Market Action

June 11, 2008

The post BIS Quarterly Review Deprecates ABX Benchmark for SubPrime has been updated to make it a little less cryptic.

Wouldn’t you know it! Just when I’m idiotically busy, Accrued Interest comes up with two good posts:How are Bonds Quoted? (great primer material) and LIBOR our only hope? No … there is another! which introduces ICAP, sponsored by ICAP PLC the “world’s biggest inter-dealer broker”. So no summaries for you, guys, I’m too busy. I hope to have escaped the current crush in about a week.

It was clobbering time again in the preferred share market, with Sunlife issues being hit particularly hard, just as they were on June 9. I confess that I don’t know what has been causing this … there doesn’t appear to be any news of note and the common stock isn’t doing anything too alarming.

Note that these indices are experimental; the absolute and relative daily values are expected to change in the final version. In this version, index values are based at 1,000.0 on 2006-6-30
Index Mean Current Yield (at bid) Mean YTW Mean Average Trading Value Mean Mod Dur (YTW) Issues Day’s Perf. Index Value
Ratchet 4.14% 3.86% 51,724 0.08 1 +0.1182% 1,114.1
Fixed-Floater 4.91% 4.65% 61,047 16.08 7 +0.3801% 1,020.5
Floater 4.04% 4.04% 66,206 17.37 2 +1.3532% 946.6
Op. Retract 4.84% 2.30% 86,355 2.64 15 -0.0331% 1,057.4
Split-Share 5.29% 5.57% 70,859 4.18 15 -0.3525% 1,050.7
Interest Bearing 6.08% 6.03% 47,157 3.79 3 +0.0002% 1,120.1
Perpetual-Premium 5.86% 4.62% 396,056 8.80 13 -0.0144% 1,023.3
Perpetual-Discount 5.76% 5.82% 223,813 14.15 59 -0.3716% 910.5
Major Price Changes
Issue Index Change Notes
SLF.PR.C PerpetualDiscount -3.7468% Now with a pre-tax bid-YTW of 5.87% based on a bid of 19.01 and a limitMaturity.
SLF.PR.B PerpetualDiscount -2.7475% Now with a pre-tax bid-YTW of 5.87% based on a bid of 20.53 and a limitMaturity.
BNA.PR.B SplitShare -2.5653% Asset coverage of just under 3.6:1 as of May 30, according to the company. Now with a pre-tax bid-YTW of 8.17% based on a bid of 20.51 and a hardMaturity 2016-3-25 at 25.00. Compare with BNA.PR.A (5.86% to 2010-9-30) and BNA.PR.C (6.81% to 2019-1-10).
SLF.PR.A PerpetualDiscount -2.4102% Now with a pre-tax bid-YTW of 5.77% based on a bid of 20.65 and a limitMaturity.
CM.PR.J PerpetualDiscount -1.7653% Now with a pre-tax bid-YTW of 6.04% based on a bid of 18.92 and a limitMaturity.
SLF.PR.D PerpetualDiscount -2.0619% Now with a pre-tax bid-YTW of 5.88% based on a bid of 19.00 and a limitMaturity.
HSB.PR.C PerpetualDiscount -1.9867% Went ex-dividend today … looks like the price over-compensated! Now with a pre-tax bid-YTW of 5.97% based on a bid of 21.45 and a limitMaturity.
RY.PR.A PerpetualDiscount -1.6288% Now with a pre-tax bid-YTW of 5.64% based on a bid of 19.93 and a limitMaturity.
CM.PR.H PerpetualDiscount -1.6569% Now with a pre-tax bid-YTW of 6.04% based on a bid of 20.18 and a limitMaturity.
GWO.PR.I PerpetualDiscount -1.5984% Now with a pre-tax bid-YTW of 5.73% based on a bid of 19.70 and a limitMaturity.
PWF.PR.L PerpetualDiscount -1.3605% Now with a pre-tax bid-YTW of 5.93% based on a bid of 21.75 and a limitMaturity.
CU.PR.B PerpetualPremium -1.1811% Now with a pre-tax bid-YTW of 5.98% based on a bid of 25.10 and a call 2012-7-1 at 25.00.
BMO.PR.K PerpetualDiscount -1.0435% Now with a pre-tax bid-YTW of 5.82% based on a bid of 22.76 and a limitMaturity.
SLF.PR.E PerpetualDiscount -1.0127% Now with a pre-tax bid-YTW of 5.77% based on a bid of 19.55 and a limitMaturity.
BCE.PR.R FixFloat +1.0941%  
IAG.PR.A PerpetualDiscount +1.1219% Now with a pre-tax bid-YTW of 5.82% based on a bid of 19.83 and a limitMaturity.
BCE.PR.C FixFloat +1.1379%  
BAM.PR.B Floater +2.8199% Went ex-dividend today, but the price went up anyway!
Volume Highlights
Issue Index Volume Notes
NTL.PR.G Scraps (Would be Ratchet, but there are credit concerns) 176,800  
NTL.PR.F Scraps (Would be Ratchet, but there are credit concerns) 142,942 CIBC crossed 100,000 at 11.00.
TD.PR.O PerpetualDiscount 113,135 Nesbitt crossed 50,000 at 22.36; National Bank crossed 50,000 at 22.30. Now with a pre-tax bid-YTW of 5.51% based on a bid of 22.32 and a limitMaturity.
RY.PR.F PerpetualDiscount 56,890 Now with a pre-tax bid-YTW of 5.63% based on a bid of 19.96 and a limitMaturity.
RY.PR.B PerpetualDiscount 49,200 Now with a pre-tax bid-YTW of 5.65% based on a bid of 21.01 and a limitMaturity.
TD.PR.R PerpetualPremium 46,300 Now with a pre-tax bid-YTW of 5.70% based on a bid of 25.13 and a limitMaturity.
BNS.PR.O PerpetualPremium 42,507 “Anonymous” bought 40,000 from RBC in five tranches, all at 25.10 … not necessarily the same “anonymous”. Now with a pre-tax bid-YTW of 5.65% based on a bid of 25.10 and a limitMaturity.

