PrefBlog

Today’s post may be foreshortened, due to the time I spent on crony capitalism. Well, anyway, here goes…

Naked Capitalism leads off with a piece suggesting that there’s not much worth saving in the monolines taking great exception to the idea that the proposed recapitalization of Ambac will be via a rights offering. I don’t see anything wrong with a rights offering myself … it allows existing shareholders to avoid dilution and, perhaps, get in on the opportunity to increase their position at a discounted price. And if they don’t want to increase their position, they can sell their rights to take their money off the table. Such procedures are much more fair to extant shareholders than private placements; I don’t understand why there aren’t more of them.

Naked Capitalism suggests that even the Good Insurer part of potential splits might be not all that good, citing a third party’s mention of the City of Vallejo, CA’s current problems:

Vallejo is a municipality. Presumably its debt would be considered AAA. Yet its civic leaders are talking about filing for bankruptcy. You wonder why local government and public works-related auction bonds are failing left, right and centre? US state and municipal finances are in dire shape – just as you would expect when the housing market is in deep depression and the economy is in recession.

And if you think Vallejo is a one off, consider California itself (isn’t it something like the tenth largest economy in the world in its own right?). Remember, US states are constitutionally bound to run a balanced budget. California is now faced with a US$16bn deficit (see here). Some legislators are calling for unilateral tax INCREASES (where’s your $170bn stimulus package now Mr Bush?) as well as spending CUTS. The US is in deep, deep trouble and it isn’t coming out of it for years.

So I looked a little into press reports about Vallejo:

Vallejo may run out of cash as early as March, council member Stephanie Gomes said.

“Not only that, but now we have 20 police and fire employees retiring because they are afraid of not getting their payouts,” Gomes said. “That means we have another few million dollars in payouts that we had not expected. So the situation is quite dire.”
…
The city currently has a $135 million liability for the present value of retiree benefits already earned by active and retired employees and an additional $6 million a year as employees continue to vest and earn this future benefit, [City Manager] Tanner said.

“The problem is basically bloated union contracts,” [Council Member] Shively said.

… and, with a bit more detail:

[Council Member] Gomes said salaries and benefits for public safety workers account for 80 percent of Vallejo’s general operating budget. “The city cannot support this anymore,” she said.

Gomes said that last year, 98 firefighters made more than $100,000 and 10 made more than $200,000 including overtime. It is overtime that some firefighters say they would just as soon not have to work.

This is happening in a city with a population of about 120,000. Quick! Somebody call David Miller! We’ve finally found a city that’s run worse than Toronto!

Vallejo was recently downgraded by Moody’s (enormous spreadsheet) to A3 (Watch Negative) from Aaa (Watch Negative), as a result of the downgrade of FGIC.

The monolines did catch a break today! S&P affirmed MBIA as AAA though it remained on Watch Negative. Ambac is still under review.

Naked Capitalism also reprints a report on the collateral accepted by the TAF. The Fed claims it lends only to sound banks, irrespective of collateral; NC says he doubts it. I’ll go with the Fed.

In what BCE shareholders will hope is not a foreshadowing of things to come, Wachovia has sued Providence Equity Partners (part of the BCE acquisition group) to get out of a financing:

Wachovia, the fourth-largest U.S. bank, said Providence officials changed the terms of the accord without consent from the Charlotte, North Carolina-based bank and voided the agreement, according to a lawsuit filed in state court in North Carolina Feb. 22. Providence and two of its investment banks, Goldman Sachs Group Inc. and UBS AG, agreed over the weekend to drop the price from $1.2 billion for the Clear Channel unit, a person briefed on the negotiations said.

Well! They drop the price and Wachovia jumps at the opportunity to call foul! This is an interesting development.

Rather a dull day for prefs, although the fact that this is only the third trading day this month that PerpetualDiscounts were down gave it some interest. Not much price action and the volume was rather lame as well.

Still no sign of new issues, much to my chagrin!

