PrefBlog

Well … today the TD Bank and National Bank financials were analyzed … and, in addition, month-end is a-coming and duty calls with a shrill, unpleasant voice.

So there won’t be much colour today.

American ABCP outstanding was down another $11-billion this week, continuing its decline as the overleveraged economy continues to unwind. Domestic Financial CP outstanding was up $25-billion; although this figure has not picked up all the slack since the peak, this illustrates the Banks Advantage in Cushioning Liquidity Shocks.

The Florida State-sponsored Money Market Fund mentioned yesterday has suspended redemptions:

Florida officials voted to suspend withdrawals from an investment fund for schools and local governments after redemptions sparked by downgrades of debt held in the portfolio reduced assets by 44 percent.
…
It wasn’t decided how long the suspension would last. The trustees meet again on Dec. 4.

“We’re getting a lot of calls,” said Mike McCauley, the spokesman for the State Board of Administration.

The Florida pool crisis is a sign of poor risk management by state officials, said Harvey Pitt, former chairman of the Securities and Exchange Commission.

“In the longer-term, it’s unlikely that those whose funds have been frozen will leave their money in the investment fund once the freeze lifts,” Pitt said. “All of this could, and should, have been avoided by careful due diligence, constant reassessment of risk, and paying close attention to market trends.”

Mr. Pitt did not disclose his own track-record as a money manager. His criticisms are the kind that really drive me wild – post-hoc criticisms of fund managers by guys who’ve never done it. It’s very easy to be wise after the fact.

The big danger is that such public funds will eventually migrate to nothing riskier than three-month T-Bills; why would a trustee allow anything else if he’s going to be vilified whenever he’s wrong on something?

One can only applaud Henri-Paul Rousseau in his testimony to the Quebec legislature’s public finance committee:

Executives of Canada’s biggest pension fund agreed after careful study that what constituted a crisis was open to interpretation, but believed the financial institutions would honour their commitments, he said under questioning at the provincial legislature’s public finance committee.

“There was some thinking out there that this was very risky,” Mr. Rousseau said. “We thought it was not plausible and it happened. That’s it.”
…
“Were we prudent? Yes. Did we miscalculate in terms of the probability that this would happen? Yes,” he said. “Unfortunately, that happens in our business.”

Way to go, M. Rousseau! I have no idea whether you’re a good or bad manager, either of people or of money, but at least you know the right things to say – and on this occasion, when things have gone wrong, you’re willing to wear it. My own question is, regardless of whether or not it was prudent to have $13-billion out of total Caisse assets of $207-billion in Canadian ABCP, was it prudent to have $13-billion in a $35-billion asset class? M. Rousseau’s full remarks have been published by the Caisse. He points out that while liquidity is a problem, the credit quality is entirely acceptable. I will confess that I haven’t even checked to see what proportion of the entire Money Market portfolio was comprised of ABCP, or what the investment rationale behind the MM allocation might have been.

The US bond market is on fire, with a buying panic and lots of corporate issuance; Bernanke seems to be guiding the market to expect an ease.

Another day of good volume for preferreds, with some evidence of rationalization of prices, although overall performance wasn’t all that great. Split shares had a great day, but are still basically clobbered on the month, while floaters are getting hit … trouble is, it’s hard to separate the company specifics (BAM & BCE) from the asset types. Still, that’s what makes it fun, right?

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

Arthur Levitt brought his travelling anti-Credit Rating Agency roadshow to Toronto yesterday, giving a speech at the 2007 Dialogue with the OSC. The Globe has a video of his remarks; they were reported as the same old same old:

Credit rating agencies have lost the trust of investors following the recent meltdown in commercial paper markets, leading to a “systemic shock” in capital markets, a former chairman of the U.S. Securities and Exchange Commission said yesterday.

Arthur Levitt, who led the SEC between 1993 and 2001, told an Ontario Securities Commission conference yesterday the rating agencies are deeply conflicted because they take money from companies to rate their securities, and also offer them consulting services.

