PrefBlog

Bill Gross of PIMCO (whose forecast of FedFunds at 3.50% was mentioned here on October 29) has called for rough justice for the monolines:

As long as the illusion lasted, however, it is clear that monoline guarantees fostered an expansion of our modern shadow banking system and therefore an extension of US and even global economic prosperity.
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…authorities through both official and backdoor channels now endorse a rescue effort. What is good for Ambac, they reason, is good for the country – and by extension the world.
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As stock markets rise on optimistic workout developments, it is clear that it is – in the short run. But like General Motors a half century back, the sense of stability imparted to an oligopolistic industry with visible flaws is not likely to last, nor may the hope for a return to economic growth of recent years. The modern US financed-based economy has a striking resemblance to Barney Fife, guaranteeing global prosperity without the productive industrial-based firepower to back it up. Neither ultra-low interest rates or tax rebates, nor investor-led and authority-based monoline bailouts are likely to change that significantly during the next few years.

I’m inclined to agree with him … as far as I can tell – without specializing in such matters – the monolines are better characterized as hedge funds than anything else. Let them fail!

Treasury trading is showing increasing nervousness:

Traders drove two-year note yields to 172 basis points below 10-year rates, the widest gap since September 2004. The spread signals increasing demand for shorter-maturity debt in anticipation that interest rates will fall. Longer-dated securities are more vulnerable to speculation that rate cuts will revive the economy, spurring inflation and eroding the bonds’ fixed payments.

Two-year notes are poised for the longest stretch of weekly gains since October 1998, while 10-year notes are headed for their biggest weekly loss in almost two months. Thirty-year yields have risen this week by the most in nine weeks.

I am fearful of US inflation, but it takes two to make a market! Janet Yellen, president of the Federal Reserve Bank of San Francisco, takes the other view:

I expect core inflation to moderate over the next few years, edging down to around 1¾ percent under appropriate monetary policy. Such an outcome is broadly consistent with my interpretation of the Fed’s price stability mandate. Moreover, I believe the risks on the upside and downside are roughly balanced. First, it appears that core inflation has been pushed up somewhat by the pass-through of higher energy and food prices and by the drop in the dollar. However, recently, energy prices have turned down in response to concerns that a slowdown in the U.S. will weaken economic growth around the world, and thereby lower the demand for energy.… Another factor that could restrain inflationary pressures is the slowdown in the U.S. economy. This can be expected to create more slack in labor and goods markets, a development that typically has been associated with reduced inflation in the past.

We shall see! 

I’ve added another blog to the blogroll … Across the Curve. As with Accrued Interest, I don’t know the guy (John Jansen) and haven’t verified any of his claimed credentials … but I’ve read his posts and yes, he’s been a player.

I discussed the effect of the TAF on bank reserves – and hysterical reactions thereof – on January 29. Naked Capitalism is now republishing a UBS research note that, frankly, I don’t understand at all:

What if the Fed’s rate cuts aren’t motivated by the desire to stave off recession, rather they’re to prevent a major banking crisis. Not one of escalating subprime losses or monoline downgrades, but actually a sheer lack of cash. The Fed’s not telling anyone what it’s up to because it doesn’t want to cause panic, but the evidence is actually there in its own data…

Ok, so things might not be quite as bad as that, but the situation isn’t far off. That’s because of the TAF. ….a savvy bank can put down lesser quality paper that it can’t generally do very much with (and certainly no one else really wants it), raise funds through the TAF, then use those funds to put down as reserves, and then conveniently gets paid a modest rate of interest against those reserves (which acts as a partial offset against the TAF). While there’s a small net cost to the banks, the real loser here is the Fed, what it gets stuck with is an ever growing pile of collateral.

Now consider this – that collateral is actually what’s backing the entire US banking system by way of its conversion to dollars and then the flow of those same dollars back to the Fed….

All this changes the complex of the US banking system somewhat. From the gold standard to the subprime standard perhaps?

