PrefBlog

I will admit to having felt a certain amount of schadenfreude when Accrued Interest brought to my attention what has to be one of the world’s worst bond funds. A loss of over 50% in a year in what was touted as a fund that would seek:

a high level of income by investing in intermediate maturity, investment grade bonds. The fund seeks capital growth as a secondary objective when consistent with the fund’s primary objective.

… must be something of a record. But this is the modern age! Faster, Stronger, Better! Citigroup’s Alternative Investments unit has brought new meaning to the word “Alternative”:

Falcon Plus Strategies, launched Sept. 30, lost 52 per cent in the fourth quarter, after betting on mortgage-backed and preferred securities and making trades based on the relative values of municipal bonds and U.S. Treasuries. Some collateralized debt obligations in the fund trade at 25 per cent of their original worth, the newspaper said.

OK, well, I think it’s funny! The WSJ had some more detail about the excellence of Citigroup’s risk-control procedures:

Mr. Pickett’s big order last June was for several hundred million dollars of leveraged loans that a group of banks was selling in a private auction on behalf of a German media company, according to people involved in the transaction. At the time, CSO had roughly $700 million in assets, meaning that Mr. Pickett wanted to commit more than half of the hedge fund’s assets.

Some investors in the fund contend that executives at Citigroup didn’t supervise Mr. Pickett closely enough. “I don’t understand…how it would have been possible for him to take on a position that was disproportionately large,” says one investor in CSO.

Citigroup defends its handling of the situation. Spokesman Jon Diat said CSO and similar funds “are subject to comprehensive internal fiduciary risk oversight, risk management practices and senior-level management supervision.”

The mention of collateralized debt obligations continues to resonate, since UBS says there’s a good chance of huge write-downs to come:

Writedowns for collateralized debt obligations and subprime related losses already total $150 billion, [UBS analyst Philip] Finch estimated. That could rise by a further $120 billion for CDOs, $50 billion for structured investment vehicles, $18 billion for commercial mortgage-backed securities and $15 billion for leveraged buyouts, UBS said. “Risks are rising and spreading and liquidity conditions are still far from normal,” the note said…..

And you’ve got to figure … a UBS analyst would know!

Monolines, monolines … Elliot Spitzer, best known for his efforts in singlehandedly saving the world from the horrors of a NY state governor who was not Elliot Spitzer, has made a bald threat to take over the monolines (well … MBIA, anyway) and split them:

During a recess, Mr. Spitzer told reporters that splitting the bond insurers’ businesses was a last resort. “The clear preference is a recapitalization of the companies,” he said. “Even if the deals don’t close, the sort of market comfort that would be needed to stabilize the marketplace could get there pretty quickly. We just have to wait and see what happens.”….

Turning up the heat yesterday on the banks’ discussions, he said in an interview that there are “some mechanisms” in the law that allow regulators to “force [the bond insurers] into what’s called ‘rehabilitation.'” During his testimony before the panel, he asked Congress for a $10 billion line of credit for the bond insurers, which he said could encourage banks to contribute capital.

There are claims that FGIC wants to be split up:

FGIC Corp., the bond insurer stripped of its Aaa rating by Moody’s Investors Service, asked to be split in two to protect the municipal bonds it covers, according to the New York Insurance Department.

FGIC, owned by Blackstone Group LP and PMI Group Inc., applied for a new license so it can separate its municipal insurance unit from its guarantees on subprime-mortgages, David Neustadt, a department spokesman, said in a telephone interview.

And was the regulator holding a gun to FGIC’s head at the time, or what? What’s the whole story? 

How can this possibly be legal? More to the point, how can it possibly be ethical? Those who purchased credit protection on sub-prime did so based on the strength of the whole company, not simply the post hoc selection of bad bits. Accrued Interest speculates that the so-called crisis might simply be political embarrassment:

But the refinancing won’t erase the embarrassment of having an auction failure. Governmental agencies, including the Port Authority, will start putting increasing pressure on the New York insurance regulators to resolve this matter once and for all.
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But the combination of heavy political pressure and a viable private sector solution will be too difficult to ignore. A deal will be worked out to insulate the municipal bond market.

Perhaps more to the point, there is at least a little concern that the so-called crisis in Auction Rate Municipals is largely self-inflicted:

Banks including Goldman Sachs Group Inc. and Citigroup Inc. allowed hundreds of auctions to fail this week after they were unable to attract bidders and decided to stop buying unwanted securities. A failed auction nearly doubled seven-day borrowing costs on $15 million of bonds sold by Harrisburg International Airport in Pennsylvania to 14 percent while a $100 million Port Authority of New York & New Jersey bond reset at 20 percent, up from 4.3 percent a week earlier.

“The problem with most auction bonds isn’t the bonds’ credit quality or default risk,” said Joseph Fichera, chief executive at Saber Partners, a New York-based financial adviser to local governments. “The problem is that there isn’t enough demand for the bonds because some issuers gave monopolies on the distribution to a few banks.”

