PrefBlog

Excitement over the Fannie and Freddie preferreds continues, with Accrued Interest noting in a late post that they showed good strength in the last hour of trading yesterday.

Amidst all this talk about how the preferred shareholders could be hurt by a bail-out, I think it’s time to take a better look at the mechanics of how they could be hurt. What can be done to them?

It’s easy to figure out how to hurt the common shareholders. Their dividend has already been slashed, the companies could just walk to the end of that road and cut it completely. After that, they could be diluted all to hell – for instance, the Treasury could backstop an issue of senior preferreds, convertable into common at $1. Presto! Permanent impairment for the common holders.

But pain by dilution is not a worry for the preferred shareholders. They have a claim for $X annual dividend and $Y liquidation value on the company, and that claim is not affected by how many prefs are outstanding. The enforcibility of that claim is affected – there’s the potential, for instance, for a liquidation to pay less than 100% – but (a) the claim is unchanged and (b) the company needs to be liquidated for this to happen. Liquidation is the ultimate step and will be a political decision – I don’t consider it too likely, frankly, but make up your own minds.

Another possibility is an offer they can’t refuse – as happened with the Thornberg prefs reported on PrefBlog on July 22. They were given the opportunity to exchange into a new series at twenty cents on the dollar, and all sorts of horrible outcomes were threatened if they didn’t accept. They had to accept; in liquidation they almost certainly would have gotten less, while there was an offer on the table to recapitalize the company provided they allowed impairment of their claim.

Is this scenario a valid fear for the Fannie and Freddie prefs? Well, make up your own minds – there’s plenty of people willing to state pseudonymously on the internet that everything is worthless. I’m not convinced. If such an offer were to be made to the Fannie and Freddie prefholders, I think that they could very well win a staring contest.

The most likely scary scenario that their dividends get cut off. This is basically the only action the company can unilaterally take – but it means no dividends to the common shareholders, either. Not a single penny until the preferred dividends re-start; and there may be other remedies in the prospectuses that I haven’t read. Such an action will make the common a little difficult to sell, eh? Even at $1.

And finally, Treasury could simply expropriate their rights – re-write the law and do whatever they like. Frankly, I don’t consider this a credible outcome; not when the base-case scenario of issuing senior, convertable preferred accomplishes the policy objective of wiping out the common shareholders and recapitalizing the company. If Treasury wants to punish the preferred shareholders, they might insist that dividends get suspended for ‘the duration of the crisis’; interested readers may work out for themselves what the yields are when dividends are suspended for a variety of periods. Sadly, all series of FNM prefs are non-cumulative – I haven’t done much investigation of the particulars, but I did check that!

Note that this is not intended to be an endorsement of the Fannie and Freddie prefs – I haven’t looked at the financials for myself and I haven’t parsed all of the political statements for myself. I am merely trying to point out that the common shareholders’ pain will not necessarily be transmitted 100% to the preferred shareholders.

However, Accrued Interest posted his latest thinking on the issue today – interestingly, his plan is very pref-favourable, and involves recapitalizing the GSEs to bank levels, although he does not explicitly support my desired outcome of turning them into banks, plain and simple. He notes:

Today both Fannie Mae and Freddie Mac management are meeting with Treasury officials. My take is that Treasury is setting a deadline for them to raise new capital before the Treasury acts.

As far as the common goes … well, the short interest is something fierce!

Marco Onado of Boccini University, Milan, writes a good review article in VoxEU regarding Bank Losses and Capital. He makes the points:

• Total assets grew much faster than the risk-weighted assets against which banks must hold capital – in other words, there is a good indication that European investment banks were “gaming the system”, by concentrating on assets with a low risk weight as defined by the Basel accords. At the same time, the Assets to Capital multiple of these players increased dramatically.
• The tangible component of equity decreased, which means that a part of the capital cushion was largely made of intangible assets deriving from the merger process within the banking system.
• new capital trails write-downs (i.e. the emergence of unexpected losses) by some $ 100 billion (See the IMF July Update to the Global Financial Stability Report)
• Much of the capital has been replaced with hybrid instruments (e.g., preferred shares and Innovative Tier 1 Capital), which has a lower equity content than the 100% equity content of the losses

Basically, he wants more regulation in future:

But regulators must face the hard truth, as Merrill Lynch did: “the credit crisis has destroyed the idea that unregulated financial markets always efficiently channel savings to the most promising investment projects”. This means that regulation must be thoroughly revised and capital adequacy rules must be strengthened

I must point out that his interpretation is logically fallacious. The failure of capital markets to achieve 100% efficiency does not imply that their level of efficiency can be increased by central planning. It could be – I’m willing to grant that much – I’ll listen to arguments! But it’s a non-sequiter.

