Miscellaneous News

Is the US Banking System Really Insolvent?

There seem to be a lot of people who will answer the headline question: “Yes!”

I recently responded to Menzie Chinn’s “Crony Capitalism” post, and highlighted my doubts there … now Econbrowser‘s James Hamilton has picked up on the theme (or acknowledged it, anyway) in a post about Bernanke’s Tightrope Act.

Some analysts are saying that Fed Chair Ben Bernanke is walking a tightrope– if he does not drop interest rates quickly enough, the U.S. will be in recession, but if he goes too far, we’ll see a resurgence of inflation. I am increasingly persuaded that’s not an accurate description of the situation.
…
The Fed chief must be worried that a recession in the present instance would precipitate major financial instability, in which case perhaps the choice between paying now and paying later argues in favor of latter.

In any case, the tightrope analogy seems a misleading way to frame the issue, in that it presupposes that there exists a choice for the fed funds rate that would somehow contain both the solvency and the inflation problems. In my opinion, there is no such ideal target rate, and the notion that we can address the difficulties with a sagely chosen combination of monetary and fiscal stimulus and regulatory workout is in my mind doing more harm than good. Better for everyone to admit up front just how bad the problem is, and acknowledge that there is no cheap way out.

No, I don’t believe that Bernanke is walking a tightrope at all. But I do hope he’s checked out the net that’s supposed to catch him if he falls.

In a recent post about Inflation Expectations, I opined that the only way I could see to make the market data on Fed Funds and Treasuries consistent was to assume that expectations (of both the market and the Fed) were for an output gap of 5.6% … which is a shockingly fierce recession and, given that the data indicate a period of two years plus, would be labelled a depression by many. So I don’t really have any quarrels with Professor Hamilton’s deduction that the Fed is “worried that a recession in the present instance would precipitate major financial instability”; with, I presume, the major financial instability feeding back into the real economy until we find ourselves all naked and homeless.

But that’s not why I’m devoting an entire post to this response … my quarrel is with the unchallenging repetition of the assertion:

But I think the primary way in which monetary expansion could help alleviate the current credit problems was described by Brad DeLong with remarkable clinical coolness:

Yes, the financial system is insolvent, but it has nominal liabilities and either it or its borrowers have some real assets. Print enough money and boost the price level enough, and the insolvency problem goes away without the risks entailed by putting the government in the investment and commercial banking business.

Let’s trace this back to the source document – always a fun exercise, I love the Internet! – starting with Mark Thoma’s post on his Economist’s View blog, Brad DeLong: Three Cures for Three Crises, dated December 31. Professor Thoma doesn’t provide any commentary with this post, but does link to a supporting WSJ blog post, Liquidity Threat Eases; Solvency Threat Still Looms.

I’ll side-track a little here … the WSJ blog links to a story in the Boston Globe:

The new rules impose surcharges of 0.75 percent to 2 percent for many conventional borrowers who have credit scores below 680, and who don’t have at least 30 percent for a down payment. Fannie Mae says the lenders may pass along those fees in a variety of ways.

Those in the industry worry many will be priced out of the market. O’Neil notes that about half her customers have credit scores less than 680. “It will definitely affect our business,” she said.

And few buyers ever pay 30 percent down payments. “That’s pretty insane . . . not a lot of buyers will be able to do that,” said Alex Coon, the Massachusetts market manager for online residential real estate brokerage Redfin. “It’s certainly not going to do any favors for the real estate market.”

To me, this story simply reinforces my belief that the US Mortgage market has been incredibly loose for quite some time. I mean … a 25% downpayment in Canada is standard, for heaven’s sake! But, to return to my argument …

The WSJ noted as support for the insolvency theme stated:

Nonetheless, as Lou Crandall, chief economist at Wrightson ICAP LLC said today, “Things are unfolding smoothly.” The first quarter is likely to start much as the fourth quarter did, with reduced concerns now that the statement date has passed.

Balance-sheet strains will continue to create concerns about the price and availability of short-term funds, Mr. Crandall said. But for the most part, “We’ve moved beyond … liquidity concerns. The focus has moved to that part of the financial fallout that central banks can’t address through technical operations.”

In other words, as 2008 begins, it’s solvency, not liquidity, that threatens the economy and the financial system. And at the root of the solvency threat is a likely decline in housing prices that will further undermine credit quality. Making banks more confident of their own ability to raise funds is not going to resolve a generalized shrinkage of lending driven by declining collateral values.

“In other words”? There seems to have been a great deal of interpretation and analysis glossed over in the rephrasing! Mr. Crandall is highlighting concerns over credit quality, sure, but

  • credit concerns are a far cry from insolvency crises, and
  • it is not even clear that he is referring to concerns about credit quality of the banks. From the quote, he could be referring to shadow-banks, non-financial corporations, investors or consumers

The apparent leap in logic might be justified by the complete WSJ interview of Mr. Crandall, but is certainly not justified by the quotations. And even if Mr. Crandall approves of the WSJ interpretation, there is no indication that this is anything more than one economist’s opinion – there is precious little data on display.

In other words, the WSJ supporting article doesn’t withstand scrutiny all that well – there’s no data and no argument. Just an assertion which may well be nothing more than an interpretation by the reporter.

And now we get to the source of this assertion – Prof. Delong‘s opinion piece. He defines three mechanisms whereby asset prices can fall:

The first — and “easiest” — mode is when investors refuse to buy at normal prices not because they know that economic fundamentals are suspect, but because they fear that others will panic, forcing everybody to sell at fire-sale prices.
…
In the second mode, asset prices fall because investors recognize that they should never have been as high as they were, or that future productivity growth is likely to be lower and interest rates higher. Either way, current asset prices are no longer warranted.
…
The third mode is like the second: A bursting bubble or bad news about future productivity or interest rates drives the fall in asset prices. But the fall is larger.

… which have different ideal policy responses. A liquidity crisis is easy to address:

The cure for this mode — a liquidity crisis caused by declining confidence in the financial system — is to ensure that banks and other financial institutions with cash liabilities can raise what they need by borrowing from others or from central banks.

This is the rule set out by Walter Bagehot more than a century ago: Calming the markets requires central banks to lend at a penalty rate to every distressed institution that would be able to put up reasonable collateral in normal times.

… while the second mode requires a policy response much like that used to recapitalize the American banking sector after the S&L crisis:

This kind of crisis cannot be solved simply by ensuring that solvent borrowers can borrow, because the problem is that banks aren’t solvent at prevailing interest rates. Banks are highly leveraged institutions with relatively small capital bases, so even a relatively small decline in the prices of assets that they or their borrowers hold can leave them unable to pay off depositors, no matter how long the liquidation process.

In this case, applying the Bagehot rule would be wrong.