Just to think … there are still some people in the world who believe that increased political involvement via regulation will save the world!

There has been an amusing twist to the increase in the allowed size of GSE mortgages, which was discussed on January 29. The effective infusion of new money into the jumbo mortgage sector will, in the absence of other factors, affect prices of existing securities:

If larger loans can be packaged into guaranteed securities that can trade in the TBA market, the difference between their rates and those on other prime mortgages would probably fall to between 4 basis points and 19 basis points, from more than 80 basis points today, New York-based Credit Suisse analysts Mukul Chhabra, Chandrajit Bhattacharya, and Mahesh Swaminathan wrote in a report last week. The rates offered on other prime mortgages would climb by a similar amount, they said.

So the trade association that regulates such matters is not allowing the GSE-jumbos to trade normally:

The larger home loans that Fannie Mae and Freddie Mac will temporarily be allowed to guarantee won’t be accepted into the main market for mortgage bonds, the Securities Industry and Financial Markets Association said.

The revised guidelines for the so-called To Be Announced market cover mortgages of more than $417,000 that the government- chartered companies are permitted to buy or guarantee under the $168 billion economic stimulus package signed into law this week, according to a statement today from the trade group in New York.

The exclusion of the larger loans should reduce the size of drops in jumbo mortgage rates that will result from the new law, according to analysts at Credit Suisse Group and Citigroup Inc. Including the loans would have hurt bondholders because their securities would have dropped in value.

A quiet day in the market – not much volume or price movement, probably due to intensive preparations for Bozo Day. With markets at current levels, and now that that $430-million in bank issuance seems to have been well-digested … it wouldn’t surprise me much to see a new issue first thing Tuesday morning, or sometime next week, anyway. Maybe one of the insurers will want some capital so they can go after AIG’s business in its weakened state? Who knows? I wouldn’t bet a dime on it, but I’d go so far as to put a nickel on a new Pfd-1 issue next week at 5.50%.

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

The bond insurance story is just getting bigger and bigger!

Accrued Interest points out:

According to data from Thomson Financial, only about 28% of municipal bonds issued in January carried insurance from a monoline insurer. That’s down from 46% in 2007. Meanwhile, according to Merrill Lynch, new insurance was dominated by FSA and to a lesser extent, Assured Guaranty. FSA insured $3.8 billion of new issues, about 70% of all new issue munis which carried insurance. Assured picked up most of the remainder ($1.3 billion or 23% of new insured issuers).
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The fact is that confidence in insurance has never been lower, and yet buyers continue to demand insurance at all tells you something. MBIA and Ambac may never be able to regain AAA levels of confidence, but municipal bond insurance as a concept will survive.

Yesterday‘s rumours that the New York insurance regulator would pursue a Good Insurer/Bad Insurer solution to the problem have been confirmed:

One part would operate the profitable municipal bond insurance business, while the other would handle so-called structured finance products, according to testimony prepared for Eric Dinallo, the New York State insurance superintendent. Dinallo is scheduled to address a U.S. congressional committee today.

“Our first priority will be to protect the municipal bondholders and issuers,” according to Dinallo’s testimony. “We cannot allow the millions of individual Americans who invested in what was a low-risk investment lose money because of subprime excesses. Nor should subprime problems cause taxpayers to unnecessarily pay more to borrow for essential capital projects.”

Naked Capitalism observes:

the priorities have been turned on their head. Before, the reason for a rescue was to prevent carnage on Wall Street. That objective has now been shunted aside as municipalities are hit by the seize-up in the auction rate securities market.

And yes, the Auction Rate Municipals market is getting worse by the day:

UBS AG won’t buy auction-rate securities that fail to attract enough bidders, joining a growing number of dealers stepping back from the $300 billion market, said a person with direct knowledge of the situation.
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As much as $20 billion of auctions didn’t attract enough buyers yesterday, an 80 percent failure rate, based on estimates from Bank of America Corp. and JPMorgan Chase & Co.

Merrill Lynch is also cutting back its support. Auction Rate Municipals were introduced to PrefBlog readers on February 6. From esoteric trivia to world crisis in eight days! I feel certain that, like the Canadian ABCP market, this is all the fault of the credit rating agencies. Did you know they get paid by the issuers?

There’s another interesting piece of trivia about the insurers … apparently many brokerages considered them such stellar credits that they didn’t have to put up collateral on their CDS exposure:

Goldman Sachs has made plenty of canny decisions in relation to the credit crunch. One of the smartest might have been its treatment of MBIA, the world’s biggest bond insurer.

While many rivals have in recent years been cheerfully using bond insurers to hedge their structured credit bets, Goldmans has refused to do so due to concern about counterparty risk.
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In taking $2bn and $3.1bn writedowns in hedges with insurers whose ability to honour those commitments is in doubt, CIBC and Merrill Lynch respectively have become the face of Wall Street’s nightmares.

