PrefBlog

Henry Blodgett of Clusterstock emphasizes a point I made September 23 regarding market value vs. intrinsic value of the securities targetted for TARB purchase in a post Warren Buffet reveals bailout’s dirty little secret:

Bernanke and Paulson want to pay a phantom “hold-to-maturity” price that is above the prices at which the banks are currently valuing their trash assets. The logic is that the banks’ carrying value is somehow artificially depressed by a lack of liquidity. (This logic is weak: If anything, the banks are trying to conceal how badly off they are by overstating the value of the assets).

Hat Tip: Naked Capitalism. Thanks to the miracles of modern hagiography, Mr. Blodgett sees no need to provide analysis supporting his thesis that banks are engaged in a coverup. Mr. Buffet is quoted (irelevantly) in the same post, so it must be true.

Dealbreaker is usually both vulgar and entertaining; on occasion they publish analysis that reflects their roots in the trading community. This is one of those times:

Mark-to-market accounting incentivizes markets to go illiquid when asset prices sink, exactly when liquidity is critical. You create an environment where an institution isn’t just poised to lose the difference between their current mark on the instrument they are selling and the transaction price, but a large multiple of that as that transaction triggers markdowns on the rest of the toxic paper. How do you handle that as a institution holding sludge? Wait. And if you see some sludge that is offered so cheaply that you couldn’t normally resist buying it? Wait, if you are holding similar assets. Liquidity has been frozen up to prevent revealing that many of these institutions might be insolvent at the current market prices. That’s the kind of thing that is going to happen when the institutions likely to go insolvent control most of the liquidity.

In general, huge corrections like this usually only reverse when prices get so low that value investors and their ilk creep out and cant help but start buying. The problem here is that there isn’t enough price discovery to tempt them out, or that the normal buyers (Goldman, etc.) face mark-to-market triggers that prevent them wanting any transactions at all. Buffett seems mercifully free of both constraints.

The opportunities TARP affords for this sort of unsupported assertion is one reason why I don’t like the plan and would prefer to see Treasury – if necessary – purchasing senior preferred shares with a punitive distribution and a proviso that shares junior to the new issue get no dividends while the issue is outstanding. If Treasury buys so much as a nickel’s worth of sub-prime paper, debate over side-issues will overwhelm any practical benefits. Even if they make a collosal profit, the move will be decried as ‘too risky but lucky!’ and condemned on grounds of idealogical impurity.

There are reports that TARP will be approved, one way or another, complete with politically driven executive compensation limits and maybe even a 25bp tax on stock trades. Fearless prediction: TARP will fail for the same reason MLEC failed: a politically satisfactory backstop makes no business sense for the participants.

Willem Buiter, writing in VoxEU, sees the problem as being one of insolvency, not illiqudity:

As the full horror story of the bad investments and bad loans made by so many American banks has gradually been revealed, it is clear that the US banking sector faces an insolvency crisis and not just an illiquidity crisis. The number of impaired mortgages is exploding, and not just in the subprime and Alt-A categories, but across the whole residential mortgage spectrum. Impaired commercial and industrial mortgages are rising fast. Bad loans to the construction industry and to developers are mushrooming. ABS backed by automobile loans, by credit card receivables are tottering in growing numbers as are many other unsecured household loans. With the economy slowing down and probably entering recession soon, even exposures to the non-financial corporate sector will become more vulnerable.

In a nutshell, the US banking sector needs recapitalisation.
…
That leaves just two sources of capital. The first is the US federal government. It could inject capital into US banks, say by purchasing preference shares. I would uncouple such a capital injection from Paulson’s toxic asset purchase plan. The market illiquidity problem is related to but not the same as the banks’ capital deficiency problem. The government could implement a system-wide capital injection by specifying maximum leverage ratios (or minimum capital ratios) for various categories of financial institutions. It could then inject capital in return for preference shares to bring all these leverage ratios down to the maximum levels (all the capital ratios up to the minimum levels).
…
Finally, there is my preferred solution to the capital deficiency problem: the compulsory conversion of some of the banks’ debt into equity. Again, this could be done by the government specifying maximum leverage ratios (or minimum capital ratios) for various categories of financial institutions. Different kinds of debt then would be mandatorily converted into equity (preference shares or ordinary shares) with the proportion of each category of debt to be converted into stock inversely related to the seniority of the debt. These proportions would have to satisfy the requirement that all leverage ratios be brought down to the maximum levels (all capital ratios up to the minimum levels).

