PrefBlog

A Bloomberg story pointed me towards remarks by Mervyn King of the BoE regarding long- and short-term bank funding:

we will also set out arrangements to ensure the banking system as a whole will continue to be able to access liquidity insurance from the Bank of England from October 22nd.

The objective of the new facility will be to provide short-term liquidity insurance to smooth the adjustment of financial institutions hit by unexpected shocks. The facility will be an important part of the contribution which the Bank can make to enhance the stability of the banking system. But it is not the purpose of central bank liquidity insurance to provide a source of long-term funding to the financial system – indeed it cannot do that. Only private savers or taxpayers via the government can provide such funds. So I hope everyone will understand that the proposals to be published next week, important though they are, will not and cannot solve the shortage of funding to finance bank lending, including mortgage lending.

So there’s a warning shot! I suspect that the touted new facility – the Special Liquidity Scheme (SLS) will not make new loans after October 21 – will follow Bagehot and include a far more penalizing rate for liquidity injections. The SLS fee is minimal:

Banks will be required to pay a fee to borrow the Treasury Bills. The fee charged will be the spread between the 3-month London Interbank interest rate (Libor) and the 3-month interest rate for borrowing against the security of government bonds, subject to a floor of 20 basis points.

Meanwhile there is the chance that Fannie & Freddie debt might be explicitly nationalized:

The federal takeover of the government-sponsored enterprises, or GSEs, on Sept. 7 failed to address whether the debt of Fannie and Freddie should be included in the budget, or whether it carries an explicit government guarantee. In an interview this week, Treasury Secretary Henry Paulson cited the “incongruities” in the law and said “we should be clear, is there a government guarantee or isn’t there?”

Any decision to add Fannie and Freddie to the budget wouldn’t automatically translate into an explicit government backing for the companies’ combined $1.7 trillion in unsecured debt and $3.5 trillion of mortgage guarantees. Granting the full faith and credit of the U.S. would require an act of Congress to change the companies’ legal status.

This would bring the Fannie/Freddie debt into a position resembling CMHC mortgage bonds:

CMHC’S GUARANTEE OF CANADA MORTGAGE BONDS CARRIES THE FULL FAITH AND CREDIT OF CANADA, AND CONSTITUTES A DIRECT, UNCONDITIONAL OBLIGATION OF CANADA
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CMB have been given Canada’s S&P AAA/Moody’s Aaa credit rating and a 0% capital weighting under the BIS guidelines. CMB are not subject to withholding tax by Canada.

… and its direct debt:

CMHC’S DEBT OBLIGATIONS CARRY THE FULL FAITH AND CREDIT OF CANADA, AND CONSTITUTE DIRECT, UNCONDITIONAL OBLIGATIONS OF AND BY CANADA.
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Canada credit and a 0% capital weighting under the BIS guidelines

Though mind you, the CMHC is virtually invisible to retail-level Canadians – they buy their mortgages wholesale from the banks, except for those made in order to help cities build slums. The FannieFreddieFiasco has politicized foreclosures in an election year:

U.S. Senate Banking Committee members urged Fannie Mae and Freddie Mac, the mortgage companies placed under federal control this week, to freeze foreclosures on loans in their portfolios for at least 90 days.

“This action would provide immediate relief to many homeowners” and let the companies “turn these non-performing loans into performing assets to minimize losses,” Senators Charles Schumer, Robert Menendez and other panel Democrats said today in a letter to the companies and the Federal Housing Finance Agency, which is overseeing them under the government conservatorship. The companies also should ease their policies on modifying mortgages, the senators wrote.

I guess, if you squint, you can put this politicization in the “unintended consequences” category, together with the Municipal Ratings Mess I posted about today. I just can’t resist noting another unintended consequence of feel-good politics that I learned about today: European Universities get paid for granting diplomas:

Indeed, with the notable exception of the UK, European universities display a poor performance in most international education rankings. According to both the Times Higher Education Supplement and the Shanghai Jiao Tong university rankings, only four institutions in continental Europe would rank among the top 50 universities in the world.
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More precisely, the funds allocated to a university [in Italy] increase with the total number of full-time equivalent students (FTE), which is defined as the ratio between the number of exams passed and the number of exams that students should have taken.
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The evidence suggests that a financing scheme that was meant to reward universities that produce higher value added is, instead, favouring universities with lower standards.

Surprise, surprise! It reminds me of Communist Russia’s Five Year Plans … tractor factory heads had to meet a production quota measured by weight of shipped products … and responded by building the world’s heaviest tractors.

