PrefBlog

The Economist points out that mark-to-market accounting (which is a hallmark of securitization) can be destabilizing; it can turn bankers from rather dry borrow-short-lend-long types into market speculators. I believe we are seeing this effect in the CPDO market where the deleterious effects of spread widening on capital have been observed, but the benefits of realizing on those spreads over the mid-term have not yet materialized.

It is also possible that cooler heads will prevail and avoid rushing for the exits – a possible example is:

Washington Mutual plans to hold more loans for investment, citing potential for strong risk-adjusted returns.

And it would appear that some shops have resolved their funding issues:

Thornburg Mortgage Inc., the home lender that sold $20.5 billion of mortgage bonds at a loss last month to ease a cash shortage, now plans $3 billion to $4 billion of purchases to take advantage of low prices.

The AAA-rated securities could yield 1.25 to 2.25 percentage points over Thornburg’s cost of funds, President Larry Goldstone said in an interview. That compares with an average of 0.5 points for securities now in the Santa Fe, New Mexico-based company’s portfolio. The purchases will occur “over the next month or two,” presuming mortgage markets begin to stabilize, he said.
…
Goldstone said $546 million of fresh capital from a preferred-stock sale last week will help the company pounce on opportunities that cash-starved rivals can’t afford.

Some of my more fanatical readers may remember my post about BSABST 2005-1, in which I attempted to demonstrate that the S&P downgrade of one particular ABS wasn’t as scary as it sounded when one looked at the actual dollar values. I’m a little late reporting this, but I’ve found a S&P press release about subprime that puts a little meat on those bones:

Our July 2007 downgrades affect around 1% (by value) of the US subprime first lien mortgage tranches we rate:
• 85% of the ratings downgraded were BBB and below (ie, the weakest quality subprime securities)
• no AAA ratings on these securities were downgraded
• between July 1 and August 24, 2007, S&P received reports of only three defaults from approximately 15,000 current first lien subprime mortgage tranches rated by S&P globally (two of the defaulted tranches were issued in 2002, the other was issued in 2004).

We’ll see how it all turns out. We’ll probably find that the ratings agencies acted in a less than perfect way – I haven’t yet found an analytical system or an analyst who’s perfect. But I’ll bet a nickel that in ten years we’ll be saying that the pendulum of sentiment swung from “Everything is perfect” to “The world is about to end” and that hedgies as a group are attempting to deflect criticism of their own performance towards the agencies; aided by the regulators, who can’t stand to see anything happen in the capital markets that doesn’t involve a kow-tow to the regulators; abetted by the reporters, who don’t care what they say as long as it sells papers; and encouraged by the politicians, who need to show Concern and Judicious Thought.

Like, for instance, Flaherty:

Finance Minister Jim Flaherty says the summer credit crunch is indisputable proof of the need for a single Canadian securities regulator: one that could better guard against, and fend off, shocks buffeting this country’s capital markets.

Such nonsense – and Flaherty doesn’t do anything but wring his hands at the horrifying idea that something might happen in this country without federal regulation.

Regulation of the securities markets in Canada can clearly be improved – see my summary of sales restrictions applying to my firm, for instance – but not, I believe, in terms of the end product. There will be the same good points and bad points about the effects of the application of regulation whether we have one regulator or five hundred. The effects of regulatory unification will be noticable only in the cost – in terms of actual dollars, time and elimination of basically arbitrary selling restrictions – and should be pursued for that end alone.

There is considerable debate regarding what the Fed should be doing at their September 18 meeting. James Hamilton view is:

They can clearly communicate they’re not panicked by the market or bullied by the politicians by waiting until the scheduled September 18 meeting before announcing a cut, and even then one or two members could cast a dissenting vote. Markets would see a 25-basis-point cut delivered in that manner as a splash of pretty cold water. If next month’s data show the same trends as last week (some comforting and some alarming numbers), the Fed could cut another 25 basis points at the end-of-October meeting, adding another dissenting vote. That would leave them free to move any way they want, up or down, in December.