“The agencies have become both coach and referee,” he said. “Indeed, I believe we’re facing the prospect of a systemic shock directly as a result of investors’ loss of confidence in the ratings that they have relied upon for so long to evaluate risk.”

He said regulators must examine the conflicts of interest that “plague” rating agencies. Beyond simply prohibiting them from doing additional consulting work for companies they rate, he said the SEC should be given more authority to regulate agencies.

Well, fine. Levitt believes the agencies have lost the trust of investors. My first question is “Where’s the evidence?” and my second is “So what?”. There are plenty of shops around, well staffed and just aching to sell a subscription to their services to anybody who wants to pony up the cash. Unless, of course, having decided that the agencies screwed up, the regulators want to start awarding and yanking licenses on the basis of track record …

David Wilson, Chair of the OSC, mentioned them briefly in his published remarks:

And, we’re talking with credit rating agencies that do business in Canada.
Global securities regulators are carefully reviewing:
• the use of credit ratings in regulated instruments;
• the conflicts inherent in the rating process for structured products; and
• the transparency of the assets held and leverage embedded in these structured product vehicles.

Wilson’s remarks are reasonable enough (a regulator should certainly have some vague idea of what’s happening in capital markets!), but the fact that they invited Levitt to speak at their showcase event is more than just a little odd. 

It’s worrisome. Same old story. If there’s one thing that drives a regulator crazy, it’s the thought that somebody, somewhere, is not filling out a form. To address this issue, the agencies should hire some staff away from the regulators at, say, $200,000 p.a. + benefits, and get some of that good old revolving door regulation going – just like RS is so proud of.

Perhaps I’m feeling a little grumpy today, but I didn’t really see anything new and interesting in a Financial Times essay on the credit crunch referenced by Naked Capitalism. There was an interesting graphic, though:

Note that the sawtooth pattern for the Euribor rate is due to anticipation of well-telegraphed policy increases.

There’s more on the story about the Florida government money-market funds, which were briefly mentioned on November 14 (with friend Levitt labelling them “disgraceful”). Clients are pulling out their money:

Florida local governments and school districts pulled $8 billion out of a state-run investment pool, or 30 percent of its assets, after learning that the money- market fund contained more than $700 million of defaulted debt.
…
The Florida pool, which was the largest of its kind in the U.S. at $27 billion before the recent spate of withdrawals, has invested $2 billion in SIVs and other subprime-tainted debt, state records show. Connecticut, Maine, Montana and King County, Washington, are among other governments holding similar investments, in smaller quantities.

The Florida pool’s $900 million of defaulted asset-backed commercial paper now amounts to almost 5 percent of its holdings. The paper, which carried top ratings from Standard & Poor’s, Moody’s Investors Service and Fitch Ratings as recently as August, was downgraded after declines in the value of collateral affected by the subprime mortgage slump.

I’ve had a look at the State Board’s 2005-06 Investment Report, an extremely glossy puff-piece with little worthwhile investment reporting, but there is a description of the fund in question.

When local governments in Florida have surplus funds to invest, they often rely on the Local Government Investment Pool (LGIP). As a money market fund, the LGIP invests in short-term, highquality money market instruments issued by financial institutions, non-financial corporations, the U.S. government and federal agencies. In managing the pool, the SBA strives to maximize returns on invested surplus funds to generate revenue that helps local governments
reduce the need to impose additional taxes.

It will be most interesting to see how this pans out!

There was some bad news on the US Housing front brought to us via a National Association of Realtors press release:

Single-family home sales were unchanged from September at the seasonally adjusted annual rate of 4.37 million in October, and are 20.8 percent below 5.52 million-unit level in October 2006.  The median existing single-family home price was $205,700 in October, down 6.3 percent from a year ago.

Existing condominium and co-op sales fell 9.1 percent to a seasonally adjusted annual rate of 600,000 units in October from 660,000 in September, but are 20.2 percent below the 752,000-unit pace in October 2006.  The median existing condo price4 was $223,500 in October, up 4.9 percent from a year ago.

