PrefBlog

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

I think. Bloomberg has a story on it too.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

I must say, my respect for Arthur Levitt continues to decline – his Credit Rating Agency recommendations did not impress and now he is quoted in a manner which makes it appear he doesn’t understand investing:

The Florida agency that manages about $50 billion of short-term investments for the state, school districts and local governments holds $2.2 billion of debt that was cut below investment grade.
…
“It’s really disgraceful,” Levitt said. “I think what’s really bad about this is that the state has called for investments to be prudent and careful but clearly the custodians of this fund were reaching, they were trying to get maximum yield.”

Four percent of a portfolio goes bad (and I’ll bet a nickel that recovery handsomely exceeds 90%) and that is sufficient for Levitt to use words like “disgraceful”? This does not do a service to anyone. Four percent does not sound reckless to me; it sounds diversified – especially since there are four different vehicles involved. If Mr. Levitt wishes all public pension funds to be invested in guaranteed-no-default T-bills exclusively, he should say so, instead of gleefully crying “I told you so! Or, at least, I could have told you so if you’d asked me!” after the events.

The Prudent Man Rule goes both ways, Mr. Levitt. A Prudent Man will take Prudent Risks to increase return. Sometimes, Mr. Levitt, taking a risk will lose money. That’s why they’re called Risks, Mr. Levitt. There is nothing in Mr. Levitt’s remarks to indicate that the managers of the portfolio violated their mandate.

In somewhat related news, Naked Capitalism informs us that a GE Cash Management Fund has Broken the Buck. This is not a Money Market Fund, as regulatorially defined, but an enhanced yield fund – in addition to bailing out its MMF, Bank of America also bailed out its “institutional cash fund, which isn’t technically a money fund.” I have written an article, which I hope will be published shortly, on this general topic.

I’m a much bigger fan of Dallas Fed President Richard Fisher. He sounds much more reasonable when discussing a Central Banker’s favourite topic:

But he says rising food and energy prices are the big concern, creating “a risk of a more pernicious pass-through effect than we saw in the recent price increases of underlying commodities.”

The spread between food price inflation and core inflation hasn’t been so large in a quarter century, Mr. Fisher says. And energy prices are rising due to strong demand and trading activity. “All this gives me a sense of discomfort on the headline inflation front, and it is a reminder that the balance of risks is not skewed unilaterally toward slower growth.”
…
“You might say the credit markets have gone from the ridiculous to the subprime; the subprime and related derivatives market is the focus of angst, but the ridiculous practice of the suspension of reason in valuing all asset classes appears to be in remission, if not over,” he says.

While we’re on the topic of the Fed … explicit inflation targetting, the subject of some speculation November 12, has not been adopted. Meanwhile, Paul De Grauwe weighs in with an essay advocating:

• Asset-price targetting by Central Banks (a recurring theme discussed at the Jackson Hole conference and reported here August 31)
• Central Bank “regulation of all institutions that create credit and liquidity”.

His justification for the second point is:

During the last few years, a significant part of liquidity and credit creation has occurred outside the banking system. Hedge funds and special conduits have been borrowing short and lending long, and as a result, have created credit and liquidity on a massive scale, thereby circumventing the supervisory and regulatory framework. As long as this liquidity creation was not affecting banks, it was not a source of concern for the central bank. However, banks were heavily implicated. Thus, the central bank was implicitly extending its liquidity insurance to institutions outside the regulatory framework. It is unreasonable for a central bank to insure activities of agents over which it has no oversight, very much as it would be unreasonable for an insurance company selling fire insurance not to check whether the insured persons take sufficient precautions against the outbreak of fire.

I don’t buy it. Regular readers will remember that while I am all in favour of a very strong financial system, I am also a big fan of an unregulated “country bank” sector where innovation is king … a junior league where risks are taken and products are developed. While the existence of such a sector should not be allowed to endanger the core banking system, this policy objective does not require stringent regulation of the sector. What it requires is stringent regulation of the banking system’s exposure to this sector – readers with memories going back to October 15 will remember that I suspect that such exposure has not been stringent enough; the risk-weighted assets deemed to be on the banks’ balance sheets through such exposures should simply be weighted more highly.