Lehman continues to twist in the wind and is looking – urgently – for a buyer. The Bank of America has been mentioned. Why not? They’ve warmed up with Countrywide:

“This deal is so rancid and unpredictable,” said Christopher Whalen, managing director at the consulting firm Institutional Risk Analytics. “Bank of America’s executives can’t even articulate what the total liabilities from this deal are.”

Another possibility is for them simply to sell off their crown jewel, but there are financing problems:

Lehman Brothers Holdings originally sought to sell as much as 70% of its investment-management division but scaled that back to a sale of a 55% stake thinking that the private-equity firms mulling a bid would have trouble finding the financing for a bigger deal.

Final bids are due Friday, setting the stage for a weekend of wheeling and dealing if Lehman can fend off today’s brutal market evisceration of its stock, according to people familiar with the matter.
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In a comment completely unrelated to Lehman, Blackstone Group COO Tony James said Wednesday that LBO financing has a hard limit of $5 billion these days.

A lot of European junk bond product is now classified as distressed:

More than 30 percent of European high-risk, high-yield bonds are trading at distressed levels, the most in five years, stoking speculation defaults will rise.

Investors demand an extra yield over government debt of more than 10 percentage points to hold 53 of the 169 bonds in Merrill Lynch & Co.’s Euro High Yield Constrained Index. That’s the biggest proportion of distressed debt since March 2003, in the aftermath of the Sept. 11 terror attacks and the dot-com crisis.

A surprisingly quiet day on the market, with very few issues trading in substantial size. PerpetualDiscounts eked out a small gain, closing with a pre-tax bid-YTW of 6.09%, equivalent to interest of 8.53% at the standard 1.4x tax-equivalency factor. Long corporates are at 6.20%, so the spread is still a relatively high 233bp.

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

The question of whether the functions of Central Bank and Bank Regulator should be combined or not has been often discussed on PrefBlog. Elsewhere, too, like Frankfurt, with remarks by Ms. Gertrude Tumpel-Gugerell of the ECB:

The main position at that time, which remains valid today, is that there is no optimal arrangement for the organisation of supervision at the national level. All organisational models – sectoral supervision, supervision by objectives, supervision in a single authority – can in principle work well or fail depending on circumstances. However, regardless of the model, it is important that there exists a very close and smooth interplay between the central banking and the supervisory function.
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Provision of Emergency Liquidity Assistance is a clear point in case where central banks need supervisory information for decision-making. In this field, I believe that an important step forward is represented by the recent MoU on financial stability arrangement signed by the EU central banks, supervisors and ministries of finance in June 2008.

Finally, referring more to the supervisory domain but still linked to the central bank interest, the turmoil has evidenced the need for strengthening the macro-prudential dimension of regulation and supervision. This means the regulatory and supervisory requirements should be able to ensure adequate capital and liquidity buffers throughout the economic cycle. In this regard, the actual impact of the new capital adequacy regime under of Basel II will have to be monitored very closely.

Very bureaucratic! There isn’t the slightest hint of a recommendation in these remarks!

Lehman reported today:

Lehman Brothers Holdings Inc., reporting the biggest loss in its 158-year history, said it will sell a majority stake in its asset-management unit, spin off commercial real-estate holdings and cut the dividend in an effort to shore up capital and regain investor confidence.

There is little risk I can see that Lehman will flame out with the frightening speed of Bear Stearns – they have access to the discount window:

The program instituted in the aftermath of the Bear Stearns debacle, the Primary Dealer Credit Facility, could be used for funding while officials, regulators and executives find alternative sources of cash, Fed watchers said.

“The PDCF could be used to keep Lehman operating until a broader solution was found,” said Brian Sack, a former Fed research manager who’s now senior economist at Macroeconomic Advisers LLC in Washington. “The challenge is figuring out what the broader solution is.”

Lehman can borrow overnight from the central bank, with escalating costs if it keeps using the program. Because it’s a stopgap, speculation may mount that the government will again intervene to prevent a large financial company from failing, after the Bear Stearns rescue and takeovers of Fannie Mae and Freddie Mac.

Speaking of Fannie & Freddie, repercussions on the US preferred share market have been severe:

Prices of fixed-rate preferred stock fell an average of 9 cents to 71.5 cents on the dollar this week, according to Merrill Lynch & Co. index data, the biggest two-day drop in more than a decade. The 11 percent decline compares with a 1.4 percent drop in the Standard & Poor’s 500 index over the same time.
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Sales of preferred securities in the U.S. have risen 48 percent this year to about $44 billion from more than $30 billion in the same period of 2007, according to data compiled by Bloomberg. The average yield as measured by the Merrill index has risen to 10.1 percent from 8.8 percent on Sept. 5 and 7.9 percent at the end of last year.

