PrefBlog

Naked Capitalism reprints a WSJ editorial that concludes:

A financial system runs on trust, and the credit crisis is continuing in part because there is so much mistrust about the magnitude of potential losses and where those losses reside. By encouraging bond insurers to unilaterally rewrite their contracts, Messrs. Spitzer and Dinallo are only creating more mistrust and uncertainty. We assume the banks that bought the bond insurance and signed the contracts will take their insurers to court.

Holy smokes, if this thing doesn’t get reasonably resolved, things are going to get messy! I can only assume that Dinallo is simply engaging in brinksmanship, with the actual object being a recapitalization of the monolines. The trouble with brinksmanship, of course, is that if it doesn’t work, things have become worse.

MBIA has announced:

it withdrew from its trade association because of differences over the direction of the industry.

“We believe that the industry must over time separate its business of insuring municipal bonds from the often riskier business of guaranteeing other types of securities,” MBIA’s new Chairman and Chief Executive Officer Jay Brown said in a statement today. The company also disagrees with the Association of Financial Guaranty Insurers’ “positions on the appropriateness of monoline financial guarantors insuring credit default swaps.”

The press release on the MBIA site states:

For one thing, we believe that the industry must over time separate its business of insuring municipal bonds from the often riskier business of guaranteeing other types of securities, such as those linked to mortgages. Additionally, we disagree with AFGI’s positions on the appropriateness of monoline financial guarantors insuring credit default swaps and the ability of U.S. financial guarantors to reinsure U.S. domestic financial guarantee insurance transactions with foreign affiliates without paying U.S. corporate tax rates.

The AFGI has posted a review of the industry dated November 2007 and the website FAQ includes asset backed securities as a field of future growth for monolines. I don’t see anything specific about Credit Default Swaps.

There was a further indication that the CDS market is strange:

Credit markets were thrown into fresh turmoil on Wednesday as the cost of protecting the debt of US and European companies against default surged to all-time highs.

The sharp jump, which rivalled the sell-off at the height of last summer’s credit market turmoil, came as traders rushed to unwind highly leveraged positions in complex structured products.

The sell-off was triggered partly by fears of more unwinding to come as investors rushed to exit before conditions worsen. As losses have snowballed, further unwinding has been triggered.
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The cost of insuring the debt of the 125 investment-grade companies in the benchmark iTraxx Europe rose more than 20 per cent to as high as 136.9 basis points, before closing at 126.5bp. That compares with a level of about 51bp at the start of the year, according to data from Markit Group.

In contrast to this, let’s take a quick glance at some recent BoC research into CDS Pricing:

The paper examines three equity-based structural models to study the nonlinear relationship between equity and credit default swap (CDS) prices. These models differ in the specification of the default barrier. With cross-firm CDS premia and equity information, we are able to estimate and compare the three models. We find that the stochastic barrier model performs better than the constant and uncertain barrier models in terms of both in-sample fit and out-of-sample forecasting of CDS premia. In addition, we demonstrate a linkage between the default barrier, jump intensity, and barrier volatility estimated from our models and firm-specific variables related to default risk, such as credit ratings, equity volatility, and leverage ratios.

At best, this study represents a good try – the data for determining the value of a CDS through a cycle simply does not exist. 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.

It’s all very complicated and I’m a simple kind of guy! The complexity was noted in a Financial Times article by Aline Van Duyn and Gillian Tett excerpted by Naked Capitalism:

The fundamental problem is that this decade’s wave of banking innovation has created a financial system that is not just highly complex but also tightly interlinked in ways that policymakers and investors sometimes struggle to understand.
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This could result in the businesses of companies such as Ambac, MBIA and FGIC being split into two, to ensure that bond insurers can ringfence the riskier assets (such as mortgages) from the municipal guarantee business.

But although such a split currently seems attractive in political terms – most notably because it would enable policymakers to protect the municipal bond market in an election year – it will not necessarilly prevent further turmoil on Wall Street. On the contrary, as Jeffrey Rosenberg, analyst at Bank of America, says: “A split may limit losses in the municipal market, but it would likely exacerbate losses to structured finance… To the extent that those losses further constrain financial institutions’ balance sheets, broader credit constaint may follow.”

Cowboys, cowboys! Playing with things they don’t really understand, and sometimes doing quite well for several years. I think they’re wonderful … selling them liquidity is a very profitable endeavor.

As I suggested when the news first came out on January 24, Kerviel’s status as a “rogue trader” must forever be preceded by the qualifier “so-called”. A SocGen report on the loss has reported:

“Controls in place were conducted without triggering a strong or persistent enough alert to enable the identification of the fraud,” the e-mailed report said.
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It did say that compliance officers rarely went beyond established routine checks.

They “don’t have the reflex to inform their superiors or the front office of anomalies, even if they concern large amounts,” the report said.

There weren’t any follow-up checks on cancelled or modified transactions, and no limits on nominal positions, just on net positions, it found.

While procedures were respected and questions were asked, “no initiative was taken to check JK’s assertions and corrections he suggested, even when they lacked plausibility,” the report said. “When the hierarchy was alerted, it didn’t react.”

The committee said there were 75 red flags between June, 2006, and the beginning of 2008 that should have alerted managers to Mr. Kerviel’s unauthorized trades. The warning signs included a trade with a maturity date on a Saturday, bets with “pending” counterparties and missing broker names, the report said.

The actual SocGen report contains a marvellous graph of reported vs. actual P&L for Kerviel’s positions (page 11 of the PDF). 

