PrefBlog

Bear Stearns! Bear Stearns! Bear Stearns!

What can I say? Their options are limited:

• Find a parter – e.g., sell out to JPMorgan at a price of about maybe $27 – this is about $60 less than book.
• Hold a fire sale of assets. Then watch the business die.
• Go broke.

Whatever they choose, common shareholders are dead. The only question is whether the franchise will survive. I suspect that it will … there’s a gun to the directors’ heads, because trying to tough it out will just destroy their business before the month is out. There’s a lot of franchise value in Bear Stearns … so they have to go cap in hand to every major investment bank in the world, and desperately hope that at least two of them show an interest. As clearing bank, JPMorgan is most familiar with the assets – if they want it.

Another day of light action in the preferred market, with PerpetualDiscounts down again. CIBC was busy!

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

There was a very gratifying article about the lopsided (disfunctional?) CDS Market today in the Financial Times reprinted by Naked Capitalism:

“The credit default swap market has become lopsided,” says Peter Fisher, co-head of fixed income at BlackRock Financial Management in New York. “It’s not deep and liquid the way we normally think of that — it’s more like an insurance market in which few want to write insurance and many want to buy.”
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In a normal world or in a world where the derivative is closely tied to the underlying cash security, if the price of the derivative became utterly divorced, market operators would step in to trade away the difference, Mr Fisher adds.

But volumes in the credit derivatives market exploded precisely because most of the bonds hardly trade at all. At Goldman Sachs, for example, for every three dollars of trading in bonds, the firm trades $97 in credit default swaps.

As I mused on February 21:

Despite my interest in the asset class, I’m not convinced that the CDS market is ready for prime time. If their main attraction is the ability to lever up a portfolio significantly, then a huge degree of uncertainty is introduced into pricing, in addition to the uncertainty introduced by debt decoupling. I continue to wrestle with the idea, but these twin, undiversifiable uncertainties probably introduce a required risk premium that makes inclusion of these instruments, long or short, in a fixed income portfolio uneconomic.

Treasury Secretary Paulson has announced an initiative to make everybody feel good:

The group also will propose directing credit-rating firms and regulators to differentiate between ratings on complex structured products and conventional bonds. In addition, it wants rating firms to disclose conflicts of interest and details of their reviews and to heighten scrutiny of outfits that originate loans that are enveloped by various securities.
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Mr. Paulson also is planning to encourage the development of a domestic market for “covered bonds,” bonds issued by banks that are secured by mortgages. Popular in Europe, these could be an alternative to securitization. When mortgages are securitized, they generally leave bank balance sheets and banks don’t hold capital against them; covered bonds remain on bank books, and banks must set aside capital to back them.

Covered bonds will be familiar to PrefBlog’s Assiduous Readers. The separate credit rating scale for structured securities is cosmetic nonsense and simply represents more political interference with credit ratings. “Don’t downgrade XYZ, it’s a big employer in my district!”.

In yet another disturbing development, it is felt that indices might attract shorts, therefore don’t have indices:

Markit Group Ltd. shelved plans to create an index that would have allowed investors to bet on the $200 billion market for securities backed by auto loans.

Markit Director Ben Logan confirmed the index was put on hold because of a lack of support from dealers.

The decision follows criticism from analysts at Merrill Lynch & Co. and Wachovia Corp., who said the index would drive down prices of the underlying bonds. Markit had been in talks with firms including Lehman Brothers Holdings Inc., Morgan Stanley, and Bear Stearns Cos. to create and index allowing investors to speculate on auto-loan securities from issuers such as Detroit-based GMAC LLC and Ford Motor Credit Co.

In happier news, S&P opines that the worst of the write-downs is over:

Standard & Poor’s said the end is in sight for subprime-mortgage writedowns by the world’s financial institutions.

Writedowns from subprime securities will probably rise to $285 billion, New York-based S&P said today in a report. The ratings company previously estimated losses of $265 billion in January. S&P raised its estimate because of increased loss assumptions for collateralized debt obligations.

“The positive news is that, in our opinion, the global financial sector appears to have already disclosed the majority of valuation writedowns” on subprime debt, S&P credit analyst Scott Bugie said in an accompanying statement. Losses on other debt such as leveraged loans are still likely to increase, the report said.

The actual report is available from S&P – thanks to Accrued Interest, who found the link and commented on the implications:

Anyway, so people love to talk about what inning we’re in when it comes to the subprime crisis. But let’s be more positive about it, shall we? We’re in the first inning of the healing process. The subprime contagion has decimated broker/dealer capital. That phase is probably wrapping up.