Accrued Interest surveys the wreckage and recommends buying mortgage-backeds, while Fannie Mae has announced a $7-billion 2-year issue of its own debt (which, as Accrued Interest pointed out, had a lot taken up by central banks) … and at the same time, Vivendi has cancelled an offering of $846-million 7-years. And another US banking company slashed its common dividend:

Synovus Financial Corp., owner of 35 banks in the Southeastern U.S., will cut 650 jobs, or about 9 percent of its staff, and reduce the dividend by 65 percent to preserve capital depleted by mortgage losses.

The bank will record $15 million in costs for the two-year plan in 2008 and another $6 million later, and expects it will add $75 million in annual pretax earnings, the Columbus, Georgia- based Synovus said today in a statement. The quarterly payout was lowered to 6 cents a share.

All this excitement leaves little time for regulatory grandstanding, but some of them manage it:

Bank of America Corp. will buy back $4.5 billion of auction-rate securities to settle a nationwide probe led by Massachusetts Secretary of State William Galvin into its sales and marketing of the failed debt.

Bank of America, one of the largest underwriters of the securities, will offer to redeem the securities from its customers between Oct. 1 and Dec. 31, it said in a statement today. The Charlotte, North Carolina-based bank said it expects to record a pretax charge of about $275 million in connection with the buybacks.

Nothing like a little extortion to spice up a regulator’s life, eh?

“Liquidity” has often been mentioned in this blog – there was a story on Bloomberg today highlighting its importance in the day-to-day mechanics of bond trading:

Trading in the corporate bond market has fallen a third after averaging $26 billion a day in the first eight months of 2007, according to Federal Reserve data on primary dealers.
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The biggest bond dealers, including JPMorgan Chase & Co., and Citigroup Inc., aren’t committing as much cash to boost corporate-bond trading. That’s because they’re shoring up their capital after the collapse of the subprime-mortgage market spurred about $511.4 billion of writedowns and losses.

While corporate-bond trading is shrinking, average daily trading in government securities has risen to about $584 billion this year from $560 billion in the same period of 2007, Fed data show.

The decline in corporate-debt trading, known in market parlance as illiquidity, is prompting fund managers to demand higher compensation to buy new bonds, driving up borrowing costs for companies, including American Express Co. and Verizon Communications Inc., and reducing returns on existing securities.

PerpetualDiscounts moved solidly upward on a moderately busy day. Royal Bank issues took the spotlight, with high volume and strong performance.

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

In the wake of the Fannie & Freddie rescue comes the news that CDSs on Treasuries are rising:

Contracts on U.S. government debt increased 3.5 basis points to a record 18 basis points, up from 6 basis points in April, according to CMA Datavision prices for five-year credit-default swaps at 4 p.m. in London. Credit-default swaps on German government bonds cost 8 basis points and Japanese bonds 16.5 basis points.

I’m not sure what constitutes a “credit event” under these swaps.

The article makes another point that is being lost amidst the hand-wringing:

The U.S. budget deficit will grow next year to $438 billion, the Congressional Budget Office said today, making it harder for President George W. Bush’s successor to either cut taxes or increase spending.

The CBO Report states:

CBO expects the deficit to rise from 1.2 percent of GDP in 2007 to 2.9 percent this year (see Summary Table 1). The significant expansion in the deficit is the result of a substantial increase in spending and a halt in the growth of tax revenues. In 2008, CBO estimates, federal spending will be 8.3 percent higher than in 2007; at the same time, total revenues will probably be less than they were in 2007.

The CBO Report Web-Page has links to various tables and supporting/extracted data … and even to the CBO Director’s Blog! Geez, you know, my respect for American institutions has been monotonically increasing for the last twenty years, at least. They do things so well there! Too bad their politics is so … um … well, what with the deficit being up so much, maybe it’s time to cut taxes again!

Anyway … my point is: even if Poole’s estimate of $300-billion in Fannie/Freddie costs is correct, that’s still less than a bad year’s deficit. Armageddon is only one year closer. As I have said before, the US will eventually hit the wall on debt, just the way Canada hit the wall in 1994. Hitting the wall caused Canadians fiscal pain, but we got out from under the monster and are now pillars of fiscal rectitude – even with “What debt?” Harper in command. Old what-debt’s policies are indicative of a weakening of resolve, but I wouldn’t have expected 1994’s dose of reality to last more than 20 years anyway; but the point is that the US will eventually hit the wall, raise taxes, cut spending, get their house in order and move on.

