PrefBlog

Unlike Quebecor, the monoline ACA Capital Holdings (of CIBC and Merrill Lynch fame) was given a little breathing room by its creditors, presumably on the grounds that it doesn’t make much difference. Three comments from the story are of interest:

Most of those guarantees are in the form of derivatives. Unlike insurance, these contracts are required to be valued at market rates.
…
“The monolines are dead, their business model is dead,” said David Roche, head of investment consultancy Independent Strategy in London. “The government is going to have to recapitalize this industry or there will be communities in the U.S. where they can’t even flush their toilets” because they can’t afford the services.
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New York State Insurance Superintendent Eric Dinallo is examining whether to limit the types of debt that can be guaranteed by bond insurers, department spokesman David Neustadt said last week.

The first item of interest is the explicit recognition of the problem inherent in the originate-and-distribute model … or perhaps we should refer to it as a problem in the originate-and-hold model! When a bank grants a mortgage, funds it with, say, a GIC and keeps everything on their books, mark-to-market problems are minimized. But if it buys that same mortgage as a security, it is exposed to market fluctuations in the value of that mortgage. I’m sure I’ve mentioned this issue before, but can’t find my reference! Perhaps this exposure to price volatility should have been mentioned as a “friction” in the Fed research paper by Ashcraft & Schuermann.

The second note … well, I’m certainly not an expert on the US Municipal market! Sounds to me a little bit like hysteria, though!

And the third not shows what we can expect over the next few years – the dead hand of regulation stifling the securities business, or at least threatening to do so.

Naked Capitalism reprinted an interesting piece by Wolfgang Munchau regarding the nature of the … projected? imminent? current? …US recession, arguing that it will be extended due its nature:

Interest rate cuts work their way through to the real economy by a number of transmission channels. During the 2001 recession in the US, the most important was housing credit. The rate cuts came at a time when the housing market was already booming. They turned the boom into a super-boom. Inflationary expectations were low. People expected interest rates to remain low. It was a great moment to take on extra debt, and this was precisely what Americans did.

The current US downturn could not be more different. House prices are falling, and have further to fall before reaching a more sustainable level (in terms of the price-to-rent ratios as well as several other measures).
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The corporate credit channel works more slowly. A company faced with an acute downturn in demand for its products is not going to start investing immediately when interest rates fall.
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With core inflation stubbornly over 2 per cent, the current 10-year yield of 3.8 per cent seems a touch optimistic. So we might be seeing a simultaneous fall in short-term rates and a rise in long-term rates.
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Cui bono? The banks, of course. The bank-bailout channel will be the only monetary transmission mechanism to function like clockwork. The steeper the yield curve, the greater the profits for banks, which make a living by borrowing at short interest rates and lending at long rates.
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As time goes on, the financial sector’s health will gradually improve. Eventually, the credit squeeze will be over – and the next irresponsible lending boom can begin.

These are important concepts … particularly for those who are outraged by the banks’ so-called defiance of the Bank of Canada, reported here January 16.

Great excitement in Canadian equities today:

The Standard & Poor’s/TSX Composite Index fell 604.98, or 4.8 percent, to 12,132.14 in Toronto for its worst drop since Feb. 16, 2001. The benchmark has retreated 17 percent from near a record on Oct. 31 to the lowest in 15 months, approaching a “bear market” drop of 20 percent.

Given that Tokyo is now getting hammered, it should be an official bear market at the opening tomorrow.

Oddly enough, the carnage spilled over into preferred shares, with the S&P/TSX  Preferred Share Index down 0.87%. Panic? Confusion? Cool-headed efficiency? You tell me. Volume was on the light side of normal.

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

Bobby Fischer, RIP. 

D. Byrne – R. Fischer

Rosenwald Memorial Tournament

New York City

October 17, 1956

17 … Be6!!

Naked Capitalism reviews the Credit Default Swaps market with an emphasis on the new two-ton gorilla in the room: counterparty risk. CIBC shareholders learnt all about counterparty risk on December 19; Merrill Lynch shareholders got a reminder more recently:

concerns ratcheted up when Merrill announced that $3.1 billion of its $16.7 writedown was due to the apparent worthlessness of hedges written by an obscure (to those not following credit guarantors) counterparty, ACA Financial Guaranty.

He also highlights the issue of insider trading, mentioned in the CDS Primer:

The Journal also mentions regulatory issues:

This market poses challenges for would-be regulators. It isn’t clear, for instance, how securities laws on fraud and insider trading would apply to credit-default swaps, because it’s not clear in what way they are even securities; they are private contracts.

Of all the regulatory concerns, fraud and insider trading are low on the list.