In the first place, there is no interest paid on reserve balances. In the second place, the monetary effect of the TAF was neutralized by the Fed’s sale of T-Bills. I note Caroline Baum’s column and say: one may take a view on the advisability of the TAF, one may take a view on capital adequacy, and one may take a view on inter-bank lending; but any hullaballoo over “negative non-borrowed reserves” is hysterical nonsense:

The writer of the e-mail directs his readers to the most recent H.3 report, which shows total reserves ($41.6 billion) less TAF credit ($50 billion) less discount window borrowings ($390 million) equals non-borrowed reserves (minus $8.8 billion). The negative number is really an accounting quirk: If banks borrow more than they need, non-borrowed reserves are a negative number.

This gentleman is overlooking the fact that the Fed is “a monopoly provider of reserves,” said Jim Glassman, senior U.S. economist at JPMorgan Chase & Co. “This is a non-starter. There is no such thing as a banking system short of reserves. The Fed has absolute control over the supply.”

[Update: See also Felix Salmon at Why Non-borrowed Reserves Don’t Matter] 

On the Better-Living-Through-More-Rules front, SEC Chairman Christopher Cox made a speech today:

Among the proposals that the Commission may consider in the spring are rules that would require credit rating agencies to make disclosures surrounding past ratings in a format that would improve the comparability of track records and promote competitive assessments of the accuracy of past ratings. In addition, the Division may propose rules aimed at enhancing investor understanding of important differences between ratings for municipal and corporate debt and for structured debt instruments.

I have also asked the Division to present proposed rules to the Commission that begin to address the significant shortcomings that we’ve identified in the municipal market. The recent financial stress on monoline insurers has heightened the importance of timely and rigorous disclosure that investors can understand. We have had ample illustration already of what happens when investors fail to look past an AAA rating to do independent analysis themselves — a problem that was exacerbated when important information was not supplied to the market in real time.

Well, I don’t have any problems with the transition analyses that the agencies currently publish, but I suppose if a standard format for these is defined it’s not horrible. I fail to see the point of the other stuff, though: “may propose rules aimed at enhancing investor understanding”; “what happens when investors fail to look past an AAA rating to do independent analysis themselves”. Seems to me these are due diligence issues, to be addressed at the SEC/Advisor level; with performance issues to be Client/Advisor.

I love the way that Mr. Cox assumes that advisors at fault in the sub-prime debacle will actually read additional information if it is available. All the rules in the world won’t make a genius out of a bad advisor.

It was a very quiet day for prefs. PerpetualDiscounts had their first down day since January 28 – they have gained 3.1% since then.

In the continuing saga of the credit rating agencies, S&P has announced the creation of an ombudsman position, together with other reforms:

Among the changes set to be announced today, S&P will rotate lead rating analysts after five years of following the same company, government bond issuer, or structured-finance arranger. The new practice, which will be phased in, should prevent professional or personal relationships from affecting ratings, company officials said.

Analysts who leave S&P to work at a bond issuer will have some deals they previously rated reviewed to make sure their objectivity wasn’t compromised by the prospect of the new job.

Hey! That makes all kinds of sense, doesn’t it? Perhaps, now that I’ve been offering advice on preferred shares for over five years, the regulators should insist that I be rotated to, say, junior oil equity. Naked Capitalism isn’t much impressed:

The real problem that the agencies are paid by the very organizations they rate, and as long as this conflict remains, all other measures are mere window-dressing. The creation of an ombudsman role is an inadequate, unrealistic remedy for a problematic payment structure.

Well, last I heard, this was still a reasonably free country. Anybody who doesn’t want to take S&P’s advice is (as far as I know) welcome to listen to somebody else. But nothing, particularly not logic, will dampen expectations for certainty and a risk-free investment environment … portfolio managers should, if anything, welcome the provision of bad advice (if we may make the assumption, for the moment, that S&P’s advice is bad), since this will lead to market mispricing that may be exploited.

Andrew Cuomo, well known for his uncanny expertise at fixed income credit analysis, isn’t much impressed either:

New York Attorney General Andrew Cuomo said “supposed reforms” by Standard & Poor’s and Moody’s Investors Service, which gave high ratings to subprime debt that later plummeted, are “too little, too late.”
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“Both S&P and Moody’s are attempting to make piece-meal changes that seem more like public relations window dressing than systemic reform,” Cuomo said in the statement.