The problem is not illiquidity but insolvency at prevailing interest rates. But if the central bank reduces interest rates and credibly commits to keeping them low in the future, asset prices will rise. Thus, low interest rates make the problem go away, while the Bagehot rule — with its high lending rate for banks — would make matters worse.

… while the solution to the third mode reflects the “Resolution Trust” that was used to contain the S&L crisis:

When this happens, governments have two options. First, they can simply nationalize the broken financial system and have the Treasury sort things out — and reprivatize the functioning and solvent parts as rapidly as possible. Government is not the best form of organization of a financial system in the long term, and even in the short term it is not very good. It is merely the best organization available.

The second option is simply inflation. Yes, the financial system is insolvent, but it has nominal liabilities and either it or its borrowers have some real assets. Print enough money and boost the price level enough, and the insolvency problem goes away without the risks entailed by putting the government in the investment and commercial banking business.

This is all very interesting, to be sure, but which mode are we actually in? Prof. DeLong does not venture a firm opinion, but concludes:

At the start, the Fed assumed that it was facing a first-mode crisis — a mere liquidity crisis — and that the principal cure would be to ensure the liquidity of fundamentally solvent institutions.

But the Fed has shifted over the past two months toward policies aimed at a second-mode crisis — more significant monetary loosening, despite the risks of higher inflation, extra moral hazard and unjust redistribution.

As Fed Vice Chair Don Kohn recently put it: “We should not hold the economy hostage to teach a small segment of the population a lesson.”

No policymakers are yet considering the possibility that the financial crisis might turn out to be in the third mode.

Therefore, then, the implication that we actually are in a mode 3 scenario of falling asset prices is due solely to Prof. Hamilton’s analysis (or, perhaps, is inadverdent, implied only by an imprecise framing of the quotation). Prof. DeLong is merely asserting that the current Fed operations (as of Dec. 31, remember!) are due to a Fed opinion that we are in mode 2; Prof. DeLong hints, but does not assert, that we could be in mode 3.

With respect to Prof. Hamilton’s analysis, there is no argument to support an assertion that we are in a mode 3 scenario. If I read his conclusion correctly, Prof. Hamilton is asserting that Bernanke is terrified of entering a mode 3 crisis and is therefore increasing his response to a mode 2 crisis.

Naked Capitalism also reflects on Prof. Hamilton’s post and suggests:

The only defense Hamitlon can find for the central bank’s actions is that it may be deliberately stoking inflation to erode the value of America’s debt overhang.

… which misses the point. Monetary policy under a mode 2 response aims to increase the carry on assets via lower real rates, while it is only in mode 3 that the fires of inflation are deliberately stoked.

I agree with what I conclude is the central conclusion of Prof. Hamilton’s post:

I think part of the basis for Bernanke’s optimism on inflation must be the dourness of his outlook for real economic activity. The basic macroeconomic framework in Bernanke’s textbook suggests that, for given inflation expectations, if output falls below the “full-employment” level, inflation should go down, not up.

But nowhere – nowhere! – in any of these posts is there support for the idea that financial system is insolvent. Hurt, yes. Insolvent, no.

Market Action

February 28, 2008

Accrued Interest leads off today with a very good piece on credit ratings, concluding:

On Monday, the Dow rallied nearly 200 points, and credit spreads almost universally tightened. Why? Because a AAA rating for MBIA and Ambac means that banks won’t have to pledge more capital against downgraded ABS. This gives them more capital to lend into the economy. No matter what you think of S&P’s analysis, that’s the reality. If that reality bothers you, perhaps your derision should not be aimed at S&P or MBIA, but at the banking regulations that are so heavily reliant on ratings.

Indeed. For an investor, a credit rating is an opinion; for a bank, a credit rating is the law. It was the regulators who made this move – with a certain amount of sense; the credit ratings agencies have a better track record than most – and now the regulators are busy trying to make the agencies the villains. 

There are howls of outrage over reports that the agencies encouraged the monolines to diversify:

Insurance regulators did not stop the financial guarantors from expanding their busineses out of the muni market, a dynamic that one of the moderators suggested could nevertheless play out in future business cycles. In response, Dinallo said his understanding of the current crisis was the the bond insurers were encouraged to expand into the structured finance by the rating agencies, who asked them to expand their books of business.

“From what I have learned so far, the bond insurers were encouraged by the rating agencies to improve their returns on equity and seek diversification through doing this structured business,” Dinallo said.

And Naked Capitalism further indicates displeasure at bank-operated credit analysis :

That procedure allows them to tell the regulators how much equity they need to hold, putting the inmates in charge of the asylum.

The source document for that post urges three steps to improve internal credit analysis:

  • Do a follow-up study using data from the Credit Crunch!
  • Enforce a “raw leverage” maximum … no risk weights, no credit conversion factors, just a straight assets/equity thing.
  • Make some amount of subordinated debt mandatory

All that’s reasonable enough (the second item is a standard feature of North American regulation); the uncertain desirability of mandatory sub-debt has been previously discussed.

Naked Capitalism also publicizes charges that the Auction Rate Securities market has always been manipulated:

DealBreaker does some serious reporting today, informing us that some traders have told them that the failed auction rate securities market was always dependent on stabilization by dealers.

But this raises the question of why the markets were faltering in the first place. In our earlier reporting, we revealed how accounting changes may have set some corporate buyers running for the exits from this market. More recent conversations with a broader array of bond traders and dealers points toward another possiblility—the market never had enough buyer demand to support itself and has been dependent on stabilization from the banks for a very long time.

I find it fascinating that there are some implications from accounting changes; if anybody can track down what that little snippet is all about, please let me know! But, as with taxation, accounting has become a complex system – a complex chaotic system – and seemingly small changes can lead to huge, unforseen and (practically speaking) unforseeable consequences. On the bright side, of course, it creates work for lawmakers, regulators, accountants and lawyers; while providing Portfolio Managers more credence for the “Well, gee, how was I supposed to know that?” defense of poor returns. All is for the best in this, the most perfect of all possible worlds.

From the what goes up must come down department comes story about dead cowboys:

Peloton Partners LLP, the London- based hedge-fund firm run by former Goldman Sachs Group Inc. partners, is liquidating its ABS Fund after “severe” losses on mortgage-backed debt and demands from banks to repay loans.

Peloton, founded by Ron Beller and Geoff Grant in 2005, is seeking buyers for the $1.8 billion fund’s assets, according to a letter sent today to investors. Firms including Citadel Investment Group LLC and GLG Partners Inc. have made bids, two people familiar with the situation said.

The fund’s demise after an 87 percent gain last year highlights the severity of the U.S. subprime-mortgage collapse, which has spread to AAA-rated securities and triggered bank margin calls.