The month/month figures is just noise; it’s the year/year statistics that look worrisome. The Wall Street Journal prepared a graphic of inventory:

I love the handy little arrow they added, to ensure we didn’t look at the chart upside-down or something. They also provided a round-up of commentary.

Prof. Stephen Cecchetti continued his VoxEU series today, which commenced on November 26. He concludes:

So, here’s the problem: discount lending requires discretionary evaluations based on incomplete information during a crisis. Deposit insurance is a set of pre-announced rules. The lesson I take away from this is that if you want to stop bank runs – and I think we all do – rules are better.

This all leads us to thinking more carefully about how to design deposit insurance. Here, we have quite a bit of experience. As is always the case, the details matter and not all schemes are created equal. A successful deposit-insurance system – one that insulates a commercial bank’s retail customers from financial crisis – has a number of essential elements. Prime among them is the ability of supervisors to close preemptively an institution prior to insolvency. This is what, in the United States, is called ‘prompt corrective action,” and it is part of the detailed regulatory and supervisory apparatus that must accompany deposit insurance.

In addition to this, there is a need for quick resolution that leaves depositors unaffected. Furthermore, since deposit insurance is about keeping depositors from withdrawing their balances, there must be a mechanism whereby institutions can be closed in a way that depositors do not notice. At its peak, during the clean-up of the US savings and loan crisis, American authorities were closing depository institutions at a rate in excess of 2 per working day – and they were doing it without any disruption to individuals’ access to their deposit balances.

Returning to my conclusion, I will reiterate that the current episode makes clear that a well-designed rules-based deposit insurance scheme should be the first step in protecting the banking system from future financial crises.

I quite agree with him. The Northern Rock episode – discussed in the context of deposit insurance on October 18, shows that politicians – and, by contagion, government sponsored departments – have squandered the trust placed in them. There have been too many broken promises, too many excuses. Additionally, it is completely unreasonable to expect small retail depositors to monitor the health of their friendly neighborhood bank, particularly at the height of a crisis. Banks should be supported by government sponsored deposit insurance as a social good; in exchange, they must pay insurance premiums based on their risk and submit to regulation of their capital adequacy.

The recent crisis is showing us that there is some cause for concern that this inner fortress of stability may not have been insulated enough from the outer, much less regulated, ring of the general capital markets; but I feel confident that the gnomes of Basel will be reviewing their stress tests over the next few years to account for new ways around the rules. As I mentioned on October 3, guarantees of liquidity and credit, particularly, need to be charged to risk-weighted assets at a higher rate. The default assumption must be that if the bank’s name is on a product – or if the bank is profitting from the product’s existence – then the risk of the product should be consolidated onto the bank’s books.

People invest in these things because of the banks’ reputations. The bank has a good name due largely due to regulation and deposit insurance. When – not if – a product fails, the banks’ reputation is harmed. Therefore, regulation should not pretend that there is no risk to capital from an off balance sheet sponsored product.

VoxEU also published an interesting paper on capital integration within the EU by Sørensen and Kalemli-Ozcan. Essentially, the authors argue that capital markets in the EU are, at least to a certain extent, balkanized, with saving regions refusing to invest in growing regions due to lack of trust.

Our findings suggest that Europe has a long way to go before its capital markets are as integrated as the U.S. market is internally. However, our work also suggests that much of the fragmentation stems from things that the EU cannot directly affect in the short run. Trust and confidence are things that evolve slowly. Policies that reward transparency and punish corruption may help but this is likely to take generations as exemplified by the low level of confidence in East Germany.

Good volume today – and at least some of the completely wierd prices that have become normal lately are starting to rationalize. I just hope there weren’t any Assiduous Readers waiting for the bottom on BNA.PR.C … but on the other hand, I don’t know where it’s going to open tomorrow. One shot wonder, or trend-reversal? Place yer bets, gents, place yer bets…

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

Update: cowboylutrell in the comments points out I screwed up the asset coverage for FTU.PR.A in the ‘Price Changes’ table. It has been corrected. Sorry!