Bear Stearns has ruthlessly prettied-up its balance sheet:

Bear Stearns Cos., after posting its biggest earnings decline in more than a decade, reduced subprime holdings by 50 percent in the past two months, limiting writedowns in the fourth quarter to $1.2 billion.
…
Bear Stearns is regaining hedge fund customers that defected amid the credit rout in the third quarter, Molinaro said.

Hedge fund balances are “coming back” to the firm’s prime brokerage unit, and have steadied in the current quarter, he said. The business is “on pace for a record year.”

I say “prettied up” rather than “improved” because I have no way of knowing whether the sale of sub-prime assets actually improved their financial condition or not. However, if you have assets held at $100 on the balance sheet with a “fair value” (whatever that means) of $90 and a market price of $80 that are being valued by investors in your company (and your customers!) at $50 … well, taking one consideration with another, you’re better off gritting your teeth and selling them at the lousy $80 price, which is $10 cheap. It pretties up the balance sheet.

Remember BCE? Geez, it’s been a long time since I’ve discussed BCE. There was a rather interesting story today about Cerberus and United Rentals:

“This deal was expected to close sometime this week,” wrote Stephen Volkmann, an analyst with J.P. Morgan Securities Inc. in New York. “The banks were struggling with selling the associated debt offering.”

The takeover agreement includes a $100 million termination fee that Cerberus, founded by former Drexel Burnham Lambert Inc. trader Stephen Feinberg, would be required to pay unless it can show that there was “material adverse change” in United Rentals financial condition.

Cerberus told United Rentals there had been no such change, according to the statement. Cerberus has commitments from its banks to finance the transaction through bridge facilities, United Rentals said, adding it believes the banks stand ready to fulfill their contractual obligations.

“It’s a combination of the financing being more expensive and they must also think the business is not as attractive,” said Steven Kaplan, a professor at the University of Chicago Graduate School of Business who studies private equity. “Paying $100 million is a better outcome than doing a deal that’s not going to work.”

I continue to have no opinion regarding whether the BCE/Teachers deal will actually be consumated – there’s simply no information available on which to base an opinion and things may change a lot between now and the last minute. But if it comes to the point at which the consortium believes it has a choice between losing $1-billion quickly or $10-billion slowly … I’ll bet a nickel I can tell you which way they’ll jump.

OK, let’s step back a bit and discuss a funny thing on the Internet I’ve seen today!

Canada Newswire has very strict terms of use, but I can’t link to them. I can only link to “CNW Group Home Page” as per their terms of use:

Unless you have a written agreement in effect with CNW Group which states otherwise, you may only provide a hypertext link to the CNW Group Web site on another Web site, provided that (a) the link is a text-only link clearly marked “CNW Group Home Page”; (b) the link “points” to (i.e. links the user directly to) the URL www.newswire.ca/en and not to other pages within the CNW Group Web site; (c) the appearance, position and other aspects of the link is not such as to damage or dilute the goodwill associated with CNW Group’s name and trade-marks; (d) the appearance, position and other aspects of the link does not create the false appearance that an entity is associated with or sponsored by any of us; (e) the link, when activated by a user, displays CNW Group Web site full-screen and not within a “frame” on the linked Web site; and (f) CNW Group reserves the right to revoke its consent to the link at any time in its sole discretion. [Emphasis added – JH]

Now, turn to any random press release. They invite you to use four different web cross-referencing techniques to link to a particular press release.

Well … I thought it was funny!

Indices will be delayed. Prices have been updated, but I’m having some kind of strange server problem, probably related to database size … buy you don’t want to know about that! I will update in the near future.

Update, 2007-11-15

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

Menzie Chinn at Econbrowser has reviewed credit and term spreads: 

He notes:

It might appear that the two phenomena are unrelated. But the DB article argues that while banks pursued off-balance sheet activities such as “rating transformation” (transmuting assets of one credit default risk category to another category by financial engineering), they moved away from reliance on maturity transformation and taking on credit risk. With the end of the structured credit market, and reorienting of banks’ operations, credit spreads and term spreads will reappear.

Interestingly, as Chart 6 illustrates, term and credit spreads are not back to where they were pre-2005. However, in terms of the latter, they’re close. And, as time on goes on, one might very well expect further curve steepening.

It would certainly be a pleasure to see some actual curve steepening! Preferably a bull steepening (in which the steepening is effected by a decline in shorter-term rates), just to wipe the smug smile off the faces of those who claim to be avoiding risk by shortening term! Bloomberg notes, however, that steepness and fear of inflation are intertwined.