Sitka & Apex Trusts, mentioned yesterday have basically defaulted, according to DBRS:

On February 27, 2008, DBRS confirmed the ratings as Under Review Negative following an agreement between Sitka Trust and a swap counterparty to Sitka Trust to extend the due date of a collateral call notice received by Sitka Trust to the close of business on February 27, 2008. That agreement has expired. Moreover, as of the date of this release, no restructuring proposal has been agreed to by the relevant transaction parties. DBRS stated in the press release of February 25, 2008, that failure to enter such an agreement would likely result in substantial rating action.

In addition to the failure of Sitka Trust to fulfill its obligations to fund a collateral call by the close of business on February 27, 2008, DBRS was informed after close of business on February 27, 2008, by BMO Nesbitt Burns Inc., as Securitization Agent and Sub-Agent of Apex Trust and Sitka Trust respectively, that on February 27, 2008, Apex Trust failed to roll over all of its Series A, Class A Notes which came due on that date. As a result, pursuant to the terms of the Apex Trust indenture, the failure to pay the principal of or interest on the Series A Notes when due is considered to be a trust default if it continues for a period of two business days after a notice in writing has been given by the Indenture Trustee to the Trust. Due to the nature of certain agreements between the Trusts, a default of Apex Trust would result in a default of all of the Notes of Sitka Trust.

It’s interesting. My guess is that the default is real and will be confirmed in two days … but the two day grace period does leave open the possibility that BMO is engaged in high stakes brinksmanship with the swap counterparty. You never get to hear the good parts about these stories!

A Globe story about the situation noted:

The bank now has just two days to make a tough call. It can support the trusts by meeting the collateral calls, which means putting more capital at risk in what may be a vain bet on a recovery in capital markets, or Bank of Montreal can cut its losses by writing off $495-million of exposure to the trusts and letting them wind down.
…
The costs likely wouldn’t end there, though, because the bank is the biggest player in Canada’s securitization market with a business that generated about $296-million in revenue last year. That business would be in jeopardy if Bank of Montreal let Apex and Sitka fail, analysts said.

“Now the question is how committed BMO is to the securitization business in Canada because letting these trusts go down would decimate them in the eyes of customers,” said industry consultant Daryl Ching, managing partner of Clarity Financial. “The problem for BMO is if they meet these collateral calls they could easily be faced with more in a month if credit markets continue to worsen.”

The $296-million figure is from 2007 Annual Report; it is not even completely clear whether Sitka/Apex feed into this number at all; over half the amount is derived from selling credit card loans to existing vehicles. Whether or not letting Sitka/Apex go down would jeopordize the revenue is a matter of opinion … my opinion is “not”.

Meanwhile, the Alt-A RMBS market is looking pretty sick:

Typical 6 percent securities rated AAA and backed by 30-year fixed-rate Alt A loans of more than $417,000 on Feb. 22 fell to 12 cents less per dollar of principal than similar “agency” securities guaranteed by government-linked entities such as Fannie Mae, according to a report this week by JPMorgan Chase & Co. That was up from 5.5 cents on Jan. 25.

AAA bonds with 6 percent coupons backed by 30-year, fixed- rate “jumbo” prime loans of more than $417,000 probably traded for 2.5 cents per dollar less than similar agency securities, the report said, compared with 2.25 cents last month.

… and this has caused yet another good sized hedge fund to call it a day …

Peloton Partners LLP, the London- based hedge-fund firm run by former Goldman Sachs Group Inc. partners, is liquidating its ABS Fund after “severe” losses on mortgage-backed debt and demands from banks to repay loans.

Peloton, founded by Ron Beller and Geoff Grant in 2005, is seeking buyers for the $1.8 billion fund’s assets, according to a letter sent today to investors. Firms including Citadel Investment Group LLC and GLG Partners Inc. have looked at the portfolio, two people familiar with the situation said.

The fund’s demise after an 87 percent gain last year highlights the severity of the U.S. subprime-mortgage collapse, which has spread to AAA rated securities backed by safer loans and triggered bank margin calls.

Volume picked up today and, the market was steady. Of interest was a plunge in price of NTL.PR.F and NTL.PR.G: there are lots of headlines. Whether the plunge reflects a genuine reevaluation of the prospects for default, or whether just being in the headlines was sufficient reason … is something we’ll never know.

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 5.52% 5.53% 36,749 14.6 2 +0.0000% 1,085.4
Fixed-Floater 4.98% 5.67% 71.918 14.69 7 -0.1239% 1,031.0
Floater 4.93% 5.00% 67,129 15.44 3 +0.0002% 857.1
Op. Retract 4.81% 2.37% 76,588 2.48 15 +0.0642% 1,050.0
Split-Share 5.27% 5.28% 96,863 4.06 15 +0.0894% 1,050.3
Interest Bearing 6.22% 6.35% 56,518 3.36 4 +0.1263% 1,089.7
Perpetual-Premium 5.71% 3.77% 331,865 4.79 16 +0.0089% 1,034.4
Perpetual-Discount 5.36% 5.39% 273,230 14.82 52 -0.0273% 961.6
Major Price Changes
Issue Index Change Notes
IAG.PR.A PerpetualDiscount -2.9242% Now with a pre-tax bid-YTW of 5.25% based on a bid of 21.91 and a limitMaturity.
NA.PR.L PerpetualDiscount -1.8625% Now with a pre-tax bid-YTW of 5.52% based on a bid of 22.13 and a limitMaturity. 
PWF.PR.L PerpetualDiscount -1.6694% Now with a pre-tax bid-YTW of 5.47% based on a bid of 23.56 and a limitMaturity.
BAM.PR.I OpRet -1.4291% Now with a pre-tax bid-YTW of 5.29% based on a bid of 25.52 and a softMaturity 2013-12-30 at 25.00.
W.PR.H PerpetualDiscount -1.2381% Now with a pre-tax bid-YTW of 5.77% based on a bid of 23.93 and a limitMaturity.
RY.PR.B PerpetualDiscount -1.1419% Now with a pre-tax bid-YTW of 5.25% based on a bid of 22.51 and a limitMaturity.
BCE.PR.I FixFloat +1.0101%  
GWO.PR.H PerpetualDiscount +1.1742% Now with a pre-tax bid-YTW of 5.21% based on a bid of 23.23 and a limitMaturity. 
BAM.PR.M PerpetualDiscount +1.4644% Now with a pre-tax bid-YTW of 6.24% based on a bid of 19.40 and a limitMaturity. 
GWO.PR.I PerpetualDiscount +1.7873% Now with a pre-tax bid-YTW of 5.11% based on a bid of 22.00 and a limitMaturity.
Volume Highlights
Issue Index Volume Notes
BMO.PR.J PerpetualDiscount 176,105 Now with a pre-tax bid-YTW of 5.27% based on a bid of 21.51 and a limitMaturity.
CM.PR.I PerpetualDiscount 42,195 Now with a pre-tax bid-YTW of 5.63% based on a bid of 21.15 and a limitMaturity.
W.PR.H PerpetualDiscount 36,021 Bolder (who?) bought 10,000 from Nesbitt at 24.00. Now with a pre-tax bid-YTW of 5.77% based on a bid of 23.93 and a limitMaturity.
BNS.PR.O PerpetualPremium 30,526 Now with a pre-tax bid-YTW of 5.36% based on a bid of 25.60 and a limitMaturity.
TD.PR.Q PerpetualPremium 26,142 Now with a pre-tax bid-YTW 5.39% based on a bid of 25.58 and a call 2017-3-2 at 25.00.

