade association that regulates such matters is not allowing the GSE-jumbos to trade normally:

The larger home loans that Fannie Mae and Freddie Mac will temporarily be allowed to guarantee won’t be accepted into the main market for mortgage bonds, the Securities Industry and Financial Markets Association said.

The revised guidelines for the so-called To Be Announced market cover mortgages of more than $417,000 that the government- chartered companies are permitted to buy or guarantee under the $168 billion economic stimulus package signed into law this week, according to a statement today from the trade group in New York.

The exclusion of the larger loans should reduce the size of drops in jumbo mortgage rates that will result from the new law, according to analysts at Credit Suisse Group and Citigroup Inc. Including the loans would have hurt bondholders because their securities would have dropped in value.

A quiet day in the market – not much volume or price movement, probably due to intensive preparations for Bozo Day. With markets at current levels, and now that that $430-million in bank issuance seems to have been well-digested … it wouldn’t surprise me much to see a new issue first thing Tuesday morning, or sometime next week, anyway. Maybe one of the insurers will want some capital so they can go after AIG’s business in its weakened state? Who knows? I wouldn’t bet a dime on it, but I’d go so far as to put a nickel on a new Pfd-1 issue next week at 5.50%.

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
Index Mean Current Yield (at bid) Mean YTW Mean Average Trading Value Mean Mod Dur (YTW) Issues Day’s Perf. Index Value
Ratchet 5.56% 5.60% 43,180 14.5 2 -0.1852% 1,072.1
Fixed-Floater 5.00% 5.65% 76,953 14.72 7 +0.1486% 1,025.3
Floater 4.95% 5.00% 72,440 15.46 3 -0.5366% 854.4
Op. Retract 4.81% 1.91% 78,029 2.56 15 -0.1900% 1,047.4
Split-Share 5.27% 5.46% 98,540 4.22 15 -0.0568% 1,044.1
Interest Bearing 6.27% 6.55% 57,942 3.56 4 -0.6207% 1,075.7
Perpetual-Premium 5.72% 4.51% 375,855 4.56 16 +0.0302% 1,030.1
Perpetual-Discount 5.36% 5.39% 285,576 14.81 52 +0.0704% 959.0
Major Price Changes
Issue Index Change Notes
BAM.PR.I OpRet -2.7468% Now with a pre-tax bid-YTW of 4.52% based on a bid of 26.20 and a call 2010-7-30 at 25.50.
FBS.PR.B SplitShare -2.4096 Asset coverage of just under 1.7:1 as of February 14, according to TD Securities. Now with a pre-tax bid-YTW of 5.85% based on a bid of 9.72 and a hardMaturity 2011-12-15 at 10.00. 
BSD.PR.A InterestBearing -2.2822% Asset coverage of just under 1.6:1 as of February 8, according to Brookfield Funds. Now with a pre-tax bid-YTW of 7.30% (mostly as interest) based on a bid of 9.42 and a hardMaturity 2015-3-31 at 10.00.
MFC.PR.A OpRet -1.5818% Now with a pre-tax bid-YTW of 3.91% based on a bid of 25.51 and a softMaturity 2015-12-18 at 25.00.
BNA.PR.C SplitShare -1.1529% Asset coverage of 3.3+:1 as of January 31 according to the company. Now with a pre-tax bid-YTW of 7.35% based on a bid of 19.72 and a hardMaturity 2019-1-10 at 25.00. Compare with BNA.PR.A (5.86% to 2010-9-30) and BNA.PR.B (7.32% to 2016-3-25).
SBN.PR.A SplitShare +1.2720% Asset coverage of just under 2.2:1 as of February 7, according to Mulvihill. Now with a pre-tax bid-YTW of 4.66% based on a bid of 10.35 and a hardMaturity 2014-12-1 at 10.00. 
RY.PR.C PerpetualDiscount +1.3116% Now with a pre-tax bid-YTW of 5.15% based on a bid of 22.40 and a limitMaturity
DFN.PR.A SplitShare +1.7442% Asset coverage of just under 2.5:1 as of January 31 according to the company. Now with a pre-tax bid-YTW of 4.45% based on a bid of 10.50 and a hardMaturity 2014-12-1 at 10.00.
Volume Highlights
Issue Index Volume Notes
PWF.PR.K PerpetualDiscount 50,100 Now with a pre-tax bid-YTW of 5.39% based on a bid of 23.13 and a limitMaturity.
BNS.PR.O PerpetualPremium 33,500 Now with a pre-tax bid-YTW of 5.42% based on a bid of 25.45 and a call 2017-5-26 at 25.00.
BNS.PR.L PerpetualDiscount 33,039 Now with a pre-tax bid-YTW of 5.20% based on a bid of 21.80 and a limitMaturity.
BNS.PR.N PerpetualDiscount 18,202 Now with a pre-tax bid-YTW of 5.37% based on a bid of 24.62 and a limitMaturity.
RY.PR.G PerpetualDiscount 17,100 Now with a pre-tax bid-YTW of 5.20% based on a bid of 21.73 and a limitMaturity.