There were twenty other index-included $25-pv-equivalent issues trading over 10,000 shares today.

Issue Comments

KSP.UN Downgraded to Pfd-3 by DBRS

Not, perhaps, unequivocally a preferred share, but Kingsway Linked Return of Capital Trust is managed by Scotia Managed Companies and is rated by both S&P and DBRS using their “preferred share scale” … and we all know how dreadfully important the ratings scales are, don’t we? Critically important! Crucially important!

So anyway, DBRS says:

DBRS has today downgraded the LROC Preferred Units (the Units) issued by Kingsway Linked Return of Capital Trust to Pfd-3 from Pfd-3 (high), with a Negative trend. The rating had been placed Under Review with Negative Implications on December 21, 2007.

The Units are supported by an exposure to a note guaranteed by Kingsway Financial Services Inc. and Kingsway America Inc. (collectively, Kingsway) through a forward purchase agreement. The downgrade of the Units is a result of DBRS downgrading the long-term debt ratings of Kingsway on June 6, 2008, to BBB (low) from BBB, with a Negative trend.

The redemption date for the Units will be June 30, 2015.

The issue continues to be rated P-3 by S&P (which rates Kingsway Financial at BB (negative trend) and issues of Kingsway America at BB.

KSP.UN is not tracked by HIMIPref™.

Issue Comments

LB.PR.D & LB.PR.E Upgraded to Pfd-3(high) by DBRS

DBRS has announced it:

has today upgraded the Deposits & Senior Debt rating of Laurentian Bank of Canada (Laurentian, LB or the Bank) to BBB (high), the Subordinated Debt to BBB and the Short-Term Instruments to R-1 (low) from BBB, BBB (low) and R-2 (high), respectively; all the trends are Stable.

The rating upgrades reflect the progress LB has made in improving its sustainable internal capital generation through improvement in its earnings profile. DBRS believes LB’s strategy to focus on its three core segments (Retail & SME Québec, B2B Trust and Real Estate & Commercial) and its improved operating efficiency have been instrumental in increasing the quality of earnings over the last several years. A more clearly defined target market, investment in technology, strengthened relations with its unionized workforce and incentive compensation programs contributed to this improvement.

The core strategy is expected to deliver further improvements in return on equity (ROE) and internal capital generation in the intermediate term, although these improvements will likely be hampered in the near term by the slowing regional economy and difficult operating environment for banks in general.

Over the longer term, material improvements in efficiency are required to eliminate the Bank’s competitive disadvantage in its cost structure. Further efficiency improvements are targeted by increasing revenues while holding expense growth to lower levels, which DBRS views as an appropriate strategy. Working with the unionized workforce and improving the sales culture of the organization are integral to this goal.

B2B Trust has been (and is expected to continue to be) a positive factor in Laurentian’s credit profile in terms of its contribution to profitability, as well as the beneficial effect it has on both business line and geographic diversification.

