PrefBlog

Today’s big news was the downgrade of ACA Financial by S&P, the subject of speculation on December 13. According to the S&P Press release:

The rating actions were prompted by worsening expectations for the performance of insured nonprime residential mortgage backed securities and CDOs of asset backed securities. Based upon current stress test analysis, the details of which are being published simultaneously with this release, the affected companies may experience claims and/or capital consumptive negative rating transitions such that their capital resources may no longer be sufficient at their respective rating levels. Another consideration in the analysis, if there is a capital shortfall, is the magnitude of the shortfall and the extent to which the company has raised or is planning to raise new capital, and the viability of that capital plan.
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Standard & Poor’s will host a teleconference today at 3 p.m. EST.
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Replay Numbers:
US/Canada: 1-866-455-0459
All Others: 1-203-369-1259
Replay will expire on Jan. 16, 2008

CIBC had this to say:

Following Standard and Poor’s announcement today that it had reduced the credit rating of ACA Financial Guaranty Corp. from “A” to “CCC”, CIBC confirmed that ACA is a hedge counterparty to CIBC in respect
of approximately U.S. $3.5 billion of its U.S. subprime real estate exposure.

    It is not known whether ACA will continue as a viable counterparty to CIBC. Although CIBC believes it is premature to predict the outcome, CIBC believes there is a reasonably high probability that it will incur a large charge in its financial results for the First Quarter ending January 31, 2008.

    As CIBC disclosed on page 52 of its Investor Presentation dated December 6, 2007, the mark of the hedge protection from the “A-rated” counterparty (ACA) as at October 31, 2007 was U.S. $1.71 billion. As at November 30, 2007, this mark was US$2.0 billion. If the charge in the First Quarter were to be U.S. $2.0 billion (US$1.3 billion after tax) CIBC currently projects its Tier 1 capital ratio to remain in excess of 9% as at January 31, 2008.

Exciting times for CIBC! I have previously examined their capitalization and later compared it to the other Canadian banks.

Morgan Stanley had another example of sub-prime related write-offs:

Morgan Stanley wrote down its subprime-infected mortgage holdings by a greater-than-expected $9.4 billion and received a $5 billion cash infusion from state- controlled China Investment Corp.

To put those numbers into perspective, have a look at the actual quarterly report:

Total capital as of November 30, 2007 was $193.7 billion, including $36.1 billion of common shareholders’ equity, preferred equity and junior subordinated debt issued to capital trusts. Book value per common share was $28.56, based on 1.1 billion shares outstanding.

The $36.1-billion figure is what would usually be referred to a “equity capital”, the rest is simply long-term subordinated debt.

I mentioned Bloomberg’s story about the antics at a Californian sub-prime origination office yesterday. They continue the series today with the story of Hayman Capital Partners that bet against them and made a fortune. Fascinating stuff!

Funny day today. Trading continued fast and furious – next Monday, Dec. 24, is the last day for tax loss selling – and there were some very strange moves. The market was down again – with the suddenly dubious Canadian Imperial Bank of Commerce greatly over-represented in the losers’ list.

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

More news today on the LIBOR front … the ECB is offering unlimited Euros for a two week term at 4.21%. There was an instant reduction in two week Euro-LIBOR:

The rate banks charge each other fell to 4.45 percent from 4.94 percent, the European Banking Federation said today. The reluctance to lend money after the collapse of the U.S. subprime market pushed interbank euro rates for two weeks to the highest level in at least six years earlier this week.The additional cash “reflects the extra tightness in the market,” said Lena Komileva, an economist at Tullett Prebon in London. “However, it doesn’t address the fundamental issues of banks hoarding cash and while the central bank has succeeded in stabilizing the shorter term rates, it makes little impact on the longer term rates.”

Even the hawkish Bank of England opened the spigots:

The BoE, meanwhile, auctioned 10 billion pounds (more than $20 billion) of three-month funds on Tuesday. Notably, it accepted bids as low as 5.36 percent, which is 14 basis points below its 5.5 percent base rate. Three-month sterling Libor fell to 6.38625 percent from 6.43125 percent on Monday.

Two-week sterling Libor jumped by around a whopping 75 basis points to 6.51250 percent but that was only down to calendar effects over the turn of the year, and mirrored similar increases in two-week euro and dollar rates last week.

Naked Capitalism reprints a piece by Ken Rogoff from the Financial Times:

The real town/gown problem is one of horizon rather than perspective. Monetary policy has long and variable lags, particularly on slow-moving inflation expectations. Sharper Fed interest rate cuts today might well mute the housing price collapse, at least in nominal terms. However, if the Fed should ease too far, too fast, it could get hit by a boomerang a couple of years down the road, in the form of sustained higher inflation.