It’s a very well written article in Mr. Buiter’s inimitable style. But although his concerns about solvency may well be justified, he presents no evidence that this is indeed the case. In any event, I have grave concerns about due process with respect to his mandatory conversion programme … this is insolvency restructuring stuff, usually carried out when the institution has, in fact, been proved to be insolvent. And, until somebody can show me otherwise, I will continue to believe that rumours of widespread insolvency in the US financial sector are greatly exaggerated.

In a speech available on the BoC website, Carney applauded TARP, albeit with very little discussion of its merits and alternatives:

Similarly, private asset sales have been limited by the complexity of the underlying assets, the ongoing impairment of securitization markets, difficulties in supplying financing to leveraged buyers and the desire of investors to “time the market.” In sum, banks have an increasing need for capital, but it has become more difficult to raise it.

In this environment, the U.S. government’s initiative to buy distressed assets is critically important. The plan announced by Treasury Secretary Paulson and being developed through discussions in the U.S. Congress is bold and timely. The size and breadth of support provided by this measure will help firms “rightsize” their balance sheets, re-liquefy closed markets and establish market prices for these distressed assets. This should eventually encourage private buyers to re-enter the market and complete the deleveraging process. A well-executed program will undoubtedly speed the resolution of this crisis and limit its economic cost.

But how urgent is the problem? Well, judging by the action at the discount window, pretty damn urgent!

Commercial banks and bond dealers borrowed $217.7 billion from the Federal Reserve as of yesterday, more than double the prior week, as the financial crisis worsened and private funding dried up.

Loans to commercial banks through the traditional discount window totaled $39.3 billion as of yesterday, up from $33.4 billion, the Fed said. Borrowing by securities firms totaled $105.7 billion, up from $59.8 billion. Under a new emergency program announced Sept. 19, banks borrowed $72.7 billion as of yesterday to buy commercial paper from money-market mutual funds.

The figures are from the Fed’s H.4.1 Statistical Release. It’s not clear to me, however, how much of that borrowing is happening because the banks can’t get funding anywhere else, and how much is because it’s cheap credit. We can assume that the AIG need is real, though!

The three-month London Interbank Offered Rate in dollars was 3.77 percent today, the highest since January. Commercial banks can take out up to 90-day loans from the Fed at 2.25 percent. Primary dealers pay the same rate for overnight loans. The AIG loan accrues interest at three-month Libor plus 8.5 percentage points.

In 2001, the discount rate was a half-point below the Fed’s benchmark federal funds rate. In 2003, the Fed reset the discount rate at 1 percentage point above federal funds. The Fed reduced the spread to a half point in August 2007 and to a quarter point in March 2008.

We shall see how it all works out. There is opposition to TARP from a group of economists and a group of Republicans. Meanwhile Fortress Investment Group is building a war-chest to go shopping for distressed paper:

Fortress has risen 38 percent in the past two weeks in New York trading as investors anticipate private-equity and hedge- fund firms will profit from financial turmoil by snapping up companies and assets at distressed prices. Fortress rose 51 cents, or 3.9 percent, to $13.50 in New York Stock Exchange composite trading today.

Private-equity firms are shifting from the large leveraged buyouts that dominated Wall Street during 2006 and 2007, raising funds to snap up distressed debt and mortgage securities. Fortress oversees about $35 billion.

… and rumours are floating that JPMorgan will buy up WaMu’s deposits. The will be a major announcement tonight, of some kind anyway:

JPMorgan Chase & Co. (NYSE: JPM) will host a conference call at 9:15 p.m. (Eastern Time) tonight, September 25, 2008. You may access the conference call by dialing 1-877-238-4671 (U.S. and Canada) / 1-719-785-5594 (International) – access code: 814030 or via live audio webcast at www.jpmorganchase.com under Investor Relations/Investor Presentations. Materials and further communication will be available on this website at the time of the call.