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

HIMI Preferred Indices

HIMIPref™ Preferred Indices : February 2006

All indices were assigned a value of 1000.0 as of December 31, 1993.

HIMI Index Values 2006-02-28
Index Closing Value (Total Return) Issues Mean Credit Quality Median YTW Median DTW Median Daily Trading Mean Current Yield
Ratchet 1,354.7 1 2.00 3.61% 18.3 59M 3.62%
FixedFloater 2,283.5 6 2.00 3.31% 17.6 92M 5.14%
Floater 2,076.1 4 2.00 -20.15% 0.1 38M 4.11%
OpRet 1,885.2 18 1.56 2.76% 2.9 84M 4.62%
SplitShare 1,949.0 16 1.94 3.52% 2.6 60M 5.06%
Interest-Bearing 2,316.6 8 2.00 5.26% 1.3 53M 6.68%
Perpetual-Premium 1,482.0 47 1.64 4.40% 5.8 113M 5.14%
Perpetual-Discount 1,613.3 3 1.34 4.54% 16.4 1,229M 4.57%

Index Constitution, 2006-02-28, Pre-rebalancing

Issue Comments

ALB.PR.A : Partial Call for Redemption

Allbanc Split Corp. II has announced:

that it has called 164,867 Preferred Shares for cash redemption on February 28, 2008 (in accordance with the Company’s Articles) representing approximately 3.524% of the outstanding Preferred Shares as a result of the special annual retraction of 1,729,032 Capital Shares by the holders thereof. The Preferred Shares shall be redeemed on a pro rata basis, so that each holder of Preferred Shares of record on February 27, 2008 will have approximately 3.524% of their Preferred Shares redeemed. The redemption price for the Preferred Shares will be $25.00 per share.

An annoyingly small redemption … big enough to turn board-lots into odd-lots, without providing (for most holders, I’m sure) a tradeable amount of cash.

ALB.PR.A is tracked by HIMIPref™ and is a member of the SplitShares Index. It has been recently removed from the S&P/TSX Preferred Share Index.

Issue Comments

PAY.PR.A : Tax Treatment of May, 2007, Dutch Auction Tenders

I love the use of the word “clarifies” in a press release. It invariably means that there’s been a monumental SNAFU and the issuing company is reversing its position.

High Income Principal and Yield Securities Corporation has issued a press release that “Clarifies Tax Treatment for Shares Tendered to Issuer Bid“:

proceeds received by former shareholders of PAY.pr.a who tendered their shares to the Dutch auction held in May 2007 should be treated as proceeds of disposition. The amount by which the proceeds of disposition exceed (or are less than) the shareholder’s adjusted cost base of the tendered shares will result in a capital gain (or loss) to the tendering shareholder.

This innocuous seeming press release, with its use of the word “clarifies” in the headline, led me to look up the April 20, 2007, Issuer Bid Circular on SEDAR, which stated:

Individual Shareholders who sell their Shares to the Company pursuant to the Offer will be deemed to receive a taxable dividend on the Shares equal to the amount by which the Purchase Price exceeds their paid-up capital for purposes of the Tax Act. The Company estimates that the paid-up capital per Share is approximately $18.20. This dividend will be subject to the gross-up and dividend tax credit rules applicable to taxable dividends received by individual Shareholders from taxable Canadian corporations, including the recently enacted enhanced dividend gross-up and tax credit where the deemed dividend has been designated as an eligible dividend by the Company. The Company will notify Shareholders, in accordance with the Tax Act, of the extent to which the deemed dividend is an eligible dividend.