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

HIMI Preferred Indices

HIMIPref™ Preferred Indices : August 2006

All indices were assigned a value of 1000.0 as of December 31, 1993.

HIMI Index Values 2006-08-31
Index Closing Value (Total Return) Issues Mean Credit Quality Median YTW Median DTW Median Daily Trading Mean Current Yield
Ratchet 1,320.8 1 2.00 4.41% 16.7 38M 4.39%
FixedFloater 2,274.1 6 2.00 4.17% 16.6 82M 4.97%
Floater 2,143.4 4 2.00 -22.71% 0.1 61M 4.64%
OpRet 1,896.6 17 1.48 3.12% 2.5 75M 4.70%
SplitShare 1,961.8 13 1.77 3.88% 3.0 48M 5.01%
Interest-Bearing 2,368.1 7 2.00 4.96% 0.9 42M 6.82%
Perpetual-Premium 1,502.9 48 1.50 4.50% 5.5 112M 5.16%
Perpetual-Discount 1,621.6 6 1.34 4.61% 16.3 387M 4.61%
HIMI Index Changes, July 31, 2006
Issue From To Because
AL.PR.F Floater Scraps Volume
CL.PR.B PerpetualPremium Scraps Volume
CM.PR.H PerpetualDiscount PerpetualPremium Price
CAC.PR.A Scraps SplitShare Volume
MFC.PR.B PerpetualDiscount PerpetualPremium Price
PWF.PR.D OpRet Scraps Volume
PWF.PR.K PerpetualDiscount PerpetualPremium Price
RY.PR.B PerpetualDiscount PerpetualPremium Price
GWO.PR.H PerpetualDiscount PerpetualPremium Price
SXT.PR.A SplitShare Scraps Volume
SLF.PR.A PerpetualDiscount PerpetualPremium Price
SLF.PR.B PerpetualDiscount PerpetualPremium Price
FTU.PR.A SplitShare Scraps Volume

There were the following intra-month changes:

HIMI Index Changes during August 2006
Issue Action Index Because
BC.PR.C Code Change FixFloat Term Change
PWF.PR.L Added PerpetualDiscount Issued

Index Constitution, 2006-08-31, Post-rebalancing

Taxation

Dividend Taxation Changes

Rob Carrick had a column in the Globe today that examines the effect of the recently announced changes in dividend taxation:

Still, there are going to be cases where investors pay more tax without the offsetting benefit of a higher dividend. Preferred shares are one example, while another is the shares of companies that maintain a steady dividend.

Since the dividend tax credit was enhanced a couple of years ago, dividends have in many cases been the most tax-efficient form of investment income (we’re talking here about so-called eligible dividends, or those typically paid by large corporations). Mr. Mida said dividend income may lose this distinction to capital gains, but not by a big margin.

The status quo will hold in dividend taxation until 2010, when a three-year phased adjustment begins.

Mr. Carrick’s source for the figures used in his report appear to be those of Price Waterhouse:

These are different from the Ernst & Young figures that I normally use. Presumably, the two accounting houses have used different assumptions regarding what constitutes a ‘base-case average taxpayer’. Not a big deal … it would be nice to know just precisely what the differences are, but we can’t have everything for free.

Enough! Let’s do some work here! Using Mr. Carrick’s published figures and assuming no change in the marginal rate charged on income:

Projected Taxation Factors
Year Income Dividend Equivalency Factor
2008 46.41% 23.96% 1.419
2009 46.41% 23.06% 1.436
2010 46.41% 24.56% 1.408
2011 46.41% 27.59% 1.351
2012 46.41% 30.19% 1.303

So … the estimate is that the equivalency factor is going to revert to approximately what it was in the nineties.

Before we take the next step, let’s emphasize to ourselves that these are estimates, approximations and forecasts! In the first place, accountancy firms can’t even agree with each other on what the top marginal rates are, such is the idiotic and increasing complexity of the Income Tax Act. In the second place, a five year forecast of something political like tax rates is going to be even more subject to error than a five-year forecast of investment returns … at least when you perform the latter operation, you can assume that at least a tiny minority of the players have functioning brain cells!

So. This is an estimate. Do with it what you will.

Estimated Effect of Tax Changes
On Perpetual Discounts
Year Equivalency Factor Change in
Spread if
Prices Constant		 Change in
Price if
Spread Constant
2008 1.419 0 0
2009 1.436 +9bp +1.33%
2010 1.408 -6bp -0.89%
2011 1.351 -37bp -5.48%
2012 1.303 -63bp -9.34%

Note on calculation: I use base case figures for 2008 of a PerpetualDiscount yield of 5.39% and a long corporate yield of 5.90%. At the 2008 equivalency factor of 1.419, the current interest-equivalent on PerpetualDiscounts (IE Spread) is 7.65%; the current spread to long corporates is therefore 175bp.

Figuring out the change in IE Spreads is easy – multiply today’s yield by tomorrow’s equivalency factor to get tomorrow’s estimated IE Yield; subtract the (constant) corporate yield to get tomorrow’s IE Spread; subtract today’s IE Spread to get the change.

To estimate the effect on price if the IE Spread is constant, I multiply the change in IE spreads by 14.82, which is the modified duration of the PerpetualDsicount index. Thus, for year 2012, the change in price (from now) is 0.63 x 14.82 = 9.34. To check this … let us assume we have a $100 pref yielding 5.39% at the moment … therefore, it pays $5.39 p.a. If the price drops by 9.34%, the new price will be $90.66; and the yield will change to (5.39 / 90.66) = 5.95%. The Interest Equivalency Factor is 1.303, so this yield will be equivalent to 7.75% interest. We were hoping to get 7.65%, but 10bp difference is due to convexity effects (the modified duration will decrease as the price decreases; modified duration is, strictly speaking, applicable only to infinitesimally small changes in price … and a 9.34% drop is not “infinitesimal”). Additionally, the extremely precise modified duration of 14.82 is calculated using HIMIPref™’s limitMaturity, which assumes a maturity at the current price in thirty years. This is not strictly accurate in itself and is not consistent with the use of Current Yield as an approximation of YieldToWorst. So a 10bp error isn’t bad!