A replay of the conference call will be available beginning at approximately 1:00 a.m. on September 26 through midnight, Thursday, October 9 by telephone at (888) 348-4629 (U.S. and Canada); access code: 942856 or (719) 884-8882 (International). The replay will also be available via webcast on www.jpmorganchase.com under Investor Relations, Investor Presentations.

Bloomberg reports that this will happen by fiat of the FDIC. Flash! JPMorgan buys WaMu’s deposits for a premium of about 1%! Now … that’s what I call a bargain. Cash is king! Flash! JPM is marking down WM’s assets by $30-billion (out of $296-billion assets at WM carrying value) as part of the transaction. See page 18 of the presentation.

Covered bonds in the States are not having a nice time:

Bank of America Corp. was the last U.S. bank to issue the bonds, selling $1.5 billion of the securities in June 2007. The spread on the Charlotte, North Carolina-based lender’s three-year notes has widened almost eight-fold to 184 basis points, according to Citigroup Inc. prices on Bloomberg.

The only other U.S. issuer is Washington Mutual, which put itself up for sale last week. Its 6 billion euros ($8.8 billion) of covered bonds were downgraded one level to Baa1, the third- lowest investment-grade ranking, by Moody’s.

The spread on its $2 billion of 4.375 percent bonds due 2014 has surged to 678 basis points, from 26 basis points when the notes were sold in May 2007, according to Royal Bank of Scotland Group Plc prices on Bloomberg.

Speaking of bear markets, how about that California real-estate, eh?:

California home prices tumbled a record 41 percent in August from a year earlier as foreclosure sales pushed down values in the biggest U.S. state.

The median price of an existing, single-family detached home fell to $350,140 and will likely fall further, the Los Angeles- based California Association of Realtors said today in a report. Sales increased 56.7 percent from August 2007 and 1.8 percent from July.

And the sales number! Far be it from me to put any credence in technical analysis, but that’s consistent with mass forced liquidation near the bottom of the market. And, bless their hearts, the guys at Dealbreaker have actually put together some numbers on housing bubble profits:

In summary, our incomplete and work-in-progress calculations figure for something like $2 trillion in fees flowing to various parties in the real-estate, mortgage, securitization and securitization^2 businesses between 2003 and mid-2008. That’s some serious swag, and you don’t have to look very far to see why no one was in much of a hurray to shut any of it down or to rock the boat.

In fact, the Dealbreaker guys did a fantastic job today, highlighting an extraordinarily testy letter from the FDIC to Bloomberg. Let’s have a little more honest reporting and a little less yellow journalism!

I’m searching for the precise metaphor to use regarding the backlash against hedge funds in the UK – should it be ‘shooting the messenger’ or ‘killing the goose that laid the golden eggs’?:

As Lehman Brothers Holdings Inc. filed for bankruptcy and HBOS Plc was pushed into a government-brokered takeover, U.K. regulators and lawmakers found a culprit: the estimated 980 hedge funds that reside in Britain, mostly in London. Harbinger Capital Partners Fund chief Philip Falcone was singled out by the Daily Mirror. The tabloid used a front-page story on Sept. 18 to brand him a “greedy pig” for short selling, or making bets that Edinburgh-based HBOS would lose market value.

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

Interesting news on the CDS market today … it isn’t as big as we thought:

The credit-default swap market, used to hedge against bond losses and speculate on corporate credit risk, shrank for the first time as efforts to eliminate duplicate trades cut contracts outstanding by 12 percent.

The volume of outstanding trades fell to $54.6 trillion from $62 trillion in the first half, the International Swaps and Derivatives Association said in a statement today. It was the first decline since ISDA started surveying traders in 2001.
…
After the March collapse of securities firm Bear Stearns Cos., 17 banks that handle about 90 percent of the trading in credit derivatives agreed to a list of initiatives to curb market risks. That included tearing up trades that offset each other, which cuts down on the day-to-day payments, paperwork and monitoring by bank staffs and reduces the potential for errors. It also may reduce the amount of capital that commercial banks are required to hold against the trades on their books.