In more interesting news, it appears that Credit Default Swaps may have increased the corellation in the mononlines sector:

Separately, the Financial Times reports on yet another largely unrecognized hole in the bond insurers’ balance sheets. Wall Street was apparently fond of a so-called negative basis trades. If they bought a bond, hedged it with credit default swaps, then hedged the risk of the guarantor defaulting (generally a monoline) with a different guarantor (generally a different monoline), they could accelerate the expected profits over the life of the deal into the current period. The result is that the bond insurers have an unknown (to the outside world) but potentially significant number of guarantees written on each other.

There is at least one player trying to whip up the panic:

Deutsche Bank AG Chief Executive Officer Josef Ackermann said rating downgrades for bond insurers pose risks that could match the U.S. subprime market collapse.

“It could be a tsunami-like event comparable to subprime,” Ackermann said in a Bloomberg Television interview in Frankfurt today. Deutsche Bank, Germany’s biggest bank, is “well positioned” on its risk from bond insurers, he said

But there is another player – one not trying to sell a specific product – who has an opinion. Bernanke is concerned that monoline problems could cause banks’s balance sheets to gross-up. And Moody’s has downgraded SCA:

Security Capital Assurance Ltd.’s bond insurance units, hobbled by a decline in subprime mortgage securities, lost their Aaa credit rating at Moody’s Investors Service.

XL Capital Assurance Inc. and XL Financial Assurance Ltd. were cut six levels to A3, New York-based Moody’s said today in a statement. The outlook for both is negative, Moody’s said.

And MBIA, desperate to avoid such a fate, has embarrassed itself even more than it did yesterday by selling even more equity at an even lower price:

MBIA Inc., the world’s biggest bond insurer, raised $1 billion by selling shares at $12.15 each in an effort to protect its AAA insurance rating.

The 82.3 million shares were sold at a 14 percent discount to Armonk, New York-based MBIA’s $14.20 closing price today, according to data compiled by Bloomberg.

MBIA increased the sale from a planned $750 million, though accepted a lower price than it had anticipated. The sale matches the price private-equity firm Warburg Pincus LLC had agreed to pay to backstop the transaction in case no buyers could be found.

Speaking of downgrades, Loblaws was downgraded today, which has implications for Weston. I’ve updated the post about Weston’s credit. 

The Cleveland Fed has updated its estimate of inflation expectations from TIPS … very interesting indeed. The breakeven rate is increasing slightly, but the analytical rate – which attempts to incorporate adjustments for the inflation-risk-premium and liquidity-premium – is skyrocketting. This epsiode will be very useful in determining the validity of these adjustments!

I have opined many times in the past that the Fed’s easing may well rebound in an unfavourable manner vis-a-vis inflation – scarcely the most original of views, but I do what I can. In this context, it was interesting to read the following report on the Treasury Bond auction:

U.S. 30-year Treasuries fell the most since June as demand was weaker than expected at the government’s $9 billion auction of the securities.

Ten- and 30-year securities declined a second straight day as investors balked at buying at this week’s auctions, with yields at record lows. Investors are also betting that the Federal Reserve’s five interest-rate cuts since September will revive economic growth and cause inflation to accelerate, reducing the value of Treasuries’ fixed payments.

“The auction went as poorly as one could imagine,” said Andrew Brenner, co-head of structured products in New York at MF Global Ltd., the world’s largest broker of exchange-traded futures and options contracts. “There isn’t a lot of demand for bonds at these levels.”

These fears are finding support at high levels:

Federal Reserve Bank of Dallas President Richard Fisher, who voted against cutting interest rates last week, warned that aggressive reductions in response to a weak economy may “juice up” inflation.
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“Given that I had yet to see a mitigation in inflation and inflationary expectations from their current high levels, and that I believed the steps we had already taken would be helpful in mitigating the downside risk to growth once they took full effect, I simply did not feel it was the proper time” for more rate cuts, Fisher said.

Another good day! PerpetualDiscounts continued to improve and volume remained above the recent average.