If we get stronger confirmation that the August employment and LA home sales numbers are not an anomaly, the Fed should be prepared to make that a 50-basis-point cut for October.

I agree; I’d like to see some language in the statement that they’re still worried about inflation, jobs number or no jobs number … monthly data can vary significantly. As JDH notes, the increase in LIBOR has done a lot of the anti-inflation heavy lifting on the Fed’s behalf.

Brad Setser notes that:

At least part of the dollar’s August rally seems – at least to me – to have been tied to deleveraging (including deleveraging by European banks) rather than safe haven flows.  Selling rubles and Asian equities to pay back borrowed dollars isn’t quite the same as seeking out the dollar because you expect it to rally in times of stress.

… and sees interesting times ahead for countries with currencies tied – explicitly or implicitly – to the dollar.

US equities looked like they were going to have a horrible day until Thornburg announced its plans to rebuild a position in some high-grade sub-prime tranches. Then they recovered, followed by Canadian equities.

Treasuries continued to roar, yields falling 6bp in a parallel shift, but it’s not doing the dealers much good and reports of foreign selling into the rally continue to accumulate. Canadas were listless.

There were a few good sized crosses in the preferred market today, but the increase in volume wasn’t very broadly based. PerpetualDiscounts continued to recover; they have had only one (minor) down day since August 16 and are up 2.05% since that date.

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

Well – a short week, but not entirely devoid of interest!

Today’s big news was that the US Jobs number was negative, which hasn’t happened in a while. Politicians reacted according to their stripe; economists hastily revised downwards their expectations for both growth and rates. Greenspan sounds very happy it’s not his problem. There is general agreement chances of a recession have increased.

I’ve previously mentioned Deutsche Bank’s success at Credit Anticipation in betting against sub-prime. Another winner emerged today:

The $4.5 billion Credit Opportunities fund, started last year, gained 26.7 percent in August, according to a Paulson investor. Credit Opportunities II, a newer $2.3 billion fund, is up more than threefold after a 32 percent return last month.

I feel quite sure that a lot of these massive losses we’re reading about are just hedge funds transferring money back and forth … when you share 20% of winnings and 0% of losses, why not bet the firm?

The Canadian bank-operated ABCP market is having major problems. Three-month BAs are yielding about 5% … ABCP is yielding about about 5.60% … when three-month bills are at 4.04%. That kind of spread is … well, let’s just say that banks are not having a nice time. Mind you, it’s even worse in the States, with bills at 4.07% and financial paper at 5.48% (US ABCP at 6.18%). While we’re on the topic of ABCP, the outstandings in America continue to shrivel, which indicates a ferocious combination of deleveraging and transfer to bank lines. The ‘transfer to bank lines’ part is dangerous – there is some concern regarding the banks’ committments and whether regulators need to step in. I don’t know, frankly, if line committments are added in any way to risk-adjusted capital. They should be! Especially since laying off risk is, to an extent, boomeranging.

Countrywide Credit is having a mass layoff, trying to survive in environment where it’s difficult, to say the least, to securitize mortgages that it originates. Citigroup is reportedly refusing to accept new mortgage clients. But maybe they’re just providing bigger lines to fewer clients.

Centex Corp., a Dallas-based homebuilder and lender, said in a regulatory filing today it replaced a warehouse credit line with a larger one arranged by JPMorgan Chase & Co. that may provide as much as $1 billion. Centex increased the credit line because the global credit crunch made it hard to rely on selling short-term notes to finance mortgages, the filing said.

US equities went splat on the jobs number. Recessions aren’t generally good for profits! Canadian equities also fell.

Treasuries had such a good day on the back of the jobs number it has to be referred to as panic-buying (possibly sending a lot of profit to foreign central banks, since boneheaded fiscal policies have sent a lot of money abroad). Why not, when Fed Fund Futures are predicting a rate of 4.5% by December? Well, perhaps because Fed officials are watching the economy, not markets. Canadas had a super day, with the ten-years’ yield declining about 13bp.