The first stage of compression, completed Aug. 27, with the participation of 14 dealers, reduced contracts submitted on North American telecommunications companies by 56 percent, Markit Group Ltd. and Creditex Group Inc., which are processing the tear-ups, said this month. The second stage, completed Sept. 4, with 15 dealers, cut contracts on European telecommunications companies by 53 percent.

Well, PerpetualDiscount yields were recently higher (6.22% on September 18), but today’s closing bid-YTW of 6.20% was otherwise last seen on August 11 (when falling) and July 7 (6.23%, when rising). A fair bit of sloppy action today, especially with BAM.PR.K falling out of bed!

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

The drive to send the CDS market to London and Dubai continues, with Christopher Cox of the SEC jumping on the bandwagon:

U.S. Securities and Exchange Commission Chairman Christopher Cox said Congress should grant authority to regulate the credit-default swaps market amid concern the bets are helping fuel the global financial crisis.

Lawmakers should “provide in statute the authority to regulate these products to enhance investor protection and ensure the operation of fair and orderly markets,” Cox told the Senate Banking Committee today at a hearing in Washington.
…
Cox today said investors who buy swaps without owning the underlying debt may be similar to naked short sellers who sell stocks they don’t own or borrow. Such short sales can flood the market and illegally drive down stocks.

Similar to naked shorts of stocks? Well … hasn’t that been obvious from the beginning? The mechanics of CDSs have been discussed on PrefBlog; Mr. Cox’s full remarks have been posted at the SEC site.

The theory that Sarbanes-Oxley makes the US capital markets less attractive is one to which I subscribe; but there is a column on VoxEU by Craig Doidge, George Andrew Karolyi and Rene M. Stulz that takes the opposite view:

In a recent paper, we examined the 59 firms that deregistered in the six months after Rule 12h-6 was adopted.1 Our analysis shows that deregistering firms have poor growth opportunities and experienced poor stock return performance over a number of years before deregistration. Compared to other foreign firms cross-listed on US exchanges, deregistering firms also have a significantly lower “cross-listing premium”, the valuation difference between cross-listed firms and their home-market counterparts, and this lower cross-listing premium cannot be explained by an adverse impact of Sarbanes-Oxley.
…
Overall, the evidence supports the hypothesis that foreign firms list shares in the US in order to raise capital at the lowest possible cost to finance growth opportunities and that, when those opportunities disappear, a US listing becomes less valuable to corporate insiders, so such firms are more likely to deregister and go home.

I’m not sure that the Sarbanes-Oxley is as easily excused as all that. I quite agree that companies will – in general – make a rational investment choice when listing in the US and will leave when the costs outweigh the benefits. If Sarbanes-Oxley is a cost, however, a decision to leave becomes more likely. More insidiously, and much harder to examine in an academically satisfactory way, is the initial decision to list.

For example, Marsh Carter of the NYSE stated in 2006:

Finally, foreign companies are unquestionably concerned about the costs and added regulatory burdens associated with the U.S. regulation, including Sarbanes-Oxley.
…
Indeed, one of the underlying motivations for companies listing in the U.S. is the increase in value – which averages about 30 percent — that accrues as a result of adhering to the high standards of governance that the U.S. markets demand. But companies are increasingly viewing the costs associated with these regulatory requirements, as well as their impact on the speed with which they can reach the market, as outweighing the valuation premium they offer. The way that the requirements of Section 404 were implemented is perceived to have resulted in substantial cost and duplication of effort that has caused international companies to conclude that the additional costs of our regulatory structure outweigh the benefits.
…
When the London Stock Exchange surveyed 80 international companies that conduced IPOs on its market, it reported that 90 percent of the companies that had listed on the LSE felt that the demands of U.S. corporate governance rules made listing in London more attractive. The Wall Street Journal recently reported that small U.S. companies are turning to London’s small-cap market, AIM, for a variety of reasons, including the regulatory costs of going public. The article noted that “one of the reasons most commonly cited is the strain of Sarbanes-Oxley regulations in the [United S]tates.”