There were twenty-six other index-included $25.00-equivalent issues trading over 10,000 shares today.

Willem Buiter was last mentioned in PrefBlog on January 25 in connection with inflation concerns. He’s back again today, preaching not just the likelihood, but the necessity of a US recession:

Therefore, to restore a sustainable external balance and to accumulate the financial assets that will support a greying US population in the style it would like to and hopes and expects to be accustomed to, the US private and public sectors must save more. To get to a higher saving and wealth trajectory, the US economy will first have to pass through the valley of the shadow of deficient effective demand, rising excess capacity and growing unemployment. Postponing the necessary adjustment will just make the pain of the eventual unavoidable correction that much greater.

The trouble with such a prescription is that it runs headlong into the American “can do” attitude. This attitude is admirable and has served them well … but sometimes it comes a cropper. “Reduce taxes and the deficit while increasing services? Can do!” “Bring Western Democracy to regions where even those who understand it don’t want it? Can do!”.

The failure of a few auctions for American Auction Rate Municipals has attracted some notice lately. Accrued Interest explains the situation … it all comes down to the monolines!

The bank was only willing to provide liquidity if there was some additional credit support. No problem, thought the municipal bond bankers! We’ll bring in a monoline insurer! The bank would therefore agree to provide liquidity so long as the bond insurer was rated at some minimal credit rating level. What that level is depends on the deal. Might be AA, might be A. I haven’t seen any that were actually AAA but they could be out there.

But what happens if the unthinkable happens? A monoline insurer gets downgraded? Well, the bank’s liquidity agreement becomes null and void. Where does that leave bond holders? It leaves them with no credit support at all. Only the issuer itself would remain.

Auction rate securities are a recurring niche in the markets – I remember (a long, long time ago) there were some Hees (remember Hees?) MAPS – Monthly Auction Preferred Shares. It’s really just another mechanism whereby issuers can finance long at short rates and investors can pretend they’re money-market superstars by outperforming the 3-month benchmark with 100-year paper … for a while.

And the mention of monolines reminds me of a funny story … remember MBIA’s line in the sand, discussed on January 31? Well, the tide’s come in:

MBIA Inc., the world’s biggest bond insurer, plans to raise an additional $750 million by selling about 50.3 million common shares, bolstering capital in an attempt to retain its AAA credit rating.

Investment firm Warburg Pincus will backstop the offering by purchasing as much as $750 million of convertible participating preferred stock, the Armonk, New York-based company said in a statement today. MBIA, which has already raised at least $1.5 billion since November, said it would contribute most of the proceeds to its MBIA Insurance Corp. unit.

Another article highlighted by Naked Capitalism delivers a rather vague exhortation for increased bank regulation while one particular example purporting to show the need concerns some recent problems with Wachovia:

AmeriNet was a “payment processor,” a company that creates unsigned checks on behalf of telemarketers to withdraw funds automatically from customer accounts. Such checks, once widely used by businesses collecting monthly fees, are legal if customers approve the transactions.
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In 2006, an executive at Citizens Bank wrote via e-mail that thieves were routing unauthorized checks through Wachovia that stole from Citizens account holders.

“We have spoken to many of our customers who have been victimized by this scam,” wrote the Citizens executive, according to court documents. “We would appreciate it if you would shut down accounts of any customers of yours that may be engaging in improper activity.”

But Wachovia kept that account open until it was frozen by a federal court a few weeks later, as part of a government lawsuit against the client.

This is just more nonsense from the “Everything will be better with just a few more rules” camp. It is very tempting to believe that a few more rules will bring the new millennium, but those who argue in favour of this have never seen what happens in real life. Rules such as this – shutting down accounts due to suspicions of fraud – are not investigated by dispassionate keen-eyed investigators who have the evidence weighed by judicious descendents of Solomon. It is, in fact, a virtually random process in which facts become secondary to ass-covering.

In the quoted text above, the Citizens Bank executive should not have been contacting Wachovia – if they became involved at all, I suggest that police are generally considered the proper authorities for investigation of impropriety.