Under DBRS’s global rating methodology for banks, Laurentian’s long-term Deposits & Senior Debt rating has an Intrinsic Assessment of BBB (high) and a Support Assessment of SA3. The SA3 rating, which reflects the expectation of no timely external support, results in the final rating being equivalent to the Intrinsic Assessment.

Laurentian reported adjusted ROE and internal capital generation in the first half of 2008 of 10.9% and 7.1%, respectively. While still comparatively low and assisted by an outsized securitization gain, these results are the highest in the past six years. Relative to other Canadian banks, LB has benefited from its higher proportion of retail deposit funding over the past nine months of credit market instability. Asset quality has remained strong.

While not mentioned in the text of the press release, the summary shows the preferreds being upgraded to Pfd-3(high).

This is a welcome change in direction for the bank’s ratings:

DBRS Ratings for LB
From To Rating
2001-11-08 2003-12-15 Pfd-2(low)
2003-12-16 2004-10-7 Pfd-3(high)
2004-10-8 2008-6-11 Pfd-3
2008-6-12 ? Pfd-3(high)

Update: The preferreds continue to be rated P-3(high) by S&P, while the credit rating is BBB with a positive trend.

Update: See also previous commentary for LB.PR.D and LB.PR.E

Regulation

OSFI: This is How It's Supposed To Work!

OSFI has come under a certain amount of media criticism regarding ABCP – the media criticism is completely uninformed and reflects a notion that a regulator of anything should regulate everything – but felt sufficiently pressured to address the issue to take Public Relations action.

Assiduous Readers will remember that I am currently considering the new form of hybrid Tier 1 Capital that dropped, ker-plunk! onto OSFI’s website without notice or explanation. An inquiry directed to OSFI did result in a call from an OSFI staffer who was as helpful as he could be … but background material and discussion papers simply do not exist.

This is completely unacceptable.

We can, for instance, go to the website of the Committee of European Banking Supervisors – which, by the way, looks a lot more professional than the OSFI website – and see a plethora of links to news, other stories, publications and consultations. We can sign up for eMail alerts. And, with a minimum of effort, we can find the publication Proposal for a common EU definition of Tier 1 hybrids, released on March 26, 2008, which deals with the question of cumulativity (which I’ll examine in another post), and includes the information:

12. During the whole process CEBS maintained a dialogue with market participants in order to gain a better understanding of the range of concerns the current definition of own funds in the EU, and especially Tier 1 hybrid capital instruments, causes for market participants and their views on what a more consistent definition would look like.

13. For this purpose, CEBS organized public hearings in June and November 2007 as well as bilateral meetings with representatives of institutions, rating agencies and investors.

14. On 7 December 2007 the draft proposals were published for public consultation. CEBS received 31 responses. The comments and proposals provided have been incorporated, where appropriate. For details please see the feedback table (CEBS 2008 33).

Responses? You want to know what the players are saying? All 31 responses are published and the list of responses is easy to find through the announcement of publication. Anybody who wants to understand the issues and come to an independent judgement as to the adequacy of bank capitalization rules with respect to this issue will find a wealth of information on the European site.

Why does Canada’s financial regulator maintain a third-world website and conduct its practices with such comparitive secrecy?

Canadian banks have mythic status to Canadians, due largely to the lack of large bankruptcies. While I will not grudge OSFI any of the credit for maintaining a strong banking system, I will provide some friendly warning: pull up your socks and communicate your processes more clearly or, when a real crisis actually does hit Canadian banks, the whining about ABCP will seem laughably picayune.

New Issues

New Issue: Loblaw 5.95% 7-Year Retractibles

Loblaw Companies has announced:

a domestic public offering of 9 million cumulative redeemable convertible Second Preferred Shares, Series A (the “Preferred Shares Series A”) at a price of $25.00 per share, to yield 5.95% per annum, for an aggregate gross amount of $225 million.

Loblaw has agreed to sell the Preferred Shares Series A to a syndicate of underwriters co-led by RBC Dominion Securities Inc. and CIBC World Markets Inc. on a bought deal basis. Loblaw has granted to the underwriters an option to purchase an additional $75 million of the Preferred Shares Series A at any time up to 48 hours prior to closing.

The Preferred Shares Series A will be offered by way of prospectus supplement under the short form base shelf prospectus of Loblaw Companies Limited dated June 5, 2008. The prospectus supplement will be filed with securities regulatory authorities in all provinces of Canada.

The net proceeds of the issue will be added to the general funds of Loblaw Companies Limited and used for general corporate purposes. The offering is expected to close on or about June 20, 2008.