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

Month-end is taking its dreaded toll … there will be no indices AGAIN today and precious little commentary.

My sole comment for today is that DBRS is sounding very defensive! They have released a “commentary” titled Rating Volatility in Structured Credit and a press release titled DBRS Approach to Canadian ABCP Surveillance – neither of which I can link to because ratings agencies, for all their good points, are complete dorks when it comes to public relations. So visit their web site and poke around for a few hours until you find their precious commentary.

If we do manage to avoid government regulation and control of the credit ratings process – the prospect that fills me with dread – it won’t be because of the slick publicity campaign managed by the agencies, that’s for sure.

The S&P equivalent was published August 23 and titled Structured Finance Commentary.

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

Update, 2007-09-07

It was an interesting day, with a number of cross-currents resulting in a strong day for bonds at the expense of stocks.

The day started with a thump, as the Financial Post reported a gloomy sentiment from Edward Devlin of PIMCO:

The vast majority of about $35-billion of non-bank ABCP is backed by risky bets on credit default rates that are now so far underwater that investors could be looking at losses as high as 50 on the dollar

With all respect to Mr. Devlin, I’ll repeat my tired old refrain of “I wanna see more detail”! Readers will remember the sad story of Global DIGIT’s suspension of redemptions, which fits his story quite well – they’re leveraged to hell and gone on credit-default-swaps on the dreaded sub-prime (senior tranches only, so they claim). Global Digit issued a press release on August 28, stating:

The Trustee has now received from the Bank the indicative price which will be used to calculate the NAV as at August 31, 2007. If that indicative price, which was based on market conditions known on August 28, 2007, had been used to calculate the NAV as at July 31, 2007, the NAV would be $7.92, representing a reduction of about 12.5% from the NAV calculated based on the July 16, 2007 market conditions.

So, on the cheerful side, we can say that August 28 was pretty close to the height of the hysteria and the loss, while not likely to make the equity holders very happy, are not yet eating into the security of the ABCP holders. Now, there’s problems with this statement. In the first place, “indicative prices” don’t necessarily mean very much, as most rookie bond guys find to their consternation sometime before their tenth trade. And, of course, many many bad things can happen before those CDSs in the DG.UN portfolio unwind. And there’s no indication that DG.UN is representative of the kind of problem that Mr. Devlin refers to. Lots of uncertainty … but uncertainty with respect to Mr. Devlin’s statement as well. Details! Give me details!

This topic arose during a lunch I had today with a PrefLetter subscriber (He bought! I wish to take this opportunity, firstly to thank him, and secondly to encourage subscribers and others to buy me lunch at every opportunity!). We were talking about Tier 1 Capital Ratios, and the National Bank’s purchase of ABCP, preferred shares and how all those things related. My friend made the comment that ABCP buyers – buying assets that were levered 10+:1 – got everything they deserved. But, as I have now confirmed, such leverage is normal! Royal Bank’s financials reveal $537-billion in assets supported by $22-billion in equity, a gearing of 24:1.

They have a perfectly adequate Tier 1 Capital Ratio nonetheless, because not all assets are created equal. I’ve looked at a document from BIS that gives a few formulae and rules of thumb for calculating capital adequacy … on Page 160 of the document, for instance, we get the risk weights for various terms of bonds, while Page 156 gives the risks weights for various grades of issuer. As may be understood by comparing RBC’s asset-to-equity gearing with its Tier 1 Capital Ratio, the RBC assets have an average risk-weight of about-maybe 33%.

So – I’m not drawing any conclusions about the riskiness of ABCP or of RBC paper, but I’m just pointing out … there’s risk and then there’s risk; the leveraging factor in and of itself conveys some of the answer, but not all.

In news today with implications on the FedFunds rate, the Beige Book was released:

“Outside of real estate, reports that the turmoil in financial markets had affected economic activity during the survey period were limited,” the Fed said in the survey, which concluded before Aug. 27 and was released today in Washington. “Economic activity has continued to expand” nationwide, the Fed said in the Beige Book, named for the color of its cover.