A bank clerk is not a cop I trust. A branch manager is not a judge I trust. And wishing won’t make it so.

But, that’s what happens when stuff hits the headlines – everybody’s an expert:

Regulators may restrict Moody’s Investors Service and Standard & Poor’s from advising banks on structured debt securities after criticism the firms failed to downgrade subprime-related debt as investor losses mounted.

Ratings firms may face a new code of conduct that limits their business and requires “reasonable steps” to ensure “a credible rating,” the International Organization of Securities Commissions in Madrid said in a statement today. IOSCO is the main forum for regulators, covering more than 100 countries from the U.S. to Japan.

I sure wish there was a code of conduct for regulators forcing them to take reasonable steps to ensure credible regulation!

An IMF research group has summarized a paper on VoxEU arguing that the subprime crisis is not unusual:

The subprime experience demonstrates that even highly-developed financial markets are not immune to problems associated with credit booms.

What can be done to curb bad credit booms? Historically, the effectiveness of macroeconomic polices in reducing credit growth has varied (see, for example, Enoch and Ötker-Robe, 2007). While monetary tightening can reduce both the demand and supply of bank loans, its effectiveness is often limited by capital account openness. This is especially the case in small open economies and in countries with more advanced financial sectors, where banks have easy access to foreign credit, including from parent institutions. Monetary tightening may also lead to significant substitution between domestic and foreign-denominated credit, especially in countries with (perceived) rigid exchange rate regimes. Fiscal tightening may also help reduce the expansionary pressures associated with credit booms, though this is often not politically feasible.

Fiscal tightening didn’t have much chance under a Republican administration! When in doubt, assume the best, right? It is very interesting to speculate as to what might have happened under Prof. Taylor’s counterfactual scenario of Fed tightening during the boom. We are certainly seeing that sub-prime sucked in a lot of money from Europe even with the relatively loose Fed policy during that time.

A very good day for the preferred share market, although I don’t see how the S&P/TSX Index was able to improve by 0.55% … half that, sure, two-thirds, maybe, but I suspect that this is an artefact of calculation caused either by low closes yesterday or high closes today.

Be that as it may, it was a strong day, with volume picking up and good strength throughout the entire PerpetualDiscount index. This index now has an interest-equivalent yield of 7.62% (at a conversion factor of 1.4), which is Canadas +350bp, Long Corporates +180bp. This latter (and probably more meaningful) figure has narrowed in about 30bp since last reviewed October 30, but still has a long way to go before reaching last spring’s levels of Long Corporates + ~110bp.

Hmmmm …. 70bp x 14years duration = … I’ll take it!

There were twenty-six other index-included $25.00-equivalent issues trading over 10,000 shares today.

The roar erupts from the angry crowds: when is PrefBlog going to get any work done? Again today, general commentary will be greatly foreshortened. In my defence, I can only say that I was able to post about Seniority of BAs, ruin Kaspu‘s day with a comment on CCS.PR.C, report on performance of Malachite Aggressive Preferred Fund (my little fund did well! So why is it a little fund?), Best & Worst January Performers and finally January Index Performance.

So, apart from time constraints, my fingers are tired.

Econbrowser‘s Menzie Chinn commented on the Bush Budget and highlights the Reuters report by David Lawder :

“I think the main deceptions in the budget are the same ones we’ve seen for five years. The costs for Iraq and Afghanistan has consistently been $200 billion a year, but they’ve only put aside $70 billion,” said Chris Edwards, economist at the libertarian Cato Institute. “The war will cost $100 (billion) to $150 billion a year until 2012 or so.”

Coupled with unrealistic growth forecasts, the additional war costs mean the fiscal 2008 deficit will likely top $500 billion, he said.

Even Captain’s Quarters, a political blog which can usually be counted on to toe the Republican party line, has thrown in the towel on any hopes for fiscal conservatism. I continue to think that American fiscal profligacy will continue until conditions are in a lot worse shape than they are now – and, as in Canada, it will be the non-(so-called)-conservative party that does it, because they’re the ones who can’t be attacked for preaching hard times and shooting the hippo.