Of most interest today (well … last night!) was the Abu-Dhabi SWF investment in Citigroup. As noted by Naked Capitalism, this deal was done, effectively, at a concession to the current market price, given that the preferreds are protected against a dividend cut on the common, have a dividend yield that is greatly in excess of the common yield, and convert to common at prices not all that much in excess of current prices in a few years’ time. The concession has not escaped notice:

The deal may dilute the value of Citigroup’s stock, reducing 2008 earnings by as much as 20 cents a share, Bank of America analyst John McDonald estimated.

Citigroup shareholders are “ultimately the ones who are paying,” said William Smith, chief executive officer of Smith Asset Management in New York, which oversees $80 million, including about 70,000 Citigroup shares. “If you look at 11 percent, that’s basically junk bond yields, and so it’s great for Abu Dhabi.”

However, the deal will reinforce Citigroup’s capital ratios and that’s what counts. A bad capital ratio could mean no profits to be diluted! Freddie Mac is also selling prefs at concessionary prices:

Freddie Mac, the second-biggest source of money for U.S. home loans, plans to sell $6 billion in preferred stock and cut its dividend in half to shore up capital depleted by record mortgage defaults and foreclosures.

The two-part sale will include non-convertible, non- cumulative preferred stock and a “substantially smaller” portion of convertible preferred shares, Freddie Mac said in a statement today.
…
Freddie Mac sold $500 million of preferred shares in September with a fixed dividend rate of 6.55 percent. The shares, issued at $25 each, were trading at about $20 today.

Those who are familiar with the rules for Tier 1 bank capital will be most amused by the following bizarre attempt to create a controversy (hat tip: Financial Webring Forum):

When either Freddie or Fannie attempt to build capital, they are handicapped by a peculiarity that very few investors know about: They cannot sell the most popular kind of preferred stock, the “cumulative” variety, because their regulator will not let these securities count toward capital.

What “cumulative” signifies in this context is that if dividends are missed, they pile up to be paid on some brighter day, if that arrives. To the extent that Freddie and Fannie issue preferred shares, therefore, they are forced into selling the “non-cumulative” variety. That means if a dividend is missed, say, in the first quarter of 2008, the owners of the preferred will never get that dividend. It’s just gone, zip!

Naturally, prudent investors are not wild about owning non-cumulative preferred shares, which is why there are not many of these securities around. What smart investor unnecessarily wants to put himself in the position – no matter how remote – of missing a dividend and never thereafter being able to capture it?

Note that Quantum Online lists 144 non-cumulative US issues. Cumulative issues are very nice to have, but they don’t count as Tier 1 Capital for banks. OFHEO is to be applauded for disallowing the inclusion of such issues in capital.

These deals, I think, may be classed in the same category as GWO’s sale of its US healthcare business, in that what is going on – once all the frippery is tossed aside, is a conversion of debt into equity. Lord knows what Abu-Dhabi has had its money invested in until now – I mentioned the transparency issue briefly on September 24 – but there is no reason why it can’t have been a savings account at Citigroup, which is now, as far as they’re concerned, moving up the ladder to become equity; with no effect on Citigroup’s cash, but salutary effects on their ratios.

GWO  is using the proceeds of their sale to repay the bridge debt on their purchase of Putnam, instead of selling term debt to finance this. Even if the buyer, Cigna, finances through debt it will be term debt from a strategic buyer.

There is another very similar – in its essentials – situation occuring in the SIV area. MBIA and its problems in finding financing for its conduit, Hudson-Thames was mentioned here on October 25. Now we learn that:

MBIA Inc., the largest bond insurer, is winding down its structured investment vehicle after failing to find buyers for the SIV’s short-term debt since August, Chief Financial Officer Chuck Chaplin said.

MBIA has shrunk its Hudson Thames Capital SIV to about $400 million from $2 billion through asset sales to bondholders, Chaplin said. The Armonk, New York-based company has taken an “impairment” on its own $15.8 million equity stake, Chaplin told a conference hosted by Bank of America Corp. in New York today.
…
MBIA asked holders of the lowest ranking bonds of Hudson Thames, known as capital notes, to buy a share of the SIV’s bank bonds, asset-backed securities and other holdings in proportion to the amount of debt they own.