I was pleased when Treasury took my advice regarding the structuring of the GSE rescue, but they didn’t follow my instructions of September 5:

I continue to feel that nothing should happen until the GSEs either fall below their regulatory minimum capital (a la IndyMac), or become unable to finance themselves in a normal commercial manner (a la Bear Stearns).
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Any GSE bail-out will be politically divisive enough; to take action before the last minute will simply exacerbate the attention paid to side issues while increasing the potential for future moral hazard without providing a solution that is necessarily any more effective.

Instead, they went ahead when it was still possible to argue the companies could survive on a stand-alone basis. So now the squabbling over side issues has started:

Senator Jim Bunning said Treasury Secretary Henry Paulson, by rescuing Fannie Mae and Freddie Mac, is acting like China’s finance minister and both Paulson and Federal Reserve Chairman Ben S. Bernanke should step down.
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“We no longer have a free market in the United States, we have a government controlled free market,” Bunning said in an interview. Paulson, a former chief executive officer of Goldman Sachs Group Inc., “is acting like the minister of finance in China.”

So now we’re headed for twenty years’ worth of idealogical bickering, instead of concentrating on what constitutes – or should constitute – 90% of government business: What’s gonna work best?

Naked Capitalism reprints an opinion piece by Ken Rogoff:

If central banks are faced with a massive hit to their balance sheets, it will not necessarily be the end of the world. It has happened before – for example, during the financial crises of the 1990s. But history suggests that fixing a central bank’s balance sheet is never pleasant. Faced with credit losses, a central bank can either dig its way out through inflation or await recapitalisation by taxpayers. Both solutions are extremely traumatic.

Raging inflation causes all kinds of distortions and inefficiencies. (And don’t think central banks have ruled out the inflation tax. In fact, inflation has spiked during the past year, conveniently facilitating a necessary correction in the real price of houses.) Taxpayer bailouts, on the other hand, are seldom smooth and inevitably compromise central bank independence.

Well, there is one other solution, technically. If you want to spend money you can:

• Tax it
• Print it
• Borrow it

After a period of massive expansion during which the financial services sector nearly doubled in size, some retrenchment is natural and normal. The sub-prime mortgage loan problem triggered a drop in some financial institutions’ key lines of business, particularly their opaque but extremely profitable derivatives businesses. Some shrinkage of the industry is inevitable. Central banks have to start fostering consolidation, rather than indiscriminately extending credit.

Quite true – as was first stated by Bagehot. As the turmoil decreases, the central banks should be tightening the screws, with the “penalty rate” on discount-window (including the new menagerie of special facilities) becoming more penalizing. I don’t think we’re there yet … but I suggest that bank investors should be keeping a sharp eye on their ratios and favouring banks that have, or a building up, large war chests for acquisitions in the coming buyers’ market.

As it is, shareholders are being punished in the usual fashion – huge dilution, unrealized capital losses, lower dividend expectations – and it’s only a matter of degree. It seems to me that Lehmann shareholders aren’t exchanging high-fives about putting one over the authorities:

Lehman Brothers Holdings Inc. fell as much as 43 percent in New York trading after talks about a capital infusion from Korea Development Bank ended. The Wall Street firm is continuing to negotiate with other potential investors, a person briefed on the matter said.
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The lack of a deal “is depressing shareholders and infuriating insiders,” said Richard Bove, an analyst at Ladenburg Thalmann & Co., in a report today. The bank “refuses to take what it believes are fire-sale prices for its key assets,” he said.

In the Everything Bad Always Happens at the Worst Time Department, we have issuer-side damage estimates from the Auction Rate Securities mess:

The collapse of the market for auction-rate bonds put New York state in the same position as millions of homeowners whose adjustable-rate mortgages reset: It wanted to refinance.

The state had $4 billion in debt with interest rates, set in periodic auctions, that soared as high as 14.2 percent after bidders vanished in February. That was more than triple the January average. The cost to taxpayers rose even more when the state’s first option, replacing auction-rate debt with variable- rate bonds, wasn’t available for the full amount.

Taxpayers and not-for-profit institutions across the U.S. are on the hook for the same kinds of fees and added interest as New York. The bill for replacing the $166 billion in auction- rate debt may top $7 billion, not counting extra interest, based on New York’s expenses. Most of that money is going to the same banks that created and controlled the auction market.

“It’s unfortunate that borrowing costs will rise at the very time the state plans to increase bond sales and the budget is under stress,” said Elizabeth Lynam, deputy research director at the Citizens Budget Commission in New York, a business-funded group that monitors state and city fiscal issues.

PerpetualDiscounts were down a tad on the day, but nobody noticed since Energy & Materials equities got slaughtered. The fund is doing quite well, solidly positive on the month to date and handsomely outperforming CPD … which I use as a handy external benchmark.

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