Also in VoxEU, Jeffrey Frankel wants a piece of the bank action, not just Bagehot:

What Mallaby calls the core insight is also the crux of Krugman’s logic (“Cash for Trash”):

“…the financial system needs more capital. And if the government is going to provide capital to financial firms, it should get what people who provide capital are entitled to – a share in ownership, so that all the gains if the rescue plan works don’t go to the people who made the mess in the first place.”

This follows a call by Charles W. Calomiris for preferred stock buys rather than loans:

Instead of buying toxic assets, the US government should buy preferred stock capital in ailing banks that could raise matching private sector equity. This would avoid the intractable problems of how the government should value the toxic assets and directly address the banks’ immediate problem – a lack of bank capital.

I like that idea a lot better. Look, a lot of the problem here is simply that sub-prime paper is not being rationally priced and the owners are being forced to mark to market. I recently noted that Moody’s is projecting a 22% loss on 2006 vintage mortgages. As I have discussed at length, the AAA portion of subprime debt is subordinated by roughly 20% (the precise amount will depend on the deal). So, OK, the mezzanine and equity portions have been wiped out … but the AAA tranches are only a little impaired. But as was noted by the OECD paper previously discussed, the mark-to-market on these things is a discount of 14%!

I suggest that banks do not want to sell paper worth $98 for only $86. They want to hoard their cash, let the paper run off gradually, and get their $98. So they won’t want to sell to Treasury at “market price” and Treasury will not – politically – be able to come close to “intrinsic value”. Stand off. To fix the problem in a Bagehotish sort of way, allow the banks term financing at Fed Funds + 100bp … which is the old discount window + 50bp, and the new discount window + 75bp. This is similar to the preferred stock idea of Calomiris, but gets the capital threat to Treasury more deeply subordinated, particularly if there’s a nice stiff haircut in the loan value.

CEBS has released a rather bureaucratic Statement on the Current Crisis Situation with the main points (bolded in the original):

• In our view, banks’ exposures to Lehman Brothers are manageable and mostly non-material, compared to the banks’ total assets and capital base.
• …
• With respect to EU banks’ exposures on AIG: given the US government support provided to AIG, EU bank supervisors view that this counterparty risk can be sufficiently mitigated for the moment.

So we can all sleep better at night. C-EBS has spoken!

James Hamilton of Econbrowser makes an interesting point regarding Monday’s spike in oil prices:

The most striking thing about yesterday’s oil prices was the disparity between different futures contracts. The October contract, which expired yesterday, did indeed settle at $120.92, up more than $16. But oil for delivery in November closed at $109.27, an increase of only $6.62, and longer-forward contracts saw an even more modest increase. Unquestionably what was going on was a short squeeze, in which traders who had sold the October contract short were scrambling to close out their positions before expiration, and having a hard time finding people willing to take the other side.
…
I’m guessing that part of the answer must be that some of these operators were following rules of thumb which usually work just fine in a properly functioning market, and weren’t alert to the profit opportunities at hand. I certainly would not expect a discrepancy of this magnitude to persist for as long as 24 hours.

But another possibility that suggests itself is some degree of local monopoly power in the Cushing market. If you’re selling that $121 October oil, you might not be anxious to cook the golden goose by bringing any extra oil to the temporarily thirsty market. This might be a reasonable case for the FTC and CFTC to investigate the mechanics of exactly what happened yesterday.

PerpetualDiscounts were off a bit today on average volume. The excitement of the day was Nesbitt’s crosses of BCE issues – some of them usually very sleepy traders.

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

Morgan Stanley and Goldman Sachs are turning into banks; on September 16 I said:

I suspect that all this will change; in ten years, says I, all the global Large Complex Financial Institutions will be banks with access to multiple discount windows.

Sometimes things move faster than you think! The Bank of England published a list of their selected LCFIs … all banks now, or bust, every one. Although some of those players might no longer qualify as sufficiently large for the A list!

Accrued Interest calls for more regulation of CDSs, repeating his call for exchange trading, standardizing contracts and increasing margin requirements. While I agree that margin requirements are in order – with the regulators demanding that such-and-such margin be put up, or the equivalent is deducted from capital – I’m not entirely sure he’s right about the implications:

Increasing collateral requirements would force protection buyers to be more judicious about which names they short.