Mr. Smith does not explain his reporting of the ranking of fraud and insider trading. I will certainly grant that the question of regulatory capital requirements for “normal” transactions should be the number one concern [hint regarding my position: shorting a CDS and buying the notional amount of BAs is roughly the same exposure as an outright investment in the underlying corporate credit, for a term equal to the term of the contract], but fraud and insider trading are always concerns.

And the monolines continue to career down the road to oblivion:

Ambac Financial Group Inc. scrapped a plan to raise equity capital after the bond insurer’s shares plunged 70 percent in the past two days, putting its AAA credit rating in jeopardy.
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MBIA raised $1 billion last week in the sale of surplus notes and last month entered a deal to sell $1 billion of equity to private-equity firm Warburg Pincus LLC. Both companies slashed their dividends and took out reinsurance on some securities to help shore up capital.

The surplus notes plunged as low as 70 cents on the dollar today, indicating a yield of about 25 percent, traders said. MBIA dropped $1.63, or 18 percent, to $7.59 on the New York Stock Exchange, extending its 56 percent decline this week.

And, as the market closed, Naked Capitalism republished news and commentary on the Fitch downgrade of Ambac.

More speculation in the press about the BCE / Teachers deal:

The Montreal-based company’s shares were down for the fifth consecutive trading day, losing 16 cents to $36.37 Friday.

The shares are down from a peak of $41.80 in July.

Crandall said the share price suggests many investors now believe there’s only a 50/50 chance the company will be sold to a group led by the Ontario Teachers’ Pension Plan. The group offered $42.75 per share in June for BCE and plans to finance the deal with up to $40 billion of debt.
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Toronto Dominion Bank chief executive Ed Clark this week reinforced his bank’s commitment to provide $3.8 billion to the BCE deal.

“I know everyone stews and worries about it. I would like to tell you that I’m stewing and worrying, but I’m not,” he said at a conference of bank CEOs on Tuesday.
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But Teachers spokeswoman Deborah Allan said the prospective buyers of Canada’s largest telecommunications won’t be distracted by “the noise that’s in the marketplace.”

“As far as this transaction is concerned, we have an agreement, we’re committed to it and we’re focusing on closing the deal,” she said in an interview.

Now, as PrefBlog’s Assiduous Readers will know, the way to read a press release is to see what it is that they DON’T say. Have a look at Deborah Allan’s remarks (as quoted by the CP reporter, Ross Marowits). Did she actually say anything at all meaningful? We know they have an agreement (it’s on SEDAR), we know they’re committed to it (they signed) and it’s not clear to me what “we’re focusing on closing the deal” means. We know that TD is happy about financing 10% of the price, but … where’s the other 90%?

Given everything that’s happened to the credit markets and to BCE over the past seven months, I suspect that a loss of a mere $1-billion break fee is a pretty cheap exit. But, I say again: what do I know? Either way it’s a speculation on basically zero information; I can have more fun playing blackjack.

As part of its continuing effort to prevent business from being done in Canada, Regulation Services has released Guidance on the Supervision of Algorithmic Trading, with the lovely little paragraph:

If a Participant has provided Dealer-Sponsored Access, commonly known as direct market access, to a client (“DSA Client”), the Participant, as part of its on-going supervision of client orders, must be aware of the origin of the orders entered by the DSA Client, including whether the DSA Client employs the use of algorithmic trading systems. The Participant must ensure the proper testing of any algorithmic trading system used by a DSA Client to enter orders on a marketplace by means of the Dealer-Sponsored Access provided by the Participant.

In other words, it’s not sufficient to take responsibility for your orders. Your process must be questioned, tested, validated and approved by Responsible Authorities. Assiduous Readers will remember that the purpose of rules only very rarely has anything to do with accomplishing anything … the purpose of rules is to give authorities their authority. Hail RS!

It is my understanding that a lot of proprietary traders (day traders who work for dealers) are finding out that their bonuses (and profits of the banks dealers) have not been due so much to their uncanny understanding of the market and brilliant exploitation of subtle shifts in supply and demand as they were to control of the order flow, better access to data and execution than their buy-side competitors and tick-sizes on prices of more than a penny.

Principal revenues earned from proprietary desks and market-making activities also succumbed to the market downturn. Equity trading revenues were off $209 million, a whopping 120 per cent lower than the previous quarter and off 123 per cent against the same period in 2006. For the quarter, equity trading resulted in a net loss of $35 million. This represents the first time since the third quarter of 2002, about the same time the TSX bottomed out from the tech market collapse, that the industry reported a net loss from their principal equity trading business.

Don’t expect much squawking from the street on this one.

After yesterday’s fall, the preferred share market took a little breather today – volume was way down and, overall, losses were minor. All eyes are on equities at this point … the Monday back from a weekend of worrying and second-guessing can often be rather exciting. What effect the US holiday will have on this process is something that I’m afraid even to contemplate!

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