Update, 2008-2-29: This post updates Federal Budget – Effect on Prefs

Market Action

February 27, 2008

Accrued Interest has a very good post today regarding S&P’s views on the monolines:

S&P and Moody’s have now both affirmed MBIA. S&P also more or less said they would affirm Ambac as well if the reported $3 billion capital infusion is completed. MBIA’s infamous 14% surplus note is now trading comfortably above par ($101 bid, $104 offer last night). So are we out of the woods with the monolines?

Well let’s start by looking at S&P’s methodology. In short, S&P will bestow a AAA rating if they believe an insurer can survive their “stressed” scenario. Here are their assumptions for various types of mortgage-related securities.
…

…
So all in all, I’d say that’s a pretty stressful scenario.

S&P, with its customary eagerness to become a credit rating agency that charges both the issuers and the subscribers, does not make the full report freely available. But Moody’s has published some notes:

Although losses on the 2006 mortgages are still low – mainly because the loans are still relatively unseasoned and the foreclosure process is taking longer than in previous years – Moody’s expects that they will rise considerably in the next few years. The most significant components of the uncertainty regarding the ultimate loss outcomes are (1) the extent to which loans will be modified and these modifications are successful in preventing defaults, (2) the impact of interest rate resets in 2008 and (3) the strength of the US economy in 2008 and beyond.

In this article, we provide projections of the lifetime average cumulative losses for each of 2006’s quarterly vintages, given each transaction’s current level of losses and delinquencies, and assumptions regarding the “roll rates” into default from various categories of delinquent loans and the severity of losses on loans that default.
…
Moody’s projection for mortgage losses on the 2006 vintage is in the 14-18% range

The Buiter/Sibert column on Barack Obama’s “Patriot Employer Act”, mentioned yesterday,  has drawn a lot of comment. Tanta at Calculated Risk has a very entertaining and devastating commentary about Lost Note Affidavits with respect to foreclosures, prompted by a story about legal maneuvering that caught my eye at the time, but went unremarked here. I’ve added some updates to the Crony Capitalism post and have made a little progress on Seniority of Bankers Acceptances.

The rather surprising level of lending by the Federal Home Loan Banks (FHLB) mentioned here on November 26 was attacked by Nouriel Roubini yesterday, as noted by the WSJ. I found his views on the monolines more interesting:

Similarly, the concern about the writedowns that will follow a downgrade of the monolines is well taken. However, desperate attempt to avoid a rating downgrade of monolines that do not deserve such AAA rating are highly inappropriate as the insurance by these monolines of toxic ABS was reckless in the first place. If public concerns about access to financing by state and local governments during a recession period are warranted it is better to split the monoline insured assets between muni bonds and structured finance vehicle, ring fence the muni component and let the rest be downgraded and accept the necessary writedowns on the structured finance assets. If these necessary writedowns will then hurt financial institutions that hold this “insured” toxic waste so be it as these assets should have never been insured in the first place. The ensuing fallout from the necessary writedown – such as the need to avoid fire sales in illiquid markets – should then be addressed with other policy actions.

I can’t agree with this at all. You can’t just split up a company’s committments – effectively, expropriating the rights of whoever’s guaranteed by the “bad” side – just on the basis of which set of guaranteed counterparties are nicer people. Should the monolines fail – and they’re not close to that yet, they’re merely close to losing their AAA ratings – and need to be recapitalized, then company splits can make sense. But not until their equity has gone to zero!

The hills are alive with the word that Apex & Sitka trusts might fail, costing the Bank of Montreal something like $495-million. DBRS explained in a Feb. 25 press release:

The Trusts were organized to enter into collateralized debt obligation (CDO) transactions, including CDO transactions that employ leverage. As of the date of this press release, 100% of the transactions entered into by the Trusts are LSS transactions. A LSS transaction is a type of transaction where a credit protection seller (such as a Canadian asset-backed commercial paper (ABCP) issuer (Conduit) that issues ABCP, extendible commercial paper or floating rate notes) writes credit protection on a tranche of a CDO transaction which is less than 100% collateralized and that will incur its first dollar of loss above the AAA attachment point. Losses to LSS transactions are considered a remote credit risk; however, these transactions exhibit funding risk. LSS transactions include leverage in that the collateral held by the Swap Counterparty will be smaller than the potential maximum exposure under the credit default swap. As such, the credit protection seller may be required to post additional collateral if its exposure under the swap increases.

Well, I’m not going to take a strong view on this. I don’t know how profitable the business was for BMO or how carefully they measured their risk. On the surface, it sounds like just another failed CDPO (“Whoopsy! Long term returns can be interupted by margin calls!”) … but again, I don’t know what risk controls BMO had in place (and leverage of loans is what banks do, right? The difference is that most loans don’t have to be marked-to-panicky-market every day … the bankers exercise judgement, good or bad, as to whether there is permanent impairment). What I do know is: Show me somebody who’s never failed, and I’ll show you somebody who’s never tried.

Another quiet day, with PerpetualDiscounts easing down.

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 5.52% 5.53% 37,758 14.6 2 +0.9099% 1,085.4
Fixed-Floater 4.97% 5.65% 72,802 14.70 7 +0.2682% 1,032.3
Floater 4.93% 5.00% 67,530 15.44 3 +0.0240% 857.1
Op. Retract 4.80% 2.14% 76,782 3.12 15 +0.0715% 1,049.3
Split-Share 5.27% 5.15% 97,812 4.06 15 -0.0687% 1,049.4
Interest Bearing 6.22% 6.38% 57,229 3.36 4 +0.2251% 1,088.4
Perpetual-Premium 5.70% 4.16% 334,582 4.32 16 +0.0982% 1,034.3
Perpetual-Discount 5.35% 5.39% 273,783 14.82 52 -0.1060% 961.8
Major Price Changes
Issue Index Change Notes
LBS.PR.A SplitShare -1.9305% Asset coverage of just under 2.2:1 as of February 21, according to Brompton Group. Now with a pre-tax bid-YTW of 5.08% based on a bid of 10.16 and a hardMaturity 2013-11-29 at 10.00. 
BCE.PR.I FixFloat -1.2058%  
IGM.PR.A OpRet -1.1431% Now with a pre-tax bid-YTW of 3.92% based on a bid of 26.81 and a call 2009-7-30 at 26.00.
BSD.PR.A InterestBearing +1.0460% Asset coverage of just under 1.6+:1 as of February 22, according to Brookfield Funds. Now with a pre-tax bid-YTW of 6.89% based on a bid of 9.51 and a hardMaturity 2015-3-31 at 10.00.
GWO.PR.F PerpetualPremium +1.1525% Now with a pre-tax bid-YTW of 4.87% based on any of a call on 2010-10-30 at 25.50, on 2011-10-30 at 25.25, or 2012-10-30 at 25.00 … take your pick. 
WFS.PR.A SplitShare +1.1788% Asset coverage of just under 1.8:1 as of February 21, according to the company. Now with a pre-tax bid-YTW of 4.57% based on a bid of 10.30 and a hardMaturity 2011-6-30 at 10.00.
BAM.PR.K Floater +1.1998%  
BCE.PR.B FixFloat +1.3323%  
Volume Highlights
Issue Index Volume Notes
BCE.PR.C FixFloat 152,500 Nesbitt crossed 42,000, then 20,000, then 88,000 within a minute, all at 24.35.
BMO.PR.K PerpetualDiscount 60,443 Now with a pre-tax bid-YTW of 5.33% based on a bid of 24.75 and a limitMaturity.
DFN.PR.A SplitShare 148,100 Desjardins crossed 135,000 at 10.25. Asset coverage of just under 2.5:1 as of February 15, according to the company. Now with a pre-tax bid-YTW of 4.85% based on a bid of 10.24 and a hardMaturity 2014-12-1 at 10.00.
BCE.PR.R FixFloat 50,000 Nesbitt crossed 50,000 at 24.10.
BNS.PR.O PerpetualPremium 22,850 Now with a pre-tax bid-YTW 5.33% based on a bid of 25.65 and a call 2017-5-26 at 25.00.