Now, it seems to me that if I buy protection with a five-year CDS at 500bp, my maximum loss is 25% of notional, and that’s in gross dollars, not present value. If I sell protection, my maximum loss is 100% of notional. It seems to me that any rational margining requirement is going to force protection sellers to be more judicious about which names they go long; the same will also work out relative to current reality, since a large part of the problem is that protection buyers have been relatively powerless hedge funds, while sellers have been insurers – who were enabled to put on massive leverage due the their policy of not doing the deal if they had to put up collateral.

Naked Capitalism reprints a report that New York State is moving into CDS regulation, presumably in an effort to drive all the business to London or Dubai.

A quiet day, although there were a few violent price moves. PerpetualDiscounts eked out a small gain.

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

The previously scheduled end of the world has been postponed.

Accrued Interest foresees a period of intense confusion:

Bonds are highly illiquid right now. Even Treasuries are showing unusual bid/ask spreads. There are many many many players who are going to be caught on the wrong side of this thing.
…
Some hedge funds are going to get crushed. I mean, anyone who was leveraged short financials may wind up getting busted out. That will result in some weird trading in seemingly unrelated instruments.

The Reserve Primary Fund buck-breaking has caused a huge onslaught of MMF redemptions:

Confidence in money-market funds was shaken this week when Reserve Primary Fund became the first in 14 years that failed to repay investors in full because of losses on debt issued by Lehman Brothers Holdings Inc. Investors responded by pulling a record $89.2 billion from funds on Sept. 17, according to data compiled by the Money Fund Report, a newsletter based in Westborough, Massachusetts. That equaled 2.6 percent of industry assets.

… and so Treasury is writing CDSs on Money Market Instruments:

The U.S. Treasury Department today announced the establishment of a temporary guaranty program for the U.S. money market mutual fund industry. For the next year, the U.S. Treasury will insure the holdings of any publicly offered eligible money market mutual fund – both retail and institutional – that pays a fee to participate in the program.

This is wild. I’m going to have to think about it a little more … but will this lead to a new financial industry? In which CP that’s issued will not only have bank-lines guaranteeing liquidity, but CDSs guaranteeing credit? Maybe this will be a good replacement business for the currently unfashionable municipal bond insurance game!

The American Bankers’ Association is upset because the Treasury move undercuts their FDIC advantage:

“Today’s action will undermine the role of banks during this current crisis and has the potential to have an extremely negative impact,” [ABA CEO Edward] Yingling said in the statement. “Our bankers are, understandably, very upset.”

Banks compete with money funds by offering accounts that are already covered by the Federal Deposit Insurance Corp. The extra margin of safety gives banks a competitive advantage with some consumers who want to avoid any chance of losses. Money- market funds hold about $3.35 trillion in assets.

Maybe that’s what will happen … MMFs will have to sign up with the FDIC / CDIC and all the other deposit guarantors, fill out all those forms and pay the insurance fees, and hire ex-regulators at fat salaries (only the smartest and most knowledgable ones, of course). Maybe they’ll even have to keep some capital with the fund to absorb losses and maintain capital and leverage ratios – and show the MER as a P&L item. Investor advocates will doubtless consider this a step forward. Because then everybody will get free money, right? Extra return without the slightest scrap of risk or necessity of thought is a fundamental human right, isn’t it?

Mind you, I’m not disagreeing with the Treasury move. Clearly, redemptions on the scale reported will have a long term negative effect and a short-term horrific effect … all the usual sales conduits busted, liquidity guarantees exercised, bank balance sheets bloating, the discount window getting a workout to finance the bloat … the move seems to me to be the lesser of the two evils.

And – as I have often said – the ultimate cause of the credit crunch is that there is a lot more demand for short-term investments than there is supply; which has led the industry to create pretend-short-term paper. Heightened uncertainty about the long-term ability to finance short-term will have effects that I’m going to have to think through carefully, but are guaranteed to be … interesting.

Sorry this report is late. I was up all night typing up the list of big winners! … No, I cannot tell a lie. I went home early and was asleep by 9pm and am now bright-eyed, bushy-tailed and eager to find out who goes bust next week.

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