The so-called “vertical slice” deals enable SIVs to raise cash while bondholders avoid the risk of their investment being wiped out in a fire sale, Fitch said in a report this month.

And this is how the credit crunch will be resolved. Equity holders will take their lumps; debt holders will move up the risk-return ladder at concessionary prices; and the indigestible debt will slowly, but as inexorably as the ticking of a clock, be run off the books.

I think.

There is shock and horror all over the place with the release of the Case-Shiller US Housing Price Index for September:

“The declines in the national figure are notable for two reasons,” says Robert J. Shiller, Chief Economist at MacroMarkets LLC. “First, the 3rd quarter decline, at 1.7%, was the largest quarterly decline in the index’s 21-year history. And, second, the year-over-year decline posted its second consecutive record low at -4.5%. Consistent with prior 2007 reports, there is no real positive news in today’s data. Most of the metro areas continue to show declining or decelerating returns on both an annual and monthly basis. All 20 metro areas were in decline in September over August. Even the five metro areas that still have positive annual growth rates — Atlanta, Charlotte, Dallas, Portland and Seattle — show continued deceleration in returns.”

Appallingly, the annualized internal rate of return for the indices since their base-date of January 2000 is a mere 9.15%. There’s a great post at the Irvine Housing Blog (hat tip: WSJ) about the loan history of a Very Nice House:

The property was purchased in January 2005 for $1,157,000. The combined first and second mortgages totalled $1,156,730 leaving a downpayment of $270. Let’s just call it 100% financing.

By April, they owners were able to find refinancing through Countrywide with a $999,999 first mortgage. This mortgage was an Option ARM with a 1% teaser rate. The minimum payment would be $3,216 per month.

Also in April of 2005, they took out a simultaneous second mortgage for $215,000 pulling out their first $58,000.

So look at their situation: They are living in a million dollar plus home in Turtle Ridge making payments less than those renting, and they “made” $58,000 in their first 4 months of ownership.

Apparently, these owners liked how hard their house was working for them, so they opened a revolving line of credit (HELOC) in August 2005 for $293,000. Did they spend it all? I can’t be sure, but the following certainly suggests they did.

In December of 2005, they extended their HELOC to $397,990.

In June of 2006, they extended their HELOC to $485,000.

In April of 2007, the well ran dry as they did their final HELOC of $491,000. I bet they were pissed when they couldn’t get more money.

So by April 2007, they have a first mortgage (Option ARM with a 1% teaser rate) for $999,999, and a HELOC for $491,000. These owners pulled $333,000 in HELOC money to fuel consumer spending.

Assuming they spent the entire HELOC (does anyone think they didn’t?), and assuming the negative amortization on the first mortgage has increased the loan balance, the total debt on the property exceeds $1,500,000. The asking price of $1,249,000 does not look like a rollback, but if the property actually sells at this price, the lender on the HELOC (Washington Mutual) will lose over $300,000.

Speculation about the forthcoming Fed meeting is ramping up, with Goldman calling for 150bp easing by the second quarter, but … what are the implications for inflation?

So far, inflation expectations have remained stable. Yet I consider those expectations more fragile now than I did four to six months ago. The rise in oil prices and the simultaneous increases in a broader basket of commodity prices suggest that significant inflationary pressures exist in the economy and thus the Fed must be very vigilant. If inflationary expectations rise, it could prove very costly to put the genie back in the bottle.

Very good volume in the pref market today, but performance continued to be (i) Weird and (ii) Poor. Splitshares bounced back (despite their expulsion from the S&P/TSX index), but that was more of a dead cat kind of thing than anything else – although it is rather pleasant to say that WFS.PR.A closed at 9.70-79, 121x10.

The PerpetualDiscount index broke below the 900-mark, setting yet another new low. But with all this volume, things must rationalize soon … mustn’t they?

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