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

HIMI Preferred Indices

HIMIPref™ Preferred Indices : July 2006

All indices were assigned a value of 1000.0 as of December 31, 1993.

HIMI Index Values 2006-07-31
Index Closing Value (Total Return) Issues Mean Credit Quality Median YTW Median DTW Median Daily Trading Mean Current Yield
Ratchet 1,349.1 1 2.00 4.29% 16.9 25M 4.28%
FixedFloater 2,289.1 6 2.00 4.05% 16.8 108M 5.09%
Floater 2,132.3 5 2.00 -16.67% 0.1 50M 4.60%
OpRet 1,876.7 18 1.45 3.27% 2.7 64M 4.74%
SplitShare 1,957.2 14 1.86 3.91% 3.1 61M 5.02%
Interest-Bearing 2,351.2 7 2.00 5.34% 0.9 48M 6.86%
Perpetual-Premium 1,485.1 41 1.56 4.65% 3.9 106M 5.30%
Perpetual-Discount 1,582.6 13 1.23 4.81% 15.8 366M 4.77%
HIMI Index Changes, July 31, 2006
Issue From To Because
AL.PR.F Scraps Floater Volume
BNA.PR.B SplitShare Scraps Volume
CAC.PR.A SplitShare Scraps Volume
CVF.PR.A SplitShare Scraps Volume
PWF.PR.A Floater Scraps Volume
PWF.PR.K PerpetualPremium PerpetualDiscount Price
FIG.PR.A InterestBearing Scraps Volume

There were the following intra-month changes:

HIMI Index Changes during July 2006
Issue Action Index Because
RY.PR.B Added PerpetualDiscount Issued

Index Constitution, 2006-07-31, Post-rebalancing

Market Action

February 26, 2008

Nobody must ever get hurt in the field of finance! This has been confirmed by all the political attention paid to states and municipalities now that their auction rate securities are paying high yields:

Gregoire, Corzine and Spitzer joined other governors Feb. 24 in forming a group that will “produce something that gets us out of the problem, but most importantly produce something for Congress” to deter a future borrowing squeeze, Gregoire, a Democrat, said during a National Governors Association meeting in Washington yesterday…

“A lot of governors really hadn’t anticipated that,” Gregoire told reporters in Washington. The group, which plans to meet soon, hasn’t discussed specific solutions, she said

Some people may also be upset that the Fed has no direct power over mortgage rates:

When Bernanke faces Congress tomorrow and Feb. 28, he will be questioned about why long-term bond yields are moving in the opposite direction to the Fed funds rate, said Credit Suisse Group Chief Economist Neal Soss. Lower fixed mortgage rates would avert foreclosures and give consumers more money to spend, said Diane Swonk, chief economist of Mesirow Financial Inc. in Chicago.

“Chairman Bernanke is caught in a tug-of-war between growth and inflation,” said Swonk, who is a member of the Congressional Budget Office’s panel of economic advisers. “Inflation is still a threat and that influences the mortgage-bond investors who ultimately set the fixed rates.”

All the above is probably just political grand-standing in an election year, but boy! Does this kind of thing ever irritate me!

The always reliable Willem Buiter, with Anne Sibert, highlights an interesting plank in Barack Obama’s presidential platform:

on 2 Aug 2007, along with Senators Dick Durbin and Sherrod Brown and Representative Jan Schakowsky, Obama introduced the yet unpassed Patriot Employer Act. On 13 February 2008, he stopped in Janesville, Wisconsin to give a speech extolling this accomplishment.
…
The legislation would provide a tax credit equal to one percent of taxable income to employers who fulfill the following conditions:

  • First, employers must not decrease their ratio of full-time workers in the United States to full-time workers outside the United States and they must maintain corporate headquarters in the United States if the company has ever been headquartered there. 
  • Second, they must pay a minimum hourly wage sufficient to keep a family of three out of poverty: at least $7.80 per hour. 
  • Third, they must provide a defined benefit retirement plan or a defined contribution retirement plan that fully matches at least five percent of each worker’s contribution. 
  • Fourth, they must pay at least sixty percent of each worker’s health care premiums. 
  • Fifth, they must pay the difference between a worker’s regular salary and military salary and continue the health insurance for all National Guard and Reserve employees who are called for active duty. 
  • Sixth, they must maintain neutrality in employee organising campaigns. 

…
Sen. Barack Obama’s proposal is reactionary, populist, xenophobic and just plain silly. It is time for him to stop pandering and to show the world that hope and reason are not mutually exclusive. 

There was some interesting news on the regulatory front today, with respect to hedge funds front-running PIPEs:

Since October, judges in three cases rejected the U.S. Securities and Exchange Commission’s argument that closing out short positions with shares bought in private offerings is illegal. The SEC sued hedge-fund managers that engaged in the transactions.
…
PIPEs offer a chance to make a guaranteed profit because the stock is sold for less than market prices. The average discount was 12 percent last year, according to PlacementTracker.

In a typical scenario the SEC has targeted, a hedge-fund manager learned of a PIPE through a placement agent and shorted the company’s stock before the offer was announced. The fund bought the equity at a discount in the private sale to cover the short position.

The SEC lost its argument that the entire transaction was completed when the short position was created. The insider- trading claim is based on the SEC’s accusation that the hedge funds used confidential information to trade before the PIPE was disclosed.

The accused managers argue in part they didn’t have nonpublic information or agree to forgo trading before the PIPEs were announced.
…
Robert A. Berlacher, 53, on Feb. 15 asked a judge in Philadelphia to dismiss the insider-trading accusations in a case involving buying and selling Radyne Comstream Inc., now Radyne Corp., in 2004. Berlacher’s lawyer, Perrie M. Weiner of DLA Piper in Los Angeles, said knowledge of a PIPE isn’t the “material nonpublic information” required to show insider trading.