Issue: Loblaw Companies Limited 5.95% Cumulative Redeemable Second Preferred Shares, Series A

Size: 9-million shares @ $25 (= $225-million) + greenshoe of 3-million shares (= $75-million) exercisable prior to closing.

Dividends: $1.4875 p.a., payable quarterly; long first dividend of $0.5394 payable 2008-10-31

Redemption: Redeemable at $25.75 commencing 2013-7-31; redemption price declines to $25.50 commencing 2014-7-31; declines to $25.00 if redeemed on or after 2015-7-31. Redemption price may be satisfied with shares of Loblaw at 95% of market (as defined).

Retraction: At $25 into shares of Loblaw at 95% of market (as defined), commencing 2015-7-31. Company can substitute cash at its option.

Ratings: S&P: P-3(high); DBRS Pfd-3 (negative trend)

Closing: 2008-6-20

Well, it’s certainly nice to see an operating-retractible issue offered in size; sadly, the ratings will keep it out of the HIMIPref™ indices and many portfolios. More later.

Update: This issue looks expensive.

Loblaw New Issue
and Some Comparators
Ticker DBRS
Rating		 Current
Quote		 Retraction
Date		 Yield
to
Retraction
L.PR.? Pfd-3 25.00
Issue
Price		 2015-7-30

6.05%
BPO.PR.K Pfd-3(high) 23.11-35 2016-12-30 6.57%
YPG.PR.B Pfd-3(high) 20.75-90 2017-6-29 7.65%
DW.PR.A Pfd-3 21.80-94 2017-3-12 6.91%
Market Action

June 10, 2008

Sorry, folks! Not much today!

Bloomberg reports:

The average yield over similar-duration Treasuries on AAA securities backed by subprime or second mortgages was at 6.23 percentage points yesterday, the highest since the last week of April, according to Lehman index data. The spread rose as high as 7.52 percentage points on May 9, according to the New York-based securities firm’s index.

Renewed investor demand remains strong for the types of AAA rated subprime-mortgage bonds that are the first to be repaid with principal returned from the underlying loans, “with little price discovery in other tranche types,” according to a report yesterday from Countrywide Financial Corp. analysts including Anand Bhattacharya and Bill Berliner.

The ABX-HE-AAA 07-2 subprime index fell as low as 50.67 in March, according to administrator Markit Group Ltd. New ABX indexes created last month and tied to the second-to-last-to-be- repaid AAA classes have fallen to record lows for each six-month ABX series, with the latest declining from a high of 70 to 57.72.

There are rumours of a cosmetic change in rating indicators:

Regulators’ plans to add a letter to credit ratings of asset-backed debt may constrict the $4.6 trillion market and choke off consumer credit at a time when Federal Reserve Chairman Ben Bernanke wants more lending to bolster the economy.

The U.S. Securities and Exchange Commission may recommend this week that Moody’s Investors Service, Standard & Poor’s and Fitch Ratings include a new designation to the scale created by John Moody in 1909, according to people familiar with the plans.

The sad part is that some people actually think it matters.

Central Banks of all descriptions, not just the Bank of Canada, have remembered inflation.

The BoC’s decision not to move KILLED the front end of the market today, with DEX reporting 2-Years +31bp to 3.30%, 5s +23bp to 3.52%, 7s +18bp to 3.62% and 10s +12bp to 3.84%. Long corporates are still in the 6.05% neighborhood (about 190bp over Canadas); Interest-equivalent Perpetual Discounts are now about at 8.12% so spreads are about +207bp … a modest widening.

