PrefBlog

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

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

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

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

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

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

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

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

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

The previously scheduled end of the world has been postponed.

Accrued Interest foresees a period of intense confusion:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The FDIC is working a bit of overtime sorting out the situation with bank holdings of FannieFreddie prefs:

The Federal Deposit Insurance Corporation (FDIC) will work with the limited number of institutions that have significant holdings of common or perpetual preferred shares in Fannie Mae and Freddie Mac to develop Capital Restoration Plans pursuant to federal regulations. These equity investments should be reported as available-for-sale equity securities, if not held for trading purposes, and any net unrealized losses should be deducted from regulatory capital. Attached is the FDIC’s “Statement on Investments in Fannie Mae and Freddie Mac Equity Securities.”

There’s rather a disturbing quote from John McCain:

LAUER: So if we get to the point middle of the week as we heard in that report where AIG might have to file for bankruptcy, they’re on their own?
McCAIN: Well…quote, “on their own”…we have to – we cannot have the taxpayers bail out AIG or anybody else…this is something we’re gonna have to work through — there’s too much corruption, there’s too much access, we can fix it, I believe in America – we can have a 9/11 commission such as we had after 9/11, ’cause this is a huge crisis and we can come up with fixes and we can make sure that every American has a safer future and that is to make them know that their bank deposits are safe and insured.

The disturbing part is “corruption”. “Corruption” implies criminality. There is a huge difference between ‘investments that didn’t work out’ and ‘incompetence and recklessness’ and ‘corruption’. If the next President approaches the issue of regulation of the financial sector with the idea that it was – somewhere, perhaps unprovable, but somewhere – widescale criminality that caused the current crunch, the economy’s in trouble. Sarbanes-Oxley has had a bad enough effect; a reprise will simply accellerate the slow erosion of New York as the world’s premier financial centre.

Reserve Primary Fund broke the buck on September 16; related events and reverberations are wild. State Street & BONY Mellon got hammered:

State Street Corp. fell as much as 55 percent and Federated Investors Inc. and Bank of New York Mellon Corp. declined in New York trading on concerns that money-market funds will be hit by a wave of losses.

The stocks plunged after BNY Mellon said a $22 billion institutional fund suffered losses on debt issued by bankrupt Lehman Brothers Holdings Inc. While not a money-market fund, BNY Mellon’s $22 billion Institutional Cash Reserves was designed to work like one.

.
Dealbreaker is amused.

And Putnam is closing down a huge fund:

Putnam Investments LLC closed its $12.3 billion institutional Putnam Prime Money Market Fund yesterday and plans to return all cash to investors.

The fund, which was valued yesterday at $1 a share, experienced “significant redemption pressure,” the Boston- based company said in a statement. A drop below $1 a share, known as breaking the buck, would have exposed investors to losses.

I discussed this issue – a bit – in my essay A Collateral Proposal, but I’m still having some trouble understanding it. Money market funds invest in commercial paper, not just T-Bills. This is because Commercial Paper pays more. It pays more due to both liquidity concerns and credit concerns. Credit Concerns! Occasionally, there will be a loss. If the Portfolio Manager is doing his job right, these losses will be few and far between; but there will be losses. That’s why you get paid extra!

So a loss of 1-2% on a money market fund is unpleasant, sure, but I’m afraid I just don’t understand why it’s the end of the world.

Another crummy day for prefs, and we can no longer talk about a yield curve. It’s more of a yield smudge, a yield Rorschach (pronounced “Raw-Shock”). Today’s closing average bid-YTW of 6.22% was seen on August 8 (moving down) and July 7 (moving up). The peak, remember, was 6.63%.

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