PrefBlog

The travails of Fannie & Freddie continued to attract attention, with James Hamilton of Econbrowser reviewing their purpose, capital structure and capital adequacy and concluding:

Perhaps you think we’ll probably muddle through OK, unless the sale of Freddie’s assets would so depress the market as to hinder extensions of new loans to creditworthy borrowers, thereby reducing home sales further, thereby depressing house prices further, thereby inducing more borrowers to default, so that we go from the good equilibrium to the bad equilibrium. But figuring out exactly where we stand currently on that slippery slope between A and B is not an easy matter.

Here’s my bottom line: if Freddie cuts its dividend, that’s a good thing. All the rest is worrisome.

The disagreement at issue is expressed by Felix Salmon:

According to the WSJ, Freddie Mac has serious capital-adequacy problems, and they’re basically the fault of the Office of Federal Housing Enterprise Oversight
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because OFHEO is being strict with Freddie, it’s being forced to sell tens of billions of dollars’ worth of mortgages.
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Instead, they’re dumping mortgages onto the secondary market in order to comply with OFHEO’s capital-adequacy requirements. There’s a time and a place for those kind of requirements, and it is emphatically not now.

My position remains that the GSEs walk like banks, talk like bank, make profits like banks and should be regulated like banks – as James Hamilton implied at Jackson Hole. I have been unable to determine what the Tier 1 and Total Capital ratios of the GSEs would be were this to be put into effect, but OFHEO head James B. Lockhart’s March speech to America’s Community Bankers is telling:

Presently, Fannie Mae and Freddie Mac have low regulatory minimum capital requirements compared with other financial institutions. The 1992 Act that created OFHEO requires them to maintain stockholder’s equity equal to 2.5 percent of assets. The FHLBanks hold 4 percent, albeit with a much different capital structure, and major banks hold over 6 percent. Given Fannie Mae’s and Freddie Mac’s present condition, I am certainly more comfortable with today’s extra 30 percent add-on for operational risk.

OFHEO’s risk-based capital test is also prescribed by that 15-year-old statute and needs to be modernized. Risk-based capital should be based on the full array of Enterprise risks — market, credit, and operational risk, as well as the risks they present to the overall financial markets. A new, stronger regulator needs the flexibility and authority to change both the risk-based and minimum capital requirements through a regulatory process supplemented by the ability to respond quickly to changing conditions.

So … my bottom line is that the GSEs are grossly undercapitalized. If they want to grow, let them issue more equity. If it is deemed to be a social good that they grow, enough of a social good that the US Government is explicitly willing to bear some losses if things get really bad (right now the guarantee is only implicit) then fine! Make that decision! Have the US Government buy and pay for a big fat whack of common and preferred stock! 

In other news, it looks as if the MLEC / Super-Conduit is getting under way slowly, though not without carping from Naked Capitalism:

am now wondering who, exactly, will purchase the commercial paper that will fund this new entity. While this is anecdotal, I have heard a fair number of people, including financially savvy ones, say they would take money out of a money market fund that invested in this entity. So retail money market funds are somewhere between a hard sell and a non-starter. Enhanced cash management fund would have been the perfect target, but a number have broken the buck recently. Some mangers are contributing cash to the fund to make investors whole; others are letting investors take losses. As a result, that type of fund is operating under a cloud right now. Expect there to be near-term net withdrawals and greater conservatism in investment, which works against the SIV rescue program.

Hey – show me that the assets are fairly valued, show me that I’m senior to a good whack of mezzanine and capital notes, and show me that there’s a solid liquidity guarantee and I’ll invest! To be fair, Naked Capitalism has been dubious from the beginning as to whether my first condition would be met!

Naked Capitalism also provides a round-up of recent news concerning the bond insurance industry. ACA Capital and its woes – and subsequent vulnerability to a deep-pocketted strategic acquirer – was briefly mentioned yesterday. A ratings downgrade of the firm could have significant effects:

ACA Capital Holdings Inc., the bond insurer under scrutiny by Standard & Poor’s, may have its credit rating cut, forcing banks to take on $60 billion of collateralized debt obligations, JPMorgan Chase & Co. analyst Andrew Wessel said.

After all, there has just been a bail-out of a French insurer by those with a deep interest in its continuing health!

Natixis SA’s bond-insurance unit, CIFG Guaranty, will be taken over by the French bank’s controlling shareholders in a $1.5 billion rescue to preserve its top credit rating.

Natixis, France’s fourth-largest bank by market value, rose 16 percent in Paris trading after Groupe Banque Populaire and Groupe Caisse d’Epargne, French mutual banks that jointly control Natixis, said today they will provide the capital and assume full ownership of CIFG. They said the purchase will be completed “as quickly as possible.”

And continuing on the bond insurance theme, Accrued Interest has taken a look at AMBAC and doesn’t like what he sees:

I have completed a deep dive of AMBAC’s insured portfolio. The conclusion: I don’t see how they maintain a AAA rating without raising new capital.
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So how much in capital would they need to retain their rating? Probably at least $2 billion.
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Whether they can raise this kind of capital or not is difficult to see. It will be a question of whether a well-capitalized partner sees long-term value in their lucrative municipal insurance franchise in excess of the losses expected in ABS. I don’t doubt that many potential partners would be interested in the municipal business.

We’ll see how it goes … speaking for myself, and without having done any analysis or understanding the culture … I say this is a Canadian banking opportunity. Come on, guys! You’ve got great balance sheets and a strong currency behind you! Put them to work!