In somewhat related news:

JPMorgan Chase & Co. CEO Jamie Dimon said SIVs, whose assets have dwindled by at least $75 billion since July, will “go the way of the dinosaur.”

“SIVs don’t have a business purpose,” Dimon, 51, said at the Merrill Lynch conference today.

I consider this “somewhat related” because of the term spread; a SIV is nothing more nor less than an unregulated “country bank”, seeking to make money from the term spread (financing long-term assets with short paper) and the credit spread (enhancing the credit quality of its debt by subordination of its senior tranches with equity tranches). What we are seeing now is the unravelling of the business model due to:

• General loss of confidence (equivalent to a bank run)
• Bad quality on their asset side

… which are the same things that will do in any bank.

While I agree that SIVs qua SIVs are dead, I’m not so sure that they served no business purpose; and feel entirely confident that other vehicles – probably better capitalized and not so aggressive with their financing models – will arise to take their place. People want to lend short and borrow long. In the aggregate, short-term money is available for the long term. Banks, SIVs and ABCP conduits all serve the same business purpose in this respect … so I’m not sure what Dimon meant.

I mentioned possible downgrades of bond insurers on November 9. Accrued Interest has continued his educational campaign by analyzing some scenarios for ABS default, insurance and recovery that sheds quite a bit of light on the matter.

The CDOs are tricksy things! Fitch Ratings indulged in a mass downgrade yesterday:

Derivative Fitch–New York–12 November 2007: Derivative Fitch has downgraded $37.2 billion (U.S. dollar and U.S. dollar equivalent) and affirmed $6.9 billion of structured finance collateralized debt obligations (SF CDOs) across 84 transactions. Fitch’s rating actions follow the completion of a review of 55 U.S. and European SF CDOs executed on a synthetic basis, and 29 U.S. and Asian SF CDOs executed on a cash/hybrid basis. Ratings on 66 U.S. cash and hybrid SF CDOs remain on Rating Watch Negative pending resolution on or before Nov. 21, 2007.

A downgrade:affirm ratio in excess of 5:1 is big news, especially since many of the downgrades are multi-level:

more than $14 billion worth of transactions falling from the highest-rated AAA perch to speculative-grade, or junk, status.

The implications can be as scary as you want them to be. Naked Capitalism provides excellent links to some informed discussion. Just to make things even more interesting – for those of you who are bored by mere multi-billion writeoffs – Naked Capitalism also reports on a now somewhat dated (two weeks) judgement refusing foreclosure to Deutsche Bank:

Judge Christopher A. Boyko of the Eastern Ohio United States District Court, on October 31, 2007 dismissed 14 Deutsche Bank-filed foreclosures in a ruling based on lack of standing for not owning/holding the mortgage loan at the time the lawsuits were filed.

Whether this was an isolated SNAFU by Deutsche, or indicative of lack of paper trail maintenance by the various intermediaries, is something regarding which I do not care to speculate at this time.

Naked Capitalism also takes issue with Countrywide funding its operations with Certificates of Deposit, but I can’t see any problem with that … provided that FDIC and Fed is supervising the bank properly and it’s solvent. Otherwise, of course, it would be a Bad Thing. I’m much more concerned about the back-door guarantees via the Federal Home Loan Banks, as I noted on October 30.

I noted yesterday that Legg Mason was bailing one of its MMFs out of SIV paper – now it appears that Sun Trust is doing the same thing along with Bank of America and at least two others. This is a very worrisome development for the investment industry as a whole … I am currently trying to finish an article on the topic, but there’s a lot going on in the market just now! In an overdue development:

The 10 largest managers of U.S. money funds have about $50 billion in short term debt of SIVs, some issued by vehicles such as Cheyne Finance Plc that defaulted as investors shunned the funds on concerns about losses from securities linked to subprime mortgages, according to reports from the companies.
…
BlackRock, the largest U.S. publicly traded asset manager, has been in contact with the Treasury, Fink said. BlackRock will raise “multibillion dollars” to invest in distressed securities that are resulting from the “chaos” in the market, Fink said, while declining to elaborate on fund details.

Well, whether Superconduit = Vulture or not, there’s at least one major player stepping up!

If today’s news has been too cheery for you: consider deadly bird flu!

Good volume, poor returns in the preferred share market today.

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