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

Not much today! I did, however, post about RS’s attitude towards icebergs and Inflation Expectations … you guys will just have to make do with that.

I see there are rumours of an Ambac rescue:

Banks may invest about $3 billion in the company, said the person, who declined to be named because no details have been set. The New York-based company rose 16 percent in New York Stock Exchange trading today after CNBC Television said Ambac and its banks were preparing to announce a deal.
…
A rescue that enabled Ambac to retain its AAA rating for the municipal and asset-backed securities guaranty units would help banks and municipal debt investors avoid losses on securities it guarantees. Banks stood to lose as much as $70 billion if the top-rated bond insurers, which include MBIA Inc. and FGIC Corp., lose their credit ratings, Oppenheimer & Co. analysts estimated.

Let me see if I have this straight … the banks are looking at a mark-to-market loss of $70-billion, which they can avoid with an investment of … oh, call it $10-billion, if Ambac gets three. How can anybody talk about market efficiency with a straight face?

Volume picked up today and performance was good … nothing earthshattering, but given that down days are currently rare, monny a mickle maks a muckle. As they say.

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

Naked Capitalism reprints a WSJ editorial that concludes:

A financial system runs on trust, and the credit crisis is continuing in part because there is so much mistrust about the magnitude of potential losses and where those losses reside. By encouraging bond insurers to unilaterally rewrite their contracts, Messrs. Spitzer and Dinallo are only creating more mistrust and uncertainty. We assume the banks that bought the bond insurance and signed the contracts will take their insurers to court.

Holy smokes, if this thing doesn’t get reasonably resolved, things are going to get messy! I can only assume that Dinallo is simply engaging in brinksmanship, with the actual object being a recapitalization of the monolines. The trouble with brinksmanship, of course, is that if it doesn’t work, things have become worse.

MBIA has announced:

it withdrew from its trade association because of differences over the direction of the industry.

“We believe that the industry must over time separate its business of insuring municipal bonds from the often riskier business of guaranteeing other types of securities,” MBIA’s new Chairman and Chief Executive Officer Jay Brown said in a statement today. The company also disagrees with the Association of Financial Guaranty Insurers’ “positions on the appropriateness of monoline financial guarantors insuring credit default swaps.”

The press release on the MBIA site states:

For one thing, we believe that the industry must over time separate its business of insuring municipal bonds from the often riskier business of guaranteeing other types of securities, such as those linked to mortgages. Additionally, we disagree with AFGI’s positions on the appropriateness of monoline financial guarantors insuring credit default swaps and the ability of U.S. financial guarantors to reinsure U.S. domestic financial guarantee insurance transactions with foreign affiliates without paying U.S. corporate tax rates.

The AFGI has posted a review of the industry dated November 2007 and the website FAQ includes asset backed securities as a field of future growth for monolines. I don’t see anything specific about Credit Default Swaps.

There was a further indication that the CDS market is strange:

Credit markets were thrown into fresh turmoil on Wednesday as the cost of protecting the debt of US and European companies against default surged to all-time highs.

The sharp jump, which rivalled the sell-off at the height of last summer’s credit market turmoil, came as traders rushed to unwind highly leveraged positions in complex structured products.

The sell-off was triggered partly by fears of more unwinding to come as investors rushed to exit before conditions worsen. As losses have snowballed, further unwinding has been triggered.
…
The cost of insuring the debt of the 125 investment-grade companies in the benchmark iTraxx Europe rose more than 20 per cent to as high as 136.9 basis points, before closing at 126.5bp. That compares with a level of about 51bp at the start of the year, according to data from Markit Group.

In contrast to this, let’s take a quick glance at some recent BoC research into CDS Pricing:

The paper examines three equity-based structural models to study the nonlinear relationship between equity and credit default swap (CDS) prices. These models differ in the specification of the default barrier. With cross-firm CDS premia and equity information, we are able to estimate and compare the three models. We find that the stochastic barrier model performs better than the constant and uncertain barrier models in terms of both in-sample fit and out-of-sample forecasting of CDS premia. In addition, we demonstrate a linkage between the default barrier, jump intensity, and barrier volatility estimated from our models and firm-specific variables related to default risk, such as credit ratings, equity volatility, and leverage ratios.