My sympathies are entirely with the SEC on this matter. It may possibly be that the hedge fund managers are taking advantage of a loophole and should not be punished … but in such a case, the loophole must be plugged. If I’m considering placing an order to buy XYZ Corp. at $50.00, then I consider XYZ’s plans to issue more shares – and dilute my holdings – at $45.00 to be material.

I can see that with such private placements, the company may have a legitimate interest in keeping the plans quiet … but sizes and prices should not be negotiated with other players unless those players have entered a short-term stand-still and confidentiality agreement.

I’m uncomfortable with this method of financing, anyway. Let’s see more exchange offerings and rights issues!

Yields on the Fed’s Term Auction Facility increased in the current auction to 3.08%. This auction was for $30-billion in term loans, from Feb 28 – March 27. It replaces funds awarded in the January 28 auction, which went for 3.123%. The Fed Funds contract for March is now trading at about 2.77%; as of Feb 25, both the target and the effective Fed Funds Rates were 3.00%. It would appear that a term premium has now crept into the auctions … I note that one month LIBOR is at 3.12%. So … I think the result, together with an entirely reasonable FDIC report, is pretty good sign. If the sky really were falling, then insolvent banks, shut out of the uncollateralized interbank market, would bid the TAF rate to the sky as they attempted to foist their worthless collateral on the dumb old Fed.

Reliable data is hard to come by, but preliminary indications are that the new Federal Budget is dividend hostile – not good news for prefs, but (based on historical experience with the trend in the other direction) probably not that bad, either. Fresh from flapping his yap about the need for efficiency (except in egg and dairy products), Our Glorious Finance Minister introduced yet another tax-assisted savings plan, which will be of interest to the few Canadians who have maxed out their RRSPs (which is to say: those who don’t need any specially targetted help anyway). It is not clear whether the line item for this deduction has been efficiently placed above or below the line where you claim your public transit fare deduction. There are things, Assiduous Readers, which man was not meant to know.

On the plus side, the government’s desire to spend every cent coming in and to bloat the size of the Income Tax Act makes deficits much more likely. This will increase the supply of government bonds and hence act to decrease Preferred/Government yield spreads.

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 5.54% 5.59% 39,260 14.5 2 -0.3702% 1,075.6
Fixed-Floater 4.98% 5.67% 71,013 14.69 7 +0.3445% 1,029.5
Floater 4.93% 5.00% 68,256 15.44 3 -0.0128% 856.9
Op. Retract 4.81% 1.98% 76,957 3.12 15 +0.0906% 1,048.5
Split-Share 5.26% 5.28% 97,587 4.06 15 +0.1714% 1,050.1
Interest Bearing 6.21% 6.38% 57,713 3.34 4 -0.1983% 1,085.9
Perpetual-Premium 5.70% 4.15% 338,488 4.37 16 +0.0127% 1,033.3
Perpetual-Discount 5.34% 5.38% 276,388 14.83 52 +0.0688% 962.8
Major Price Changes
Issue Index Change Notes
HSB.PR.D PerpetualDiscount -1.1725% Now with a pre-tax bid-YTW of 5.38% based on a bid of 23.60 and limitMaturity.
IAG.PR.A PerpetualDiscount +1.1810% Now with a pre-tax bid-YTW of 5.07% based on a bid of 22.63 and a limitMaturity. 
NA.PR.L PerpetualDiscount +1.3538% Now with a pre-tax bid-YTW of 5.44% based on a bid of 22.46 and a limitMaturity.
Volume Highlights
Issue Index Volume Notes
BNS.PR.M PerpetualDiscount 157,870 Nesbitt bought 145,000 from National Bank at 21.72. Now with a pre-tax bid-YTW of 5.23% based on a bid of 21.73 and limitMaturity.
BNS.PR.L PerpetualDiscount 99,305 BMO bought 41,800 from National Bank at 21.72, then crossed 50,000 at the same price. Now with a pre-tax bid-YTW of 5.22% based on a bid of 21.72 and a limitMaturity.
CM.PR.H PerpetualDiscount 64,500 Now with a pre-tax bid-YTW of 5.59% based on a bid of 21.66 and a limitMaturity.
BMO.PR.J PerpetualDiscount 56,660 National Bank bought 26,400 from Nesbitt at 21.60. Now with a pre-tax bid-YTW of 5.22% based on a bid of 21.60 and a limitMaturity.
LFE.PR.A SplitShare 106,720 CIBC crossed 101,800 for cash at 10.70 (ex-dividend date is 2/27, tomorrow). Asset coverage of 2.4:1 as of February 15, according to the company. Now with a pre-tax bid-YTW of 3.93% based on a bid of 10.61 and a hardMaturity 2012-12-1 at 10.00.

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

Taxation

Federal Budget – Effect on Prefs

With a hat-tip to the Financial Webring, we can look at a story in the National Post:

Canadians may be wise putting dividend-paying stocks into their TFSAs. While the government announced last October it would slash corporate income tax rate to 15% by 2012 from 19.5%, individual investors will be making up some of that lost revenue.

The average rate investors will pay on dividend income at the top marginal tax rate of 46% will rise to 25.3% by 2012 from 18.5% in 2008.

Marginal rate of dividends increasing? What will that do?

Old / New Regimes for
Dividend Tax Credit
and Gross-up
  Old New
Interest Income $1.00 $1.00
Tax on Interest $0.46 $0.46
Net Interest After Tax (A) $0.54 $0.54
Dividend Income $1.00 $1.00
Tax on Dividend $0.185 $0.253
Net Dividend After Tax (B) $0.815 $0.747
Equivalency Factor (=B/A) 1.509 1.383

To check these figures … If we receive $1.509 in interest and pay 46% tax, or $0.694, we’re left with $0.815, which is the same as the net left after tax from dividends of $1.00 under the old regime, so that’s OK.

If we receive $1.383 in interest and pay 46% tax, or $0.636, we’re left with $0.747, which is the same as the net left after tax from dividends of $1.00 under the new regime, so that’s OK.

I don’t know where the Post got their figures from. The equivalency factor in Ontario is currently 1.40, not 1.509 as per their figures; I use a marginal rate on dividends of 21.0% and 46.4% on interest.

Throughout the 1990’s, I used 48.8% on income and 32.9% on dividends, which gave an equivalency factor of 1.311.

Before opining on the effects of the change, I want to know just what the change is! I’ll wait for the accountancy firms to crunch the numbers, then pontifficate.