In other words, SocGen risk management is a complete joke. And in response, of course, SocGen and many other firms are requiring complete ignorance of operations, rather than simply preferring it. This will also serve to emphasize to the traders that operations personnel are low-life scum, who may be ingored, lied to and sworn at with impunity. Brace yourselves for more blow-ups!

A very quiet day today, but the market continued strong. PerpetualDiscounts are now up 3.34% on the month-to-date and 3.76% on the year-to-date. They have had exactly two down days this month (so far!), both less than a beep’s worth.

To my astonishment, there have been no new issue announcements this week, in defiance of my February 15 prediction. Well, perhaps tomorrow will salvage my reputation …

I’m of two minds whether or not to write another post devoted to the BNA issues … the BNA.PR.A closed with a ludicrously strong bid, and the yield on BNA.PR.C is now lower than the equal-credit-shorter-term BNA.PR.B.

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

Monolines, monolines! Accrued Interest muses on an Ambac breakup and concludes:

The challenges of making the split are numerous. There will likely be lawsuits by structured finance holders who logically want to keep the stronger muni business around to support their policies. So we’ll see how it plays out. Since government regulators seem keen on providing aide to the muni market pronto, Ambac may get some legal cover if they manage to push this plan forward.

If they don’t, then a New York imposed plan seems inevitable. I think its time for Ambac (and MBIA) shareholders to start thinking about how to make the best of a bad situation.

While William Ackman, long a gadfly to the monolines as noted on January 31, has proposed an actual structure for such a breakup:

Ackman’s plan has two separate boards of directors, one for the municipal insurer and the other for the structured finance unit. Each board would include policyholders. The municipal insurer would pay dividends to its structured-finance parent only when the board was satisfied the unit could remain AAA rated. The structured finance insurer would send dividends to the holding company only after its board determined the money wasn’t needed to cover claims.

KKR Financial (last mentioned on August 20) continues to experience financing difficulties:

KKR Financial Holdings LLC, Kohlberg Kravis Roberts & Co.’s only publicly traded fixed-income fund, delayed repaying debt a second time in six months after failing to find buyers for commercial paper backed by mortgages.

Lenders to the fund agreed to the delay as KKR Financial seeks to restructure, the San Francisco-based company said yesterday in a regulatory filing. KKR Financial, whose stock has fallen 50 percent in the past year, didn’t say how much debt is affected.

Assiduous Reader madequota has remarked on the disconnect between the (government) bond market and preferreds, which echoes the equity/credit disconnect remarked by Naked Capitalism quoting, inter alia, John Dizard of the Financial Times:

At the moment, the most striking “arbitrage” is between the valuation of risk in the credit markets and the equity markets. Credit markets are discounting the end of the world, while equity strategists whose e-mails I spend half the morning deleting are saying that we are forming a tradeable bottom, which sounds faintly obscene.

As far as prefs are concerned, I’m more surprised by the long corporate/perpetual discount disconnect … according to the DEX long term bond indices long corporate yields are now around 6.00%, up 40bp from their bottom in early January, while long governments are now at about 4.60%, up 20bp from January’s bottom. In sharp contrast to this, PerpetualDiscounts are now at their YTD bottom, yielding 5.39% (about 7.55% interest-equivalent). Currently, the long corporate/Perpetual-Discount-Interest-Equivalent (LC/PDIE) spread is about 155bp.

This may be compared to previous LC/PDIE spreads of 113bp at the end 2006, 109 bp at the beginning of May, 2007, and 210bp at the end of October 2007. So, using these three data points to determine value, in the best of all “Look Mummy I Got A Spreadsheet” tradition, we could say (if we were willing to place our reputation on such a thing) that the LC/PDIE spread is simply moving back to a normal level and we’ve still got about 45bp to go – which is about 6.3% price appreciation.

As I’ve noted before, the end is in sight for my preparation of historical HIMIPref™ Preferred Share indices and soon I will be an enthusiastic member of the “Look Mummy I Got A GREAT BIG Spreadsheet” school of securities analysis. Until then (and after then, as well, if you really want to know) I will proudly state that I don’t have a clue where overall prices are going. I just compare risk to expected return as best I can (of the asset classes, through a cycle) and try to outperform my benchmarks. It works for me.

New York’s Auction Rate Securities, regarding which I noted my lack of panic yesterday and which were in the vanguard of a spate of failed municipal auctions on February 13 have now found that headlines are helping:

Interest rates on $100 million of bonds issued by the Port Authority of New York and New Jersey were set at 8 percent in a weekly auction after surging to 20 percent on Feb. 12.

Rates had soared from 4.3 percent when too few buyers bid for the so-called auction-rate debt and Goldman Sachs Group Inc., which runs the auction, refused to put up its own capital to buy unwanted securities. That caused the yield to be set at a level predetermined in bond documents. Rates fell yesterday as the prospect of high yields enticed investors, according to data compiled by Bloomberg.

It isn’t over, any more than the Great Credit Crunch is over, but at least things are starting to normalize.

Another solidly strong day for the preferred market, but volume was light … and if it hadn’t been for Nesbitt, doing yeoman’s work with some crosses, it would have been even lighter. I just wish I understood the prices being paid for some of those operating retractible issues though … it would seem that some players, for one reason or another, are assigning virtually zero probability to pre-last-minute calls. All the negative YTWs really screw up calculation of averages for the index!

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

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.
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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.
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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)
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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.
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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

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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.
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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.
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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.

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