Note that these indices are experimental; the absolute and relative daily values are expected to change in the final version. In this version, index values are based at 1,000.0 on 2006-6-30
Index Mean Current Yield (at bid) Mean YTW Mean Average Trading Value Mean Mod Dur (YTW) Issues Day’s Perf. Index Value
Ratchet 4.15% 4.16% 53,542 17.1 1 -0.0394% 1,112.8
Fixed-Floater 4.92% 4.68% 61,693 16.04 7 -0.0361% 1,016.6
Floater 4.04% 4.10% 64,425 17.13 2 -0.2269% 934.0
Op. Retract 4.83% 1.98% 87,145 2.84 15 -0.0742% 1,057.8
Split-Share 5.27% 5.50% 70,603 4.19 15 +0.0844% 1,054.4
Interest Bearing 6.08% 6.06% 47,763 3.79 3 -0.3304% 1,120.1
Perpetual-Premium 5.85% 5.77% 399,530 10.65 13 -0.0503% 1,023.4
Perpetual-Discount 5.73% 5.80% 224,725 14.17 59 -0.5862% 913.9
Major Price Changes
Issue Index Change Notes
GWO.PR.I PerpetualDiscount -2.8627% Now with a pre-tax bid-YTW of 5.63% based on a bid of 20.02 and a limitMaturity.
IAG.PR.A PerpetualDiscount -2.7282% Now with a pre-tax bid-YTW of 5.88% based on a bid of 19.61 and a limitMaturity.
BNS.PR.M PerpetualDiscount -1.9560% Now with a pre-tax bid-YTW of 5.70% based on a bid of 20.05 and a limitMaturity.
BNS.PR.L PerpetualDiscount -1.8618% Now with a pre-tax bid-YTW of 5.70% based on a bid of 20.03 and a limitMaturity.
CM.PR.J PerpetualDiscount -1.7653% Now with a pre-tax bid-YTW of 6.04% based on a bid of 18.92 and a limitMaturity.
GWO.PR.G PerpetualDiscount -1.7582% Now with a pre-tax bid-YTW of 5.83% based on a bid of 22.35 and a limitMaturity.
BCE.PR.Z FixFloat -1.7023%  
RY.PR.A PerpetualDiscount -1.6288% Now with a pre-tax bid-YTW of 5.64% based on a bid of 19.93 and a limitMaturity.
PWF.PR.L PerpetualDiscount -1.5625% Now with a pre-tax bid-YTW of 5.87% based on a bid of 22.05 and a limitMaturity.
BAM.PR.B Floater -1.4762%  
SLF.PR.C PerpetualDiscount -1.2994% Now with a pre-tax bid-YTW of 5.65% based on a bid of 19.75 and a limitMaturity.
BMO.PR.J PerpetualDiscount -1.2438% Now with a pre-tax bid-YTW of 5.72% based on a bid of 19.85 and a limitMaturity.
POW.PR.D PerpetualDiscount -1.1457% Now with a pre-tax bid-YTW of 5.88% based on a bid of 21.57 and a limitMaturity.
SLF.PR.E PerpetualDiscount -1.0521% Now with a pre-tax bid-YTW of 5.71% based on a bid of 19.75 and a limitMaturity.
BAM.PR.K Floater +1.0396%  
MFC.PR.C PerpetualDiscount +1.2107% Now with a pre-tax bid-YTW of 5.41% based on a bid of 20.90 and a limitMaturity.
BCE.PR.G FixFloat +1.3423%  
Volume Highlights
Issue Index Volume Notes
BAM.PR.K Floater 185,303 TD crossed 40,000 at 20.50.
RY.PR.A PerpetualDiscount 141,347 Now with a pre-tax bid-YTW of 5.64% based on a bid of 19.93 and a limitMaturity.
CM.PR.H PerpetualDiscount 74,707 Now with a pre-tax bid-YTW of 5.94% based on a bid of 20.52 and a limitMaturity.
RY.PR.W PerpetualDiscount 69,215 Now with a pre-tax bid-YTW of 5.60% based on a bid of 22.08 and a limitMaturity.
CM.PR.I PerpetualDiscount 65,765 Now with a pre-tax bid-YTW of 6.03% based on a bid of 19.80 and a limitMaturity.

There were twenty-six other index-included $25-pv-equivalent issues trading over 10,000 shares today.

Issue Comments

BDS.PR.A to be Exchanged for VIP.PR.A

Brompton Group has announced:

A special meeting of securityholders for the funds listed below (collectively, the “Funds”) was held today at which securityholders approved the extraordinary resolutions to reorganize the Funds, including the merger of certain funds.

According to the website, VIP.PR.A will come with the same terms as BDS.PR.A, although the Information Circular does not appear to make this clear. The original intent had been to redeem BDS.PR.A, but these plans were changed in April.

Issue Comments

BNS.PR.Q Closes Comfortably

Scotiabank has announced:

that it has completed the domestic offering of 14 million, non-cumulative 5-year rate reset preferred shares Series 20 (the “Preferred Shares Series 20”) including the full exercise of the underwriters’ option, at a price of $25.00 per share. The gross proceeds of the offering were $350 million.
The offering was made through a syndicate of investment dealers led by Scotia Capital Inc. Following the successful sale of the initially announced 12 million Preferred Shares Series 20, the syndicate fully exercised the underwriters’ option to purchase an additional 2 million shares. The Preferred Shares Series 20 commence trading on the Toronto Stock Exchange today under the symbol BNS.PR.Q.

The issue traded 629,480 shares today in a range of 24.95-07, closing at 24.98-00, 4×156. The related BNS.PR.P (which resets at +205) closed at 25.41-50, 15×66. It would seem the market it placing a lot of faith in actually seeing those extra thirty-five beeps!