For the Fed, two to three years is the medium term, and it matters. For many financial market participants, two to three years is an eternity, and it does not matter.

Accrued Interest is driving himself crazy trying to forecast US Housing Prices. Bloomberg has a fascinating story today on the antics at a Californian sub-prime origination office. A complicating factor is foreign ownership, especially by snowbacks:

“Fifteen of my friends are on buying trips down here, and we’re all cheap,” Mr. Sirockman said. He brought his family to Scottsdale this month while he submitted a lowball all-cash offer for a three-bedroom home.

“I don’t want to take advantage of a guy who’s having trouble in the market and is losing his shorts,” Mr. Sirockman said. “But I have no problem with a guy from California who bought on spec and has five houses in Arizona and never lived in them.”
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The market has shifted totally in the buyer’s favour, especially those offering cash, said Jeff Russell of Alberta. Last month, Russell snapped up a patio home next to a golf course in Scottsdale with a $299,000 check. It was listed at $463,000.
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Mr. Sirockman also returned to Canada without a house after the owner of the Scottsdale home turned down his offer. No worries. Mr. Sirockman told the seller there were a thousand other homes like his on the market, and someone was going to deal.

When I need to hire a trader, I know who I’m going to invite over for an interview!

As noted on December 13, the consolidation of SIV assets by their major sponsoring banks has greatly reduced the need for the MLEC/Super-conduit (although it could still be useful in Canada!), but the plan is going ahead anyway:

The “SuperSIV” fund, set up to provide cash to structured investment vehicles hurt by subprime- mortgage holdings, plans to start buying assets “within weeks,” its sponsors said today.

The fund’s size, originally envisioned at about $80 billion, will be determined by “SIVs’ needs and evolving market circumstances,” Citigroup Inc., Bank of America Corp. and JPMorgan Chase & Co. said in an e-mailed statement. New York- based BlackRock Inc., the largest publicly traded U.S. asset manager, will oversee the fund.

BlackRock, I suspect, is going to have to earn its money the hard way. Now that the major sponsors have bitten the bullet, the urgency of the cash requirement has declined considerably, which gives considerable scope to traders playing games. The idea has been presented as pricing the assets to be bought at the levels of small transactions – rather than as a vulture fund – which may lead to a certain amount of cherry-picking as the banks’ traders try to pick off the fund. We shall see!

Another very active, negative day for preferreds. The Claymore ETF is now down for the month-to-date … but it looks as if Malachite Fund is hanging on to very good relative returns, anyway. So far! It is interesting to note that what I consider to be the four “main” HIMIPref™ indices (Operating Retractible, Split Share and the two Perpetuals) are all still up on the month – most of the damage to date has been done to the floating rate indices and especially the non-investment-grade issues.

As recently as the December 6 review of the Weston issues, WN.PR.E (to choose one) was quoted at 16.46-53 … it closed today at 15.10-17 after going ex-dividend Dec 12 for $0.296875. That’s a loss of almost 7.5%!

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

There has been a lot of commentary regarding the coordinated liquidity injection (discussed on December 12) led by the Fed. First to the plate was Stephen Cecchitti, who has written many high quality essays for VoxEU, the most recent of which was discussed on December 5.

The problem of credit tightness has as its most visible sympton a spike in LIBOR, as discussed on December 13 and December 14 (after the announcement) with a graph shown on November 28. Mr. Cecchetti claims that:

Clearly, they were worried about the quality of the assets on the balance sheets of the potential borrowers. My guess is that banks were having enough trouble figuring out the value of the things they owned, so they figure that other banks must be having the same problems. The result has been paralysis in inter-bank lending markets.

and that the critical problem being addressed is:

The Fed can get liquidity to the primary dealers, but it has no way to ensure that those reserves are then lent out to the banks that need them.
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Not only do Central Banks need to ensure distribution of funds within a country’s banking system, they also need to make sure that cross-border distribution is adequate to meet the needs of banks in one country that require the currency of another. Today we have the new problem that dollars are in short supply outside of the United States.

He emphasizes that:

Standard open market operations give the Fed control over the level of short-term interest rates. The purpose of the Term Auction Facility is to give them a tool for influencing interest rate spreads.  

This is what I noted (in a much less knowledgable manner) on December 13:

The redemption of T-Bills is significant: it means there is (basically) no net improvement in systemic liquidity. What there is is simply a smearing of the extant Fed-provided liquidity over a broader section of the market. For a while.