Another perspective is available from the WSJ Economics Blog which also produced a summary by district. ADP is projecting a lousy jobs number for Friday’s release.

Longer term, the OECD released a report stating that in the US:

slower job creation, mortgage-rate resets and tighter credit standards will prompt a slowdown in the second half of the year that will drag annual growth down to 1.9%, from 2.1% forecast previously

The author does not believe a US recession is imminent.

A suggestion that banks pool and securitize their LBO debt caught Tom Graff’s attention, but another solution was implemented by AstroZeneca:

AstraZeneca Plc, the U.K.’s second- largest pharmaceutical company, sold $6.9 billion of bonds in the biggest U.S. debt offering in more than five years.

AstraZeneca will use proceeds from the sale to pay back commercial paper that financed the $15.2 billion purchase of U.S. biotechnology firm MedImmune Inc. in June

That’s the way to reduce liquidity risk on your balance sheet! Bite the bullet and extend term, even if it hurts.

The five-year 5.4 percent debt priced to yield 130 basis points more than Treasuries of similar maturity; the 10-year 5.9 percent securities have a yield premium of 145 basis points; and the 30-year 6.45 percent bonds paid a spread of 170 basis points.
…
AstraZeneca’s debt is rated A1 by Moody’s Investors Service, the fifth-highest investment grade and AA- by Standard & Poor’s, the fourth-highest ranking.

In this context, it’s worth noting that the Treasury 10-year to Baa spread, highlighted by James Hamilton a while ago, doesn’t appear to have moved much: the Fed is now showing Baa paper at 6.60%, which is actually less than each of the three most recent monthly observations. Granted, Treasury 10-years are down a lot but while spread-to-treasuries is important, spread-to-business risk is even more important. This looks like good insurance for the issuer.

Citigroup is closing a poorly performing hedge fund; it should be noted that while it underperformed its peers, it’s down only slightly on the year. It’s not all hedge funds that will blow up over the next few months … only some of them. Particularly those who are forced to sell their assets at whatever they will fetch in this environment.

The losers will be replaced:

The amount of debt in the Merrill Lynch distressed bond index tripled in July to $13.8 billion, and about doubled again in August to $24.8 billion. In addition to Residential Capital and WCI, the debt of New York-based amusement park operator Six Flags Inc., and pizza chain Uno Restaurant Corp. of West Roxbury, Massachusetts, is distressed based on their yields.

Investors specializing in distressed debt are gearing up for more opportunities. They raised $23 billion this year through Aug. 17, breaking 2006’s record of more than $16 billion, according to London-based Private Equity Intelligence Ltd.

There’s another good quote in that story too, that will help give some perspective on the Credit Rating Agency controversy:

Moody’s in January 2005 predicted the default rate would rise to 2.7 percent by the end of that year from 2.2 percent. Instead, it fell to 1.8 percent. Moody’s then forecast it would rise to 3.3 percent by the end of 2006. It fell again, to 1.7 percent, the lowest year-end level in a decade.

“The last couple of years we always used to say `Gee, isn’t it crazy, we’re seeing top of market behavior and this can’t be sustained,”’ Marshella said. “It did go on longer and we were wrong. You always thought there’d be an inflection point and, finally, an inflection point came,” he said, referring the increase in financing costs caused by the contamination of asset- backed securities by subprime mortgages.

US equities fell, as financials are now out of favour; Canadian stocks also fell on fears of a credit crunch. LIBOR just won’t go down!

Treasuries had a banner day; Canada didn’t do quite so well but there was a major steepening.

I wasn’t able to update the index values today, although I did update the index constituents. Tomorrow, I promise! 

Note: Somehow … don’t ask me how … I managed to screw up the input of the Volume and Price Change tables so completely that my software has given up. Sorry.

Update, 2007-09-07