Bank of Canada Governor Mark Carney gave a speech today that was also soothing in its message:

some of the world’s largest financial institutions have recorded substantial losses, the cost of borrowing has increased, and the availability of credit has decreased. More than seven months on, the end is not yet in sight, although it is safe to say that we have reached the end of the beginning of this turmoil. This is not because the dislocations in markets have eased; in fact, strains in financial markets have intensified recently, but rather because we are entering a new phase where policy-makers and market participants have a better understanding of both the shortcomings in the current financial system and what needs to be done – by both groups – to address them.

Mr. Carney gave some very strong indications of his desires for financial market reforms going forward; the speech is important enough that I will attempt to review it thoroughly tomorrow.

The preferred market was weak again on more light volume, with the general malaise resulting in some violent pricing moves when some players absolutely had to get some selling done (RY.PR.F was particularly noteworthy). The PerpetualDiscount index has had only one up-day in the twelve trading days following February 26 and is currently down 2.78% from its 2/26 level.

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

Econbrowser‘s James Hamilton has an interesting philosophical piece on the limits to the Fed’s ability to influence the economy, Asking too much of monetary policy:

I am certainly a believer in the potential real effects, sometimes for good, sometimes for ill, of monetary policy. But I just as certainly do not believe, nor should any reasonable person believe, that no matter what the economic problem might be, you can always solve it just by printing more money.
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I would nevertheless caution that we need to be open to the possibility that no matter how low the Fed brings its target rate, it may not arrest the unfolding financial disaster. Unless the intention is to go all the way with enough inflation to avert the defaults, that means we need an exit strategy– some point at which we all admit that further monetary stimulus is doing nothing more than generating inflation, and at which point we acknowledge that the goal for monetary policy is no longer the heroic objective of making bad loans become good, but instead the more modest but also more attainable objective of making sure that fluctuations in the purchasing power of a dollar are not themselves a separate destabilizing influence.

Indeed, with the Treasury curve virtually decoupled from the corporate curve, it doesn’t look like there’s anything more the Fed can do. Cutting rates again probably will not have any major effect on corporate yields, or on banks’ willingness to lend; I think that the only justification for such a move would be to help increase profit margins at the banks in order to assist their recapitalization, as was done in 1993 – the year of the steepest yield curve on record, which led to 1994 – the year of the worst government bond market on record.

At the moment, I don’t think there’s a lot of evidence that such drastic treatment is necessary. Below are some graphs available from the FDIC showing the recovery of the American banking system from 1990-94 … sorry they’re not too clear, click on them for a better version, or just go directly to the full report.

Some of this was due to Resolution Trust, to be sure, but a good chunk was due to a very steep yield curve that made it very profitable to borrow short and lend long.

It is interesting to note, from the FDIC report, that data for 4Q93 (the point at which the Fed said, “OK, play-time’s over, we’re going to start hiking now”) indicated that the 13,220 institutions reporting had $375-billion in capital backstopping $4,707-billion in total liabilities and capital, an equity leverage ratio of 12.61. The current FDIC report, 4Q07, shows 8,533 institutions with capital of $1,352-billion backstopping $13,039-billion, equity leverage of 9.6:1.

One may well quibble over the 4Q07 equity figure … perhaps there are massive unrecorded losses about to appear. And one may quibble even more about the relative quality of assets between then and now – subprime and perhaps credit card and auto debt coming up for kicking in The Great Leverage Unwinding of 2007-08. But all in all, as I’ve pointed out in posts on loss estimates and loss distribution, I’m having a hell of a time finding credible, sober analysis concluding that Armageddon is Now.

Anyway, what I’m trying to say is that I agree with Prof. Hamilton (subject to quibbles about loss estimates), when he states:

The problem then is many hundreds of billions of dollars in loans that are not going to be repaid, the prospect of whose default could completely freeze the market for credit.

That, it seems to me, is a problem you can’t solve by lowering the fed funds rate.

By me, the Fed is doing the right thing with the TSLF introduced yesterday. The problem is liquidity, and there are many players with indigestible lumps of sub-prime paper on their books. These are, I’ll bet a nickel, on their books at marked-to-disfunctional-market prices well below ultimate recovery, but so what? They can’t sell them to hot money – hot money’s got its own problems:

At least a dozen hedge funds have closed, sold assets or sought fresh capital in the past month as banks and securities firms tightened lending standards. The industry is reeling from its worst crisis because bankers — staggered by almost $190 billion of asset writedowns and credit losses caused by the collapse of the subprime-mortgage market — are raising borrowing rates and demanding extra collateral for loans.

They can’t sell them to real money – real money read in the paper just last week that it’s all worthless junk. So the paper has to sit on the books for a while and be financed in the interim.

Perhaps not entirely coincidentally, there’s an article on VoxEU titled Why Monetary Policy Cannot Stabilize Asset Prices. VoxEU is up to its old tricks … the page is blank. To read the article, you have to click “View|Source” on your browser, pick a section to copy/paste, save this extract as a .html file on your hard drive and then open this with a browser. The graph has to be viewed separately.