BNS.PR.Q was announced and analyzed on May 27.

Sub-Prime!

BIS Quarterly Review Deprecates ABX Benchmark for SubPrime

As reported by the WSJ, the BIS Quarterly Review deprecated the widespread use of the ABX indices when estimating credit losses on sub-prime.

They make three major points regarding pitfalls in using the ABX:

  • Accounting Treatment – many subprime RMBS are held by investors who do not mark-to-market, resulting in a wide gap between reported writedowns and estimated fair value of losses.
  • Market Coverage – the indices only sample the universe … but this is probably not a big deal, the sample is reasonable.
  • Deal-Level coverage – “Similarly, ABX prices may not be representative because each index series covers only part of the capital structure of the 20 deals included in the index … In particular, tranches referenced by the AAA indices are not the most senior pieces in the capital structure, but those with the longest duration (expected average life) – the so-called “last cash flow bonds”.”

The last point is very important and forms the core of their argument.

This information has been available to non-specialists for some time … I could have sworn I mentioned it specifically on PrefBlog at one point, but can’t find the reference … and at any rate I should have emphasized it myself when discussing the fair value estimates. The best tracing to this information I can give is … in my discussion of the Greenlaw paper, I referenced the comments to Econbrowser’s Mortgage Securitization post, in which I referenced Felix Salmon’s How to test the accuracy of the ABX post, which referenced his prior ABX RIP post, which referenced Alea’s ABX Extra piece, which … highlighted the information.

The guts of the BIS argument are given only in the notes:

Incomplete coverage at the deal level further reduces effective market coverage: typical subprime MBS structures have some 15 tranches per deal, of which only five were originally included in the ABX indices. As a result, each series references less than 15% of the underlying deal volume at issuance.

Duration effects at the AAA level are bound to be significant for overall loss estimates as the AAA classes account for the lion’s share of MBS capital structures. Using prices for the newly instituted PENAAA indices, which reference “second to last” AAA bonds, to calculate AAA mark to market losses generates an estimate of $73 billion. This, in turn, translates into an overall valuation loss of $205 billion (ie some 18% below the unadjusted estimate of $250 billion).

I will suggest that even the PENAAA indices will be not very well corellated with actual credit analysis, but these data certainly provide an indication of the value of subordination.

The last review of loss estimates was the discussion of the OECD paper; there is not really enough data in the BIS note to put it on the board as an estimate … but it certainly seems to support the “lowball Bank of England estimate” rather than the “terrifying IMF estimate”!

The main articles – apart from the “Overview” and “Highlights” – in the BIS Review are:

  • International Banking Activity Amidst the Turmoil
  • Managing International Reserves: How Does Diversification Affect Financial Costs?
  • Credit Derivatives and Structured Credit: the Nascent Markets of Asia and the Pacific
  • Asian Banks and the International Interbank Market

Update, 2008-6-11: This post was picked up by iStockAnalyst and attracted a puzzled comment on the Housing Doom blog:

Here’s a technical criticism of the ABX index that was posted yesterday. If you can understand what this guy is complaining about you’re doing better than me.

“BIS Quarterly Review Deprecates ABX Benchmark for SubPrime”, James Hymas, iStockAnalysis, June 10, 2008.

Well, I guess for new readers who have not been assiduously reading my remarks, this post will be a little cryptic!

The gist is: in order to make a sub-prime RMBS with a large AAA component, it must be tranched; for example, the Bear Stearns ABS I use as a model had a total value of USD 395-million, which was divided into seven publicly marketed and three private tranches … payments went first to the USD 314-million senior tranche, then on down the line until the final (public) tranche of USD 4.5-million, initially rated at BBB- and downgraded to B on August 24, 2007 gets paid … if it ever does! I looked at the economics of tranching very early on.

This particular issue is relatively simple, but there are issues with more tranches … as the BIS piece above notes, the average is 15 tranches per deal of which … maybe five? I’m guessing … would be rated AAA.

So you have five AAA tranches that get paid one after the other. Obviously, the first one to be paid is the safest and most likely to meet its committments; the ratings agencies, in their infinite wisdom, determined that tranche #5 was also good enough to warrant an AAA rating. The ten that came after that would be sold to the public with worse ratings and higher yields.