James Hamilton of Econbrowser reviews the facility and concludes:

So why is it the responsibility of the Fed to try to set not just the level of the fed funds rate but also the spread between the funds rate and the LIBOR rate? One possibility is that the Fed thinks that the market is currently overweighting the riskiness of short-term interbank loans. If so, that seems to be a different vision of the role of monetary policy from that articulated by Ben Bernanke in 2002:

I think for the Fed to be an “arbiter of security speculation or values” is neither desirable nor feasible.

A second possible justification is that the market is correctly pricing the riskiness of these assets, but that the chief risk involves an aggregate financial event that the Fed, through actions like the TAF, could mitigate or avoid altogether.

I’m not sure that Professor Hamilton is focussing on the most relevant part of the Bernanke speech he references. I take note of:

Finally, if a sudden correction in asset prices does occur, the Fed’s first responsibility is to do its part to ensure the integrity of the financial infrastructure–in particular, the payments system and the systems for settling trades of securities and other financial instruments. If necessary, the Fed should provide ample liquidity until the immediate crisis has passed. The Fed’s response to the 1987 stock market break is a good example of what I have in mind

Bernanke’s speech continues with a presentation of the arguments in favour of accounting for asset prices when formulating central bank policy:

I think one can usefully boil down many of these arguments to the idea that it may be worthwhile for the Fed to take out a little “insurance,” so to speak, against the formation of an asset-price bubble and its potentially adverse effects. Like all forms of insurance, bubble insurance carries a premium, which includes (among other costs) the losses incurred if the Fed misjudges the state of the asset market or the cost of a possible reduction in the transparency of Fed policies. But, as a matter of theory, it is rarely the case in economics that the optimal amount of insurance in any situation is zero. On that principle, proponents of leaning against the bubble have argued that completely ignoring incipient potential bubbles, if in fact they can be identified, can’t possibly be the best policy. I will discuss below why I believe that, nevertheless, “leaning against the bubble” is unlikely to be productive in practice.
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But as a practical matter, this is easier said than done, particularly if we intend to use monetary policy as the instrument, for two main reasons. First, the Fed cannot reliably identify bubbles in asset prices. Second, even if it could identify bubbles, monetary policy is far too blunt a tool for effective use against them.
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The Federal Reserve went on to make a number of serious additional mistakes that deepened and extended the Great Depression of the 1930s. Besides trying to pop the stock market bubble, the Fed made little or no effort to protect the banking system from depositor runs and panics. Most seriously, it permitted a severe deflation in the price level, which drove real interest rates sky-high and greatly increased the pressure on debtors. A small compensation for the enormous tragedy of the Great Depression is that we learned some valuable lessons about central banking. It would be a shame if those lessons were to be forgotten.

The Fed Jackson Hole conference was discussed in PrefBlog on August 31 and September 4; a great deal of debate there centred on the proper role of Central Banks when confronted with a market pricing problem. I suggest that the Fed is terrified of a lock-up in the interbank markets and, by the new liquidity injection, is taking steps to ensure that such a lock-up doesn’t happen. This may thought of as the downside analogue of ‘leaning against the bubble’.

It may be thought to represent a change of thinking at the highest levels of the Fed, but I’m not so sure. I have a lot of confidence in these guys and do not think that they are idealistic zealots, parsing every suggestion for ideological purity and substituting slogans for thought. I suggest that they are beyond that and take a pragmatic approach: Whatever Works.

Paul Krugman of Princeton University, for instance, takes the view that the risk of a “liquidity trap” is rising:

Mr. Krugman, now at Princeton University, said no, but the risk of one has increased. “In general, we wouldn’t say that there’s a liquidity trap unless you’re up against the zero bound,” that is, when the short-term interest rate falls to zero, and can’t fall any lower. “So we’re not in one by the normal definition, which is a situation in which people are indifferent between cash and bonds, so that open-market operations in which the central bank trades monetary base for bonds have no effect.”

But he added: “What you could say, though, is that the unwillingness of banks to lend has reduced the effectiveness of Fed policy — and increased the likelihood that we’ll find ourselves in a liquidity trap sometime soon.”

If there’s one thing the Fed must do, it’s ensure its continued relevance! At the moment there is little evidence that credit tightening has affected the real economy and the Fed wants to keep it that way.

Prefs were down again today – particularly the BAM issues, which lends credence to prefhound‘s speculation in the comments to December 14 that Brookfield weakness could be due to their Hudson Yards project, which got a lot of ink in the Globe on the weekend.

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

Update: Typo has been struck out of the notes for BNA.PR.C.