PrefBlog

You guys all think I’m going to talk about the Lehman bankruptcy, the scramble for funding by AIG and, given the devil-take-hindmost nature of short attacks on Large Complex Financial Institutions recently, Merrill’s determination not to be hindmost. But I ain’t, except to note in passing that Merrill’s days have been numbered ever since I quit my Operations Assistant Supervisor position with them in a huff about 20 years ago. Serves ’em right.

All that stuff has been discussed to death; I have no particular insights or comments. Accrued Interest‘s post sounds a little shell-shocked. The Fed turned on the tap full force as the Fed Funds market seemed to lock up:

The Federal Reserve added $70 billion in reserves to the banking system, the most since the September 2001 terrorist attacks, to keep bank borrowing costs low after the bankruptcy of Leman Brothers Holdings Inc.

Fed funds traded as high as 6 percent, or 4 percentage points above the central bank’s target rate for overnight loans between banks, according to ICAP Plc, the world’s largest inter- dealer broker. The margin is the greatest since Bloomberg began tracking the data in 1998. The rate dropped to as low as 1.75 percent after the Fed added the temporary reserves.
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“If the fed funds rate closes high today, I would be really worried as it would mean that there really is no money out there to be lent,” said Stan Jonas, who trades interest- rate derivatives at Axiom Management Partners LLC in New York.

I’m not too sure about that ‘no money available’ line. I suspect that it’s unwillingness rather than inability that drove the spike … but there will doubtless be more data and commentary in the near future.

There’s a good review piece on VoxEU titled Transmission of liquidity shocks: Evidence from the 2007 subprime crisis:

The results of a very pronounced interaction between market and funding liquidity are consistent with the emergence of re-enforcing liquidity spirals during the crisis period. On the one side of this liquidity spiral, financial institutions were exposed to refinancing needs in the form of issuing ABCP, a situation where market illiquidity in complex structured products led to funding illiquidity. In this regard, the results also show that increased correlations between the ABCP and Libor spreads reduced the possibilities of funding from the interbank money market, thus highlighting systemic risks. On the other side of this spiral, many European banks that had large exposures to US asset-backed securities had difficulties accessing wholesale funding, inducing subsequent market illiquidity in different market segments. Due to the major importance of the interbank money market, central banks in turn intervened by reducing interest rates and providing additional liquidity to the markets in order to reduce pressures.
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The analysis presented here suggests that innovation, such as structured credit products and banks’ increased ability to move risk off their balance sheets as well as augmented interconnectedness of large complex banks, made market and funding liquidity pressures readily turn into issues of insolvency.

The full paper, on which the column is based, is available from the IMF. It makes an interesting point not highlighted in the column:

Finally, increased correlations between returns of differing asset classes due to algorithmic trading, such as by quantitative hedge funds, has heightened the vulnerability with regard to the transmission of illiquidity.

Which is kind of interesting. The great strength of a quantitative approach is that it allows the quick relative valuation of two assets (whether that relative valuation achieved so quickly is any good or not is another question entirely!) and the great strength of algorithmic trading is that it allows the quick execution of a quantitatively derived plan. Stock market “circuit breakers” were introduced in the wake of the the realization that portfolio insurance had exacerbated the crash of 1987; it is hard to tell how circuit breakers might be implemented across markets, but doubtless some regulator will be jumping up soon to tell us.

The source paper references a fascinating MIT paper by Khandani & Lo, What Happened to the Quants in August 2007?, which has the abstract:

During the week of August 6, 2007, a number of high-profile and highly successful quantitative long/short equity hedge funds experienced unprecedented losses. Based on empirical results from TASS hedge-fund data as well as the simulated performance of a specific long/short equity strategy, we hypothesize that the losses were initiated by the rapid unwinding of one or more sizable quantitative equity market-neutral portfolios. Given the speed and price impact with which this occurred, it was likely the result of a sudden liquidation by a multi-strategy fund or proprietary-trading desk, possibly due to margin calls or a risk reduction. These initial losses then put pressure on a broader set of long/short and long-only equity portfolios, causing further losses on August 9th by triggering stop-loss and de-leveraging policies. A significant rebound of these strategies occurred on August 10th, which is also consistent with the sudden liquidation hypothesis. This hypothesis suggests that the quantitative nature of the losing strategies was incidental, and the main driver of the losses in August 2007 was the firesale liquidation of similar portfolios that happened to be quantitatively constructed. The fact that the source of dislocation in long/short equity portfolios seems to lie elsewhere – apparently in a completely unrelated set of markets and instruments – suggests that systemic risk in the hedge-fund industry may have increased in recent years.

This paper looks like it has a good chance of being interesting enough to highlight … I’m working through it!

Following a press release regarding its holdings, there has been some press commentary on SunLife’s exposure to Lehman:

RBC Capital Markets analyst Andre-Philippe Hardy said he expects Sun Life to take a pre-tax charge of $167-million, assuming a 50 per cent recovery rate on Lehman exposure.

Most unpleasant, but they earn about $500-million per quarter. So, unless this relatively small exposure (about 0.3% of their investments) is a precursor of Bad Things to Come, this is a non-event for credit. They’ve got $5.2-billion in equities on the books as of June 30 … their mark-to-market losses for today alone will be comparable to their Lehman exposure.