Mechanical difficulties aside, it seems that this will soon be a CEPR discussion paper; the authors state:

Figure 1 analyses the effects of a 100 basis points increase in interest rates. Note that after about 8 quarters, interest rates have declined but remain about 35 basis points above their initial level. After 12 quarters, they have fallen further to a level some 10 basis points above the starting point. Overall, the increase in interest rates will dissipate in about three years.

Turning to real property prices, we note that these start to fall in response to the tightening of monetary policy. After 16 quarters, they reach a bottom of about 2.6% below the initial level and then start to return gradually to their starting level. Overall, property prices react quite slowly to monetary policy actions.

Next we consider the responses of real GDP.³ The figure shows that it also reaches a trough after 16 quarters, when it is some 0.8% below its initial level.⁴ Thus, the responses of real GDP are almost exactly 1/3 of those of real property prices.⁵ This is an important finding. To see why, suppose that monetary policy makers come to believe that a real property price bubble of 15% has developed, and decide to tighten monetary policy in order to bring down asset prices. In doing so, the average central bank in the 17 countries we study should also expect to depress the level of real GDP by 5%, a truly massive amount.
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Whatever merits such a stabilisation policy has in theory, our research suggests that in practice, monetary policy is too blunt an instrument to be used to target asset prices – the effects on real property prices are too small, given the responses of real GDP, and they are too slow, given the responses of real equity prices. In particular, there is a risk that setting monetary policy in response to asset price movements will lead to large output losses that exceed by a wide margin those that would arise from a possible bubble burst.

In other news, Accrued Interest points out that It’s just a dead animal:

Now I’m not here to say whether Bear Stearns has liquidity problems or not. The recovery in both the stock and bond market for Bear paper would indicate that they probably don’t. But this kind of panicky trading is exactly why its hard to own financial bonds right now. I mean, anyone who had traded through bear markets knows that the rumor mill becomes very active. Right now everyone is nervous. The longs are nervous because they’ve been losing money and/or under performing their index for months now. I’m sure there are many portfolio managers and/or traders worried about losing their jobs over poor performance.

The shorts are nervous too. Right now corporate credit spreads are at all-time wides. That means that getting short a credit is expensive to begin with.
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So amidst all this nervousness, it seems that Wall Street starts giving more credence to rumors.

Sit tight, do your homework, turn off the TV and stare at financial statements until you’re crosseyed, that’s the path to success. The bond market is excitable and always will be … ignore it, keep your company-specific bets small, your leverage non-existant and have another look at them financial statements.

In other news, it looks like Barney Frank, Chairman of the House Financial Services Committee wants to start his own credit rating agency:

U.S. Representative Barney Frank gave ratings companies a month to fix “ridiculous” standards that they apply to local government debt, as his House committee opened a hearing today on how the firms evaluate municipal bonds.

“I am going to say to the rating agencies and to the insurers: they have about a month to fix this,” Frank, the Massachusetts Democrat who chairs the House Financial Services Committee, told reporters in Washington yesterday. “We’re going to tell them they have to straighten it out.”

California Treasurer Bill Lockyer and other state officials are calling for Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings to change a system they say costs taxpayers by exaggerating the risk that municipal issuers will default on their debts. Every state except Louisiana would be AAA if measured by the scale used for corporate borrowers, according to research by Moody’s.

“This notion of having a separate standard for the municipals because they would do too well on the other standard is ridiculous,” Frank said.

Cool! Credit ratings courtesy of the politicians! Doesn’t that make you feel safe? Sign me up!

Back on Earth, Berkshire Hathaway is worried that municipal bond insurance will return to ultra-cheap levels in a price-war:

The risk of guaranteeing municipal debt is increasing because the economy is slowing and some insurers may cut prices to regain lost business, said Ajit Jain, head of Berkshire Hathaway Inc.’s new bond insurer.

Fiscal stress in Vallejo, California, and Jefferson County, Alabama, may be the “tip of the iceberg” for municipal defaults, said Jain, who runs Warren Buffett’s Berkshire Hathaway Assurance Corp. He said downgrades of some insurers hurt the industry’s integrity and those firms may spark “pricing wars” if they regain their financial footing and seek to recoup lost business.
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Ambac and MBIA, the two largest bond insurers, may trigger a price war if they stabilize their AAA ratings and start backing municipal bonds again, Jain said.

“That will be unavoidable,” he said in his testimony. “Unless you continue to believe that this is zero-loss business, that conduct assures a bleak future for this business.”

Another light day for volume. Split-shares got hammered, particularly the BNA issues that have something of a penchant for volatility. PerpetualDiscounts were also weak.

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