So … the market goes blahooey and all of sudden banks and brokerages, with a need to mark their inventories to market to meet the accounting rules, are stuck with the problem: how to assign a market price to inventory comprised of relatively small issues representing a class of security that simply isn’t trading at all. After discussion with their accountants, they determine that the methodology least likely to get them into trouble is to use the Markit ABX indices as a benchmark. This methodology is also used by third parties (e.g., the OECD, referenced above) to estimate what the total losses for the entire universe of about USD 1.4-trillion might be.

There are a number of problems with this approach. Firstly, the Markit ABX index only rates the worst tranche for each credit rating … the value for the AAA-rated index is based entirely on tranche #5 of our example, even though there are four other tranches rated AAA in this deal, each of which (this is the important bit) are safer than the chosen tranche by definition.

Secondly, the ABX index is based on Credit Default Swaps, a market that is now basically dysfunctional.

Thirdly, we are interesting times; getting out of sub-prime paper is currently a “crowded trade” and the cash market itself is dysfunctional (although it is starting to show signs of life). The market price of the securities does not have a lot to do with the present value of its expected cash flows.

All these factors mean that estimates of sub-prime losses that mark-to-market off the Markit ABX index are (a) highly imprecise, and (b) greatly overstated.

The new PENAAA index referred to above is based on the penultimate tranche in the AAA tranche – tranche #4 in our 15-tranche mini example. A quality spread is quite evident; using the value of this index to estimate market values over the universe results in BIS computing an estimate for losses that is much, much lower than the initial estimate.

Market Action

June 9, 2008

Timothy Geithner of the Federal Reserve Bank of New York has delivered a fine speech, Reducing Systemic Risk in a Dynamic Financial System. He notes:

This afternoon, 17 firms that represent more than 90 percent of credit derivatives trading, meet at the Federal Reserve Bank of New York with their primary U.S. and international supervisors to outline a comprehensive set of changes to the derivatives infrastructure. This agenda includes:

  • the establishment of a central clearing house for credit default swaps,
  • a program to reduce the level of outstanding contracts through bilateral and multilateral netting,
  • the incorporation of a protocol for managing defaults into existing and future creditderivatives contracts, and
  • concrete targets for achieving substantially greater automation of trading and settlement.

Establishment of this clearing-house has been reported on Bloomberg; a later press release from the FRBNY gave further details.

Geithner nails the essential point:

supervision will have to focus more attention on the extent of maturity transformation taking place outside the banking system.

And goes further, to make the point I have been making for a while:

I do not believe it would be desirable or feasible to extend capital requirements to institutions such as hedge funds or private equity firms. But supervision has to ensure that counterparty-credit risk management in the regulated institutions contains the level of overall exposure of the regulated to the unregulated. Prudent counterparty risk management, in turn, will work to limit the risk of a rise in overall leverage outside the regulated institutions that could threaten the stability of the financial system.

To the extent that this reflects Official Thinking, I’m very relieved. We should not be concerned that Joe’s Hot Dog Stand and Mortgages is levered 40:1 … we should only be concerned with the amount of counterparty risk taken by the banks who lend to him.

I’m not entirely certain as to what I should make of the section:

The most fundamental reform that is necessary is for all institutions that play a central role in money and funding markets—including the major globally active banks and investment banks—to operate under a unified framework that provides a stronger form of consolidated supervision, with appropriate requirements for capital and liquidity.

To complement this, we need to put in place a stronger framework of oversight authority over the critical parts of the payments system, not just the centralized payments, clearing and settlements systems but the infrastructure that underpins the decentralized over-the-counter markets.

The Federal Reserve should play a central role in this framework, working closely with supervisors here and in other countries. At present the Federal Reserve has broad responsibility for financial stability not matched by direct authority, and the consequences of the actions we have taken in this crisis make it more important that we close that gap.

I will assert that brokerages are fundamentally different from banks and should have not just different rules, but a different supervisor … in the US, the SEC is doing as well as any other regulator and should not lose any authority. I worry about how much the Bear Stearns fiasco will be used a lever in a silly bureaucratic turf fight that might, ultimately, lead to a blurring of the distinction between the two components of the financial system. He does mention Bear Stearns, by the way, but doesn’t add anything new.

Carnage on the preferred share market today, with the TXPR Index down 0.61% and Claymore’s CPD about the same. Sunlife, comprising a little over 6% of CPD, got hammered.