It’s always the same thing, eh? Times are good and leverage increases, which only deepens the downturn when it finally arrives. Not just leverage, but also sector concentration of cowboys’ portfolios, witting or unwitting. The importance of correlation has been discussed before: briefly, for example, a husband and wife might each be in jobs that have a 10% chance of disappearing in any given year. A naive analysis (zero correlation) will assign a 1% chance to them both losing their jobs in a year … but if they both work for General Motors at a SUV plant, the chance of them both losing their jobs could be as high as the 10% risk they face individually.

Aleablog has noted in a post picked up and expanded by FT Alphaville that was linked by Naked Capitalism a story by Reuters [I love the Internet] that states:

Correlation on the five-year investment-grade Markit iTraxx Europe index — a measure of investor fears of a system-wide crash — reached new highs of 45 percent on Tuesday. Analysts said the figure had room to go higher still, but some said investors who are now trading based on high correlation could get burned if companies start to default.
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Over the past six months, the credit crisis and a low corporate default rate have pushed correlation up, which means the equity tranche has gained relative to the triple-A tranches.Analysts at UBS, in a recent note to investors, said one reason was that banks and financial entities such as conduits, which accumulated billions of dollars of triple-A tranches of CDOs, have needed to unwind or hedge against those tranches.
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“Now in a world where leverage has to come down, the pressure is on the piece that is the most leveraged, and that’s the super-senior tranches,” Charpin said.
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UBS analysts said the latest rise in correlation may have come also from hedge funds’ needs to raise cash. “If you are a cash-strained hedge fund, that may be a cheap trick to get quickly money back in your pocket,” the analysts wrote. “This is all the more relevant in the last weeks as prime brokers are clamping down on hedge funds’ funding.”

This is where smart analysis is worth money. A mechanism is at work that is pushing up the price of one analytical variable (correlation) without [necessarily] having anything to do with the the actual value of that variable. Therefore, a thorough analysis might show that shorting that variable is a smart thing to do – subject, of course, to a host of risk-control measures. In the preferred share market, for example, I might determine (with the use of HIMIPref™ that convexity is cheap. I might not be able to buy convexity directly, but the valuations of each investible instrument will be adjusted to reflect that view. And, perhaps, a portfolio with an increased convexity might then become cheap enough to the current portfolio that a trade is signalled. And … sometimes it works!

Monoline woes are also spreading into the LBO market, as noted yesterday and on February 11. It seems that formerly reliable Negative Basis Trades are turning positive:

Banks’ exposures through bond insurers, or monolines, is far from limited to mortgage-related MBS and muni bonds. There’s a third big exposure – to leveraged buyout loans – that banks will have to deal with if monolines hit the rocks.

Negative basis trades have been around for a while. A bank buys a bond – say it’s AAA – and then it takes out a CDS against that bond with a monoline. Since spreads in the CDS market for such tranches have been typically much lower than in the cash market, the bank pockets the difference.

But as well as banks’ much-dissected CDO exposures, there have been two other big markets for that kind of trade: on infrastructure bonds and – most interestingly – in structured finance, on CLOs (collateralised loan obligations) – CLOs being the vehicle of choice in which to park massive buyout loans.

Monolines, of course, are no longer in a position to be writing new contracts for banks to use as one half of their negative basis trades. The consequence of that has been that banks have stopped buying AAA tranches of CLOs. Unable to sell those, CLOs have faltered and banks in turn, have found themselves with lots of big buyout loans stuck on their books. No new financing is available for private equity deals.

The monoline FGIC was downgraded by Moodys today, which won’t help things much. The last sentence of the quoted analysis might be of interest to BCE speculators! 

Meanwhile, with a continue plunge in US real-estate values, there are desperate pleas for a government bail-out:

One proposal, advanced by officials at Credit Suisse Group, would expand the scope of loans guaranteed by the Federal Housing Administration. The proposal would let the FHA guarantee mortgage refinancings by some delinquent borrowers….

The risk: If delinquent borrowers default on their refinanced loans, the federal government would have to absorb the loss…

*Yawn*. Speaking of bail-outs, the German government bailout of IKB was mentioned yesterday. Willem Buiter is not happy:

If ever a bank was sufficiently systemically insignificant and small enough to fail by any metric except for the political embarrassment metric, it is surely IKB, the German small and medium enterprise lending bank that got itself exposed fatally to the US subprime crisis through a conduit (wholly owned off-balance sheet entity) devoted to speculative ventures involving instruments it did not understand.
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I can think of no better way of encouraging more appropriate future behaviour towards risk by German banks than letting IKB go into insolvency now. The institution gambled recklessly and irresponsibly. It lost. Liquidation and sale of its assets would be the market-conform reward for its failures.

Light-ish trading again today, but holy smokes, this market is on FIRE! PerpetualDiscounts are up 2.84% month-to-date; I noticed yesterday that the S&P/TSX Preferred Share Index (as proxied by CPD) had erased its post-new-issue losses to return to the level immediately prior to the BNS new issue announcement. And more today. So there.

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