In addition, such Shareholders will be considered to have disposed of each of their Shares for proceeds of disposition equal to the amount by which the Purchase Price exceeds the deemed dividend arising on the disposition. The Shareholder will realize a capital gain (or capital loss) on disposition of Shares equal to the amount by which the Shareholder’s proceeds of disposition, net of any reasonable costs of disposition, exceed (or are less than) the Shareholder’s adjusted cost base of the Shares sold to the Company pursuant to the Offer.

According to a May 31, 2007, Press Release:

Based on the final report provided by the depositary for the Offer, 224,644 preferred shares have been deposited and not withdrawn. Pursuant to the terms of the Offer, HIPAYS determined the purchase price to be $25.90 per preferred share (the “Purchase Price”) to put it in a position to take up the maximum number of preferred shares deposited to the Offer for an aggregate purchase amount of $5,818,279.60.

This buy-back was reported on PrefBlog at the time

Maybe I’m being a little mean about publicizing all this … I wouldn’t even have reported the press release if it hadn’t been for the word “clarifies”. Come on, guys! You screwed up! Show the grace to admit it!

Interesting External Papers

US Bank Panics in the Great Depression

The WSJ Economics Blog highlighted a paper by Mark Carlson of the Fed, titled Alternatives for Distressed Banks and the Panics of the Great Depression.

I must say that I don’t consider the conclusions too earth-shattering, but it’s always good to have hard data! The penultimate and conclusive sections read as follows:

One potential reason that restructuring may have been more difficult for banks that failed during panics is that the surge in the number of failing banks during panics increased the competition for new capital. It seems quite reasonable that, at least in the short run, the pool of resources available to investors to recapitalize banks is fixed. As the number of troubled institutions competing for those resources rose, only a small fraction might have been able to obtain them. Thus, even though some banks might have been able to attract capital during ordinary times, there were simply too many banks seeking that capital during panics.

A second reason that panics may have inhibited the ability of banks to pursue alternative resolution strategies is that the number of banks in trouble during panics may have made rescuing the banks more expensive or difficult. Allen and Gale (2000) show how interbank claims can cause losses to spread across banks. Diamond Rajan (2005) present a model in which illiquidity problems at one bank can reduce the liquidity of the banking system and cause problems for other banks. In these models the more banks affected in the initial state, the greater will be the problems for the other banks. Ferderer (2006) finds evidence that market liquidity did decline at times during the Depression. Donaldson (1992) also illustrates how that value of a bank can fall as the number of other banks in distress increases.

A third potential for the difficulty in attracting capital in crises might be an increased difficulty in valuing banks during a panic. Wilson, Sylla, and Jones (1990) noted that asset price volatility increases during panics. If investors had a more difficult time than usual valuing the bank, especially with risks likely tilted to the downside, they may not have been as willing to assist in restructuring the bank.

All three of these reasons could potentially contribute to a reduction in the ability of banks to recapitalize after suspending or to merge with another bank during a panic. The data used in this paper does not allow us to explore which, if any, of these reasons appears particularly important. This area may be fruitful ground for further research.

Section 5. Conclusion

The empirical literature on banking panics finds that banks that failed during panics were generally economically weaker than the ones that survived. The analysis here comes to a similar conclusion, but argues that this comparison provides an incomplete picture of the effects of panics on the banking system. Banks had alternatives to failing during regular times; they could either suspend and reorganize or merge with other banks. This study examines whether banks that failed during panics might, had the panic not occurred, have been able to pursue these other options. Through a series of comparisons, I find evidence that the balance sheets of banks that failed during panics were at least as strong as those of banks that were able to pursue alternative resolution strategies. These findings suggest that the panics may have played a role in preventing banks from suspending and reorganizing or from finding other banks to merge with, possibly due to the increase in the number of problem banks and uncertainty in pricing financial assets during panics.

The period of liquidation following bank failure caused assets to be taken out of the banking system and frozen for extended periods. During a bank merger, the assets stay in the banking system continuously. For banks that suspended temporarily, the median length of suspension in this sample was about 5 months. By comparison, Anari, Kolari, and Mason (2005) find that the average length of liquidation of a bank that failed in the early 1930s was about 6 years. The loss of the bank expertise and the freezing of bank assets and deposits have been found to have had negative effects on output (Bernanke 1983, Anari, Kolari, and Mason 2005}. Thus, to the extent that the panics prevented banks from pursuing less disruptive resolution strategies, then the panics of the early 1930s may well have played a role in prolonging and deepening the Great Depression.