Fun and frolic for CDOs continued, with Fitch revamping its model and taking a gloomier view on the underlying securities chance of default. But nobody trades those things anymore, do they?:

Buying and selling of collateralized debt obligations based on mortgage bonds, high-yield loans or preferred shares has ground to a near-halt, traders said at the securitization industry’s largest conference.

“We’re definitely in a period of very low liquidity at the moment, which has actually been dropping precipitously in the last few weeks,” Ross Heller, an executive director at JPMorgan Securities Inc., said yesterday during a panel discussion at the American Securitization Forum’s annual conference in Las Vegas. “It’s a challenging time.”

I should note that the story is referring to American preferred shares, not Canadian ones. While some American issues are eligible for preferential tax treatment, this is a major bone of political contention, as I noted on January 10 (and continued after the charts, in the “Update” section). Without tax advantages, prefs are simply deeply subordinated debt.

This model revision is also having knock-on effects on … wait for it … the monolines:

MBIA Inc.’s AAA bond insurance ranking was placed back under review for a downgrade by Fitch Ratings less than a month after being affirmed with a stable outlook.

Fitch, which also put CIFG Financial Guaranty back under review, is updating its assumptions for higher losses on U.S. subprime-mortgage securities, the New York-based ratings company said today in a statement. If loss projections rise materially, the AAA ratings on bond insurers may no longer be appropriate regardless of how much capital they hold, the company said.

And it’s not as if the monolines don’t recognize their problems:

XL Capital Ltd., the Bermuda-based business insurer, said it lost $1.06 billion in the fourth quarter as it wrote down the value of investments including a stake in bond insurer Security Capital Assurance Ltd.

XL lost $6.01 a share, compared with a net profit of $481.1 million, or $2.62 a year earlier, the company said today in a statement. Excluding investment losses, XL earned 66 cents a share, lagging the $1.45 average estimate of 14 analysts surveyed by Bloomberg.

It seems, however, that business conditions aside, some portion of the monoline damage is self-inflicted … hedges aren’t perfect (hat tip: MarketRant).

Speaking of hedges … there is much concern and consternation about the BCE deal and the seemingly different probabilities assigned by the stock and bond markets (hat tip: Financial Webring Forum):

When it comes to the chances of the $35-billion BCE Inc. buyout falling through, the bond market isn’t buying what the equity market is selling.

Many stock market investors clearly believe the deal is likely to fail. The stock finished Friday at $36 on the Toronto Stock Exchange, well below the $42.75 that Ontario Teachers’ Pension Plan and its partners agreed to pay last June before global markets went haywire.
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Those in the bond market, on the other hand, are much more convinced the transaction will close later this year.

According to the credit-default swaps (CDS) market, an influential backroom of the financial system where big bond investors place bets, there’s at least a 70-per-cent chance that the deal succeeds.

To me, this sounds normal. Each market is taking a gloomy view. Didn’t the lawsuit over Hemlo take a billion dollars off the combined market cap of the adversaries, when logically it should have been a wash? Seems to me that if I were a hedge fund, I’d be devoting enormous resources to calculating what proportion of equity and bonds I should have in a basket that … maybe, possibly, subject to fearsome market punishment … would have an expected positive return irrespective of the outcome.

A relatively quiet day in the preferred market. I’ll admit, I view the precipituous decline in the number of issues on the “Price Mover” list with mixed feelings … on the one hand, it means I have a whole lot less typing to do (I still haven’t caught up with HIMIPref™ Preferred Indices, so I still have to do it all manually); on the other hand, huge price movements are often a source of wonderful trades. Oh well, we’ll just see how it goes.

WFS.PR.A is behaving strangely … the huge volume today is unusual, but not strange; what’s strange is the day’s high price: $10.75. Holy smokes, at that level you’re amortizing the premium by over $0.20 annually against dividends of $0.525 to wind up with a Yield-to-Maturity of about 3.1%, according to Mr. Calculator (broken link redirected 2024-2-1). Geez, and there I am, thinking it’s overpriced at $10.37, yielding 4.26%! 

There were seventeen other index-included $25.00-equivalent issues trading over 10,000 shares today.