Update: KPMG notes:

Dividend tax credit (DTC) — For 2010 and later years, the dividend gross-up factor and DTC will be adjusted in increments to reflect the corporation tax reductions to 15% in 2012 introduced in the October 30, 2007 mini-budget (for details on the corporate tax cuts, see TaxNewsFlash-Canada 2007-28, “Highlights of the 2007 Federal Mini-Budget”).

The KPMG report on the fall 2007 mini-budget states:

The mini-budget documents also say that, in light of the corporate tax rate cuts, the federal government will consider corresponding changes to the enhanced dividend tax credit for eligible dividends. The enhanced credit is designed to ensure that the combined corporate and personal tax rate on dividends from large corporations is comparable to the rate applying to other income. The credit was established based on the total average federal-provincial corporate tax rates that were expected to apply in 2010.

Update, 2008-2-29: Follow up article, with projected rates is Dividend Taxation Changes.

Issue Comments

IQW.PR.C / IQW Conversion Ratio For March 1 Announced

Quebecor World has announced:

the final conversion rate applicable to the 3,975,663 Series 5 Cumulative Redeemable First Preferred Shares (TSX: IQW.PR.C) (the “Series 5 Preferred Shares”) that will be converted into Subordinate Voting Shares effective as of March 1, 2008. Taking into account all accrued and unpaid dividends on the Series 5 Preferred Shares up to and including March 1, 2008, Quebecor World has determined that, in accordance with the provisions governing the Series 5 Preferred Shares, each Series 5 Preferred Share will be converted on March 1, 2008 into 12.93125 Subordinate Voting Shares. Registered holders of Series 5 Preferred Shares who submitted notices of conversion on or prior to December 27, 2007 will receive in the coming days from Quebecor World’s transfer agent and registrar, Computershare Investor Services Inc., certificates representing their Subordinate Voting Shares resulting from the conversion. Approximately 51.4 million new Subordinate Voting Shares will thus be issued by Quebecor World to holders of Series 5 Preferred Shares on March 1, 2008. Quebecor World will apply to list the 51.4 million Subordinate Voting Shares on The Toronto Stock Exchange (TSX), although there can be no assurance that the TSX will accept the listing of such shares.

Quebecor World is currently in creditor protection and is on review for possible delisting. The conversion of over half the IQW.PR.C has been discussed previously.

Interesting External Papers

FDIC Quarterly Report on US Banks

As noted by the WSJ, the American Federal Deposit Insurance Corporation has released its 4Q07 Quarterly Banking Report. It starts off with a bang!:

Record-high loan-loss provisions, record losses in trading activities and goodwill impairment expenses combined to dramatically reduce earnings at a number of FDIC-insured institutions in the fourth quarter of 2007. Fourth-quarter net income of $5.8 billion was the lowest amount reported by the industry since the fourth quarter of 1991, when earnings totaled $3.2 billion. It was $29.4 billion (83.5 percent) less than insured institutions earned in the fourth quarter of 2006. The average return on assets (ROA) in the quarter was 0.18 percent, down from 1.20 percent a year earlier. This is the lowest quarterly ROA since the fourth quarter of 1990, when it was a negative 0.19 percent. Insured institutions set aside a record $31.3 billion in provisions for loan losses in the fourth quarter, more than three times the $9.8 billion they set aside in the fourth quarter of 2006. Trading losses totaled $10.6 billion, marking the first time that the industry has posted a quarterly net trading loss. In the fourth quarter of 2006, the industry had trading revenue of $4.0 billion. Expenses for goodwill and other intangibles totaled $7.4 billion, compared to $1.6 billion a year earlier. Against these negative factors, net interest income remained one of the few positive elements in industry performance. Net interest income for the fourth quarter totaled $92.0 billion, an 11.8-percent ($9.7-billion) year-over-year increase.

… but things aren’t always as they seem …

Earnings weakness was fairly widespread in the fourth quarter. More than half of all institutions (51.2 percent) reported lower net income than in the fourth quarter of 2006, and 57.1 percent reported lower quarterly ROAs. However, the magnitude of the decline in industry earnings was attributable to a relatively small number of large institutions. In contrast to the steep 102 basis-point drop in the industry’s ROA, the median ROA fell by only 14 basis points, from 0.93 percent to 0.79 percent. Seven large institutions accounted for more than half of the total year-over-year increase in loss provisions. Ten large institutions accounted for the entire decline in trading results. Five institutions accounted for three-quarters of the increase in goodwill and intangibles expenses, and sixteen institutions accounted for three-quarters of the year-over-year decline in quarterly net income. One out of every four institutions with assets greater than $10 billion reported a net loss for the fourth quarter. Institutions associated with subprime mortgage lending operations and institutions engaged in significant trading activity were among those reporting the largest earnings declines.

… and capital ratios were, by and large, reasonable …

Total equity capital increased by $25.1 billion (1.9 percent) during the fourth quarter. This increase lagged behind the 2.6-percent increase in assets during the quarter, and the industry’s equity-to-assets ratio declined from 10.44 percent to 10.37 percent. Goodwill accounted for almost one-third ($7.9 billion) of the increase in equity, despite large write-downs of goodwill at several institutions. The industry’s leverage capital ratio registered a larger decline during the quarter, because leverage capital does not include goodwill. The leverage ratio fell from 8.14 percent to 7.98 percent, a four-year low. In contrast, the industry’s total risk-based capital ratio, which includes loss reserves, increased from 12.74 percent to 12.79 percent. At the end of 2007, 99 percent of all insured institutions, representing more than 99 percent of total industry assets, met or exceeded the highest regulatory capital standards.

… although things got a little hairy at the margins (and, presumably, with the big money-centre banks) …

The number of FDIC-insured institutions reporting financial results declined from 8,559 to 8,533 during the fourth quarter.2 Fifty newly chartered institutions were added during the quarter, while 74 institutions were absorbed by mergers. One insured commercial bank failed in the fourth quarter. For the full year, 181 new insured institutions were chartered, 321 charters were absorbed in mergers, and three insured institutions failed. In the previous two years, there were no failures of FDIC-insured institutions, an interval unprecedented since the inception of the FDIC. In 2004, four insured institutions failed. Five mutually owned savings institutions, with combined assets of $4.8 billion, converted to stock ownership in the fourth quarter. For the entire year, ten insured savings institutions with total assets of $10.1 billion converted from mutual ownership to stock ownership. At the end of 2007, there were 76 FDIC-insured commercial banks and savings institutions on the “Problem List,” with combined assets of $22.2 billion, up from 65 institutions with $18.5 billion at the end of the third quarter.

All in all, I think the report justifies my remark in the Crony Capitalism? post:

As far as the overall health of the banking system is concerned, let’s look at the Fed’s Term Auction Facility. The last one was reported on February 12; there was one today. The very low premium on this money relative to Fed Funds – and the continuing drop in the TED Spread – leads me to conclude that insolvency, potential or undiscovered, is not a problem in the banking system. It’s illiquidity, pure and simple.