At best, this study represents a good try – the data for determining the value of a CDS through a cycle simply does not exist. Despite my interest in the asset class, I’m not convinced that the CDS market is ready for prime time. If their main attraction is the ability to lever up a portfolio significantly, then a huge degree of uncertainty is introduced into pricing, in addition to the uncertainty introduced by debt decoupling. I continue to wrestle with the idea, but these twin, undiversifiable uncertainties probably introduce a required risk premium that makes inclusion of these instruments, long or short, in a fixed income portfolio uneconomic.

It’s all very complicated and I’m a simple kind of guy! The complexity was noted in a Financial Times article by Aline Van Duyn and Gillian Tett excerpted by Naked Capitalism:

The fundamental problem is that this decade’s wave of banking innovation has created a financial system that is not just highly complex but also tightly interlinked in ways that policymakers and investors sometimes struggle to understand.
…
This could result in the businesses of companies such as Ambac, MBIA and FGIC being split into two, to ensure that bond insurers can ringfence the riskier assets (such as mortgages) from the municipal guarantee business.

But although such a split currently seems attractive in political terms – most notably because it would enable policymakers to protect the municipal bond market in an election year – it will not necessarilly prevent further turmoil on Wall Street. On the contrary, as Jeffrey Rosenberg, analyst at Bank of America, says: “A split may limit losses in the municipal market, but it would likely exacerbate losses to structured finance… To the extent that those losses further constrain financial institutions’ balance sheets, broader credit constaint may follow.”

Cowboys, cowboys! Playing with things they don’t really understand, and sometimes doing quite well for several years. I think they’re wonderful … selling them liquidity is a very profitable endeavor.

As I suggested when the news first came out on January 24, Kerviel’s status as a “rogue trader” must forever be preceded by the qualifier “so-called”. A SocGen report on the loss has reported:

“Controls in place were conducted without triggering a strong or persistent enough alert to enable the identification of the fraud,” the e-mailed report said.
…
It did say that compliance officers rarely went beyond established routine checks.

They “don’t have the reflex to inform their superiors or the front office of anomalies, even if they concern large amounts,” the report said.

There weren’t any follow-up checks on cancelled or modified transactions, and no limits on nominal positions, just on net positions, it found.

While procedures were respected and questions were asked, “no initiative was taken to check JK’s assertions and corrections he suggested, even when they lacked plausibility,” the report said. “When the hierarchy was alerted, it didn’t react.”

The committee said there were 75 red flags between June, 2006, and the beginning of 2008 that should have alerted managers to Mr. Kerviel’s unauthorized trades. The warning signs included a trade with a maturity date on a Saturday, bets with “pending” counterparties and missing broker names, the report said.

The actual SocGen report contains a marvellous graph of reported vs. actual P&L for Kerviel’s positions (page 11 of the PDF). 

In other words, SocGen risk management is a complete joke. And in response, of course, SocGen and many other firms are requiring complete ignorance of operations, rather than simply preferring it. This will also serve to emphasize to the traders that operations personnel are low-life scum, who may be ingored, lied to and sworn at with impunity. Brace yourselves for more blow-ups!

A very quiet day today, but the market continued strong. PerpetualDiscounts are now up 3.34% on the month-to-date and 3.76% on the year-to-date. They have had exactly two down days this month (so far!), both less than a beep’s worth.

To my astonishment, there have been no new issue announcements this week, in defiance of my February 15 prediction. Well, perhaps tomorrow will salvage my reputation …

I’m of two minds whether or not to write another post devoted to the BNA issues … the BNA.PR.A closed with a ludicrously strong bid, and the yield on BNA.PR.C is now lower than the equal-credit-shorter-term BNA.PR.B.

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