The links under “US Fixed Income Data” in the right-hand panel of this blog now includes a link to the US Yield-to-Maturity Convention, continuing my struggle to remind the world that YTM is not annualized-IRR.

It was a thoroughly horrific day for preferred shares, although the nature of the market showed itself by having normal volume even though the US was closed. The Floater total return index fell below its 2006-6-30 value – negative total return for floaters over a 16+ month period – on what appears to be a combination of BAM-bashing and a conviction that Canada Prime is going to zero. Split-shares only just barely managed to hang on to positive 16+ month returns, as bids just evaporated.

P.S.: I almost forgot. The PerpetualDiscount index hit a new post-June-30-2006 low today. JH

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

Update 2007-11-22: HardMaturity price of WFS.PR.A noted in table of price changes has been corrected. Sorry!

Menzie Chinn of Econbrowser wrote a good piece yesterday reviewing the dollar’s decline, noting:

So while there is a tremendous amount of inertia in a currency’s reserve role, what we might be seeing now is the interaction of cyclical factors (low U.S. interest rates and dollar depreciation) and structural factors (the strains on dollar pegs and consequent erosion of demand for dollar assets) which could lead to a substantial drop in the dollar’s value.

It’s always the way. Any kind of accident – whether in the financial markets or in everyday life – generally results from a confluence of factors … the one percent chance that you don’t look when crossing the street will sometime coincide with somebody else’s one percent chance of not checking carefully when making a turn. The comments to the post are quite good, but I confess I’m not looking forward to the next year … an economics discussion on the Internet about the US during an election year? The mind boggles.

In a related essay, Richard Baldwin writes an excellent review of a paper by Martin Feldstein that provides an intellectual framework for thinking about currency values:

Feldstein makes a bold simplification that helps him to think clearly about the messy world. He takes US savings and investment as primitives and views the value of the dollar as the variable that adjusts to make things fit. As he writes it: “This line of reasoning leads us to the low level of the U.S. saving rate as the primary cause of the high level of the dollar.”
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If the US saving rate rises without a dollar drop, there is no narrowing of the trade gap to offset the closing saving/investment gap. Aggregate demand falls and we get a US recession or at least growth deceleration. More to the point facing us today, Feldstein notes that since a falling dollar stimulates net exports only with a lag, avoiding a slowdown in US aggregate demand growth would have required the dollar to fall before the saving rate rises, maybe a couple of quarters earlier. Or, as he puts it: “the domestic weakness will occur unless the dollar decline precedes the rise in saving.”

There was another insight into A Day in the Life of a Bond Guy on Accrued Interest; a discussion of an investment in Washington Mutual that the author is not prepared to support any more. After all the analysis, all the securities filings, all the worry … it all comes down to trust. In the comments section, AI floats the possibility of a takeover of WM … now that’s something that looks interesting. Every morning I rush to the newspaper, looking for the news that I am convinced will come in the near future: Major Canadian Bank Makes Massive Purchase in States.

The Canadian banks have balance sheets that are very strong by world standards – never mind just by comparison to US banks – AND we’re sitting on a hot currency AND the US financial sector is getting beat up beyond the bounds of rationality. If there was ever time to do something like this, it’s now. It doesn’t have to be another bank, or a big-name company like WaMu … it could be something like ACA Capital Holdings, which is not having a very nice time.

In more news of interest, yet another “enhanced yield” product was found to be in danger of breaking the buck and is getting a cash transfusion from Federated Investors. Note that Bear Stearns Cos.’ Enhanced Income Fund and General Electric Co.’s GEAM Trust Enhanced Cash Trust both broke the buck without support from their sponsors.

Readers will remember the concept of covered bonds and some will be aware that BMO is planning an issue. However, in addition to deterorating market conditions …

Abbey National Plc, the U.K. home lender owned by Banco Santander SA, became the third financial company to cancel an offering of covered bonds within a week today as investors demanded banks pay the highest interest premiums to sell bonds in the 12 years since Merrill Lynch & Co. began collecting the data.

“We are in a deteriorating situation,” Patrick Amat, chairman of the Brussels-based ECBC, said in a telephone interview. “A single sale can be like a hot potato. If repeated, this can lead to an unacceptable spread widening and you end up with an absurd situation.”

… there is now a recommendation from the trade association that:

“In light of the current market situation and in order to avoid undue over-acceleration in the widening of spreads, the 8-to-8 Market-Makers & Issuers Committee recommends that inter-bank marketmaking be suspended, temporarily, until Monday the 26th of November 2007. As this recommendation relates only to inter-bank trading, market-maker obligations to investors will remain unaffected.”

Fascinating. I have been advised that this recommendation only applies to extant market making agreements that commit the banks to calling a market in good size and is not a flat (unenforceable) prohibition of trades between two banks that want to trade. The Covered Bond Fact Book states:

Market Makers’ commitments define bid/offer spreads for sizes up to 15 million EUR for different maturities as follows:
> up to 4 years maturity – 5 cents;
> from 4 to 6 years – 6 cents;
> from 6 to 8 years – 8 cents;
> from 8 to 15 years – 10 cents;
> from 15 to 20 years – 15 cents; and
> from 20 years upwards – 20 cents.

I wrote about Fannie Mae and its accounting on November 16 … Accrued Interest has fleshed that out a little more (with the benefit of an American market background!) in a post about Freddie Mac.

Good volume for prefs today, and some of the more egregious silliness was smoothed away, but all in all performance was poor.

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