A gory day for PerpetualDiscounts – the worst since July 16, in fact, the infamous nadir of the market – but not as bad as for stocks. Names that will be familiar in the Price Changes section below (hint: they’re all negative) include:

Brookfield Properties dropped 16 percent to C$18.99, the most since August 1993. Brookfield was cut to “market perform” by BMO Capital Markets analyst Karine MacIndoe, who said that the company may face “what is likely to be an accelerated deterioration of fundamentals” in its “core Manhattan market.”

Parent company Brookfield Asset Management Inc. slid 11 percent to C$28.49, the most since the Sept. 11, 2001, attacks on the U.S.

Canadian Imperial Bank of Commerce, which accounted for two-thirds of total Canadian writedowns, fell the most since July 24, losing 4.8 percent to C$61.11. CIBC Chief Executive Officer Richard Nesbitt said at a conference that his bank expects a loss of about C$25 million from Lehman.

Update: Inspired by a thread on Financial Webring Forum, I will post a link to Across the Curve‘s closing commentary for today. The Canadian Market saw massive steepening, but not as much action as the US; two year yield down 28bp to 2.82%; five year down 21bp to 3.09%; ten year down 15bp to 3.60%; thirty-year down 8bp to 4.05%. Bets on an easing run rampant!

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

Treasury has released FAQs regarding the FNM/FRE Preferred Stock Purchase Agreement.

Naked Capitalism reprints an article in the Financial Times claiming that a consortium including BofA is looking at Lehman. Who knows? We could be having yet another Sunday Special!

Moody’s has cut Washington Mutual’s senior unsecured rating to junk:

Moody’s Investors Service downgraded the long-term deposit and issuer ratings of Washington Mutual Bank to Baa3 from Baa2. The bank’s financial strength rating was downgraded to D+ from C-, base line credit assessment (BCA) to Ba1 from Baa2, and short term rating to Prime-3 from Prime-2. Washington Mutual Inc.’s senior unsecured rating was downgraded to Ba2 from Baa3. The rating action concludes the review that was initiated on July 22, 2008. The outlook is negative.
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Moody’s also expects WaMu to report future quarters of large losses. This could exacerbate negative market sentiment and lead to franchise impairment.
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Washington Mutual Inc.’s preferred stock was downgraded to B2 from Ba2, reflecting Moody’s view that the risk of a suspension of dividends on these instruments has risen materially.

The Auction Rate Securities shakedown in the States continues, with Fidelity close to a $300-million buy-back:

Fidelity Investments is close to a settlement with New York Attorney General Andrew Cuomo to buy back $300 million in auction-rate securities, according to a person familiar with the negotiations.

If there was misrepresentation of the product, or if clients were given grossly unsuitable advice, then somebody should be losing their license. After public hearings. If there was no such fraudulent misrepresentation, if the only problem was that investments didn’t work out as hoped, then nobody should be doing anything. Attorney General Andrew Cuomo would be well advised to look back at his schoolbooks, under “Rule of Law”. This whole business of negotiated settlements in regulatory matters is an affront to civilized values.

Hard on the heels of my speculation yesterday that the BoE was preparing the ground for a more punitive rate for its liquidity operations comes the news that the Fed’s discount window is working overtime:

Borrowing from the Fed’s discount window hit record levels in six of the past eight weeks, and reached $23.5 billion as of Sept. 10, Fed data show. By comparison, lending averaged just $779 million a week in the three months after New York Fed President Timothy Geithner urged banks to use the program.

The increasing use of the funds risks delaying banks’ disposal of nonperforming assets and capital raising. It also may make it tough to restore the rate on the loans to the historical 1 percentage point premium over overnight funds, analysts said. The Fed has lowered the rate nine times since August 2007.

The data comes from the Federal Reserve Statistical Release H.4.1. Bloomberg has a neat graph:

Nine times in twelve months! There is even some speculation that that the next move move might be a loosening:

Inflation looks likely to ebb, thanks to falling commodity prices and contained labor costs. The U.S. economy, meanwhile, may be set to take another lurch down as consumer spending gives way and the credit crunch intensifies with the plunge in Lehman Brothers Holdings Inc.’s shares.
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San Francisco Fed President Janet Yellen left open the possibility of a rate cut in comments to reporters after a Sept. 4 speech in Salt Lake City. “There is some chance” of easing credit “if things start going seriously wrong,” she said.

Well … in and of itself, Yellen’s comment doesn’t mean anything. Of course there’s always the possibility of easing. There is also the possibility of … well, just about anything!

Including Lehman’s survival! They have reportedly received some serious bids for their Asset Management business:

Lehman Brothers Holdings Inc. received bids for its asset-management unit from private-equity firms including Bain Capital LLC and Clayton Dubilier & Rice Inc., as the investment bank seeks offers for the entire firm.

The bids value the unit, which includes the Neuberger Berman fund-management business, private-equity funds and a brokerage firm serving wealthy individuals, at about $5 billion, according to people familiar with the auction who asked not to be named because the process is private.

A very good day for the PerpetualDiscount sector on decent volume.

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