Note that these indices are experimental; the absolute and relative daily values are expected to change in the final version. In this version, index values are based at 1,000.0 on 2006-6-30
Index Mean Current Yield (at bid) Mean YTW Mean Average Trading Value Mean Mod Dur (YTW) Issues Day’s Perf. Index Value
Ratchet 4.16% 4.17% 54,155 17.1 1 -0.0787% 1,113.3
Fixed-Floater 4.92% 4.67% 61,982 16.03 7 -0.4778% 1,017.0
Floater 4.04% 4.09% 61,693 17.15 2 -0.0432% 936.1
Op. Retract 4.82% 1.93% 86,852 2.66 15 -0.0011% 1,058.6
Split-Share 5.27% 5.49% 70,186 4.19 15 -0.2649% 1,053.5
Interest Bearing 6.06% 6.04% 48,832 3.80 3 +0.5060% 1,123.8
Perpetual-Premium 5.85% 5.78% 405,175 9.18 13 -0.1063% 1,024.0
Perpetual-Discount 5.70% 5.76% 224,561 14.23 59 -0.3876% 919.3
Major Price Changes
Issue Index Change Notes
BNA.PR.B SplitShare -2.5487% Asset coverage of just under 3.6:1 as of May 30 according to the company. Now with a pre-tax bid-YTW of 7.76% based on a bid of 21.03 and a hardMaturity 2016-3-25 at 25.00. Compare with BNA.PR.A (6.10% to 2010-9-30) and BNA.PR.C (6.76% to 2019-1-10).
GWO.PR.G PerpetualDiscount -2.4861% Now with a pre-tax bid-YTW of 5.72% based on a bid of 22.75 and a limitMaturity.
SLF.PR.D PerpetualDiscount -2.1543% Now with a pre-tax bid-YTW of 5.71% based on a bid of 19.53 and a limitMaturity.
PWF.PR.L PerpetualDiscount -1.7544% Now with a pre-tax bid-YTW of 5.77% based on a bid of 22.40 and a limitMaturity.
POW.PR.D PerpetualDiscount -1.7117% Now with a pre-tax bid-YTW of 5.83% based on a bid of 21.82 and a limitMaturity.
WFS.PR.A SplitShare -1.6915% Asset coverage of just under 1.8:1 as of May 31, according to the company. Now with a pre-tax bid-YTW of 6.10% based on a bid of 9.88 and a hardMaturity 2011-6-30 at 10.00.
IAG.PR.A PerpetualDiscount -1.6585% Now with a pre-tax bid-YTW of 5.72% based on a bid of 20.16 and a limitMaturity.
GWO.PR.H PerpetualDiscount -1.6144% Now with a pre-tax bid-YTW of 5.54% based on a bid of 21.94 and a limitMaturity.
SLF.PR.B PerpetualDiscount -1.2617% Now with a pre-tax bid-YTW of 5.70% based on a bid of 21.13 and a limitMaturity.
SLF.PR.E PerpetualDiscount -1.2370% Now with a pre-tax bid-YTW of 5.65% based on a bid of 19.96 and a limitMaturity.
BCE.PR.R FixFloat -1.0870%  
IGM.PR.A OpRet -1.0401% Now with a pre-tax bid-YTW of 3.05% based on a bid of 26.64 and a call 2009-7-30 at 26.00.
PWF.PR.F PerpetualDiscount -1.0235% Now with a pre-tax bid-YTW of 5.72% based on a bid of 23.21 and a limitMaturity.
BSD.PR.A InterestBearing +1.5353% Now with a pre-tax bid-YTW of 6.18% (mostly as interest) based on a bid of 9.92 and a hardMaturity 2015-3-31 at 10.00.
Volume Highlights
Issue Index Volume Notes
CM.PR.I PerpetualDiscount 670,210 Nesbitt crossed 50,000 at 19.90. Now with a pre-tax bid-YTW of 6.00% based on a bid of 19.89 and a limitMaturity.
BNS.PR.K PerpetualDiscount 147,996 “Anonymous” bought 10,000 from Raymond James at 22.04, then another 20,000 at 22.02 … not necessarily the same anonymous! Now with a pre-tax bid-YTW of 5.51% based on a bid of 22.08 and a limitMaturity.
FAL.PR.B FixFloat 109,652 TD crossed 109,200 at 24.80.
RY.PR.B PerpetualDiscount 105,135 National Bank crossed 100,000 at 21.10. Now with a pre-tax bid-YTW of 5.64% based on a bid of 21.06 and a limitMaturity.
TD.PR.O PerpetualDiscount 82,325 Nesbitt bought 18,000 from anonymous in three tranches at 22.36 … not necessarily the same anonymous … and National Bank crossed 50,000 at the same price. Now with a pre-tax bid-YTW of 5.50% based on a bid of 22.33 and a limitMaturity.

There were twenty other index-included $25-pv-equivalent issues trading over 10,000 shares today.