PerpetualDiscounts had their second straight down-day on light volume.

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

Fannie and Freddie continue to be the focus of attention; Accrued Interest reminds us of an important point:

FRE and FNM preferreds are down another 20% or so today, threatening the $10 area on FRE Z. One trader told me he’s started to see bottom fishing here, which seems incredibly stupid to me. Bottom fishing can work as a strategy, but no one can put odds on whether the impending GSE nationalization will make preferred shareholders whole or not. This isn’t about financial analysis anymore.

Lacker just wants the damn things privatized:

Richmond Federal Reserve Bank President Jeffrey Lacker called for “demonstrably” privatizing Fannie Mae and Freddie Mac, becoming the first Fed official to publicly clash with the Bush administration’s strategy of keeping them as federally backed firms.

“I would prefer to see them credibly and demonstrably privatized,” Lacker said today in an interview with Bloomberg Television. He agreed with former Fed Chairman Alan Greenspan’s view that the two largest U.S. mortgage finance firms ought to be nationalized, then split up and sold off.

Amidst all this, there is speculation that Lehman will write off $4-billion this quarter and Naked Capitalism passes on reports that the Lehman delevering process continues:

From the New York Times

There has been widespread speculation that Lehman was contemplating a sale of Neuberger Berman, whose value is estimated by analysts to vary from less than $7 billion to as high as $13 billion (Lehman’s entire market capitalization is about $10.5 billion).

And here’s a report from the front lines:

“I’ve been at National City for 30 years and a month and for 29 of those we’ve seen nothing like it,” Thomas Richlovsky, National City’s 57-year-old treasurer, said in a telephone interview. “In past cycles certainly lending, or credit, has gotten more difficult. The cost of credit would go up. In this particular phenomenon of the last year it’s not like you can borrow money and the price went up. No, the market’s closed.”

National City on July 24 reported a $1.76 billion second- quarter loss and increased its 2008 forecast for uncollectible debt to as much as $2.9 billion. The Cleveland-based bank raised $7 billion of capital in April, which Richlovsky said is more than enough to weather the seizure in the credit markets.

The stock sale wasn’t enough to stop National City’s bonds from tumbling. Its $700 million of 6.875 percent notes due in 2019 traded last week at 61 cents on the dollar, down from 77.5 cents in June and 99 cents at the beginning of the year, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

The Ontario judgement on non-bank ABCP will be challenged by Ivanhoe, perhaps with others.

Amidst all this certainty, we can be glad that one thing in life is constant – there’s a lot of regulatory posturing on the US Auction rate market:

U.S. Securities and Exchange Commission Chairman Christopher Cox said investigations into the collapse of the auction-rate bond market extend beyond the banks that created the debt and settled with regulators to include brokerages that sold the investments.

“Nobody is getting a pass,” Cox said at a news conference in Washington today.
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Regulators should force Wall Street banks to buy back all the auction-rate securities they created instead of investigating brokers that sold the debt, the Washington-based Regional Bond Dealers Association said in a letter to the SEC and other regulators last week.
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Regulators focused first on the biggest underwriters, claiming they pitched securities as safe alternatives to money- market investments, even as the risk grew that the market would freeze.

Safe? What does “safe” mean? Are they talking about credit risk, liquidity risk, term risk, taxation risk, inflation risk, or one of the other million things that can go wrong? My view is that it should be treated in the same way as Canadian non-Bank ABCP should have been treated: brokers should be held liable for recommending overexposure to the asset class, but not for reasonable exposure. The credit was fine – and, as far as I know, remains fine (there are two exceptions to this generalization, I think). Liquidity … not so good.

However, consideration of more than one kind of risk – and genuine acceptance of the fact that black swans happen and all you can hope for is loss limitation by diversification – will make news reports longer than 500 words and involve a little judgement, so it won’t happen.

Amazingly, PerpetualDiscounts were weak today, losing 0.14% in their second down-day since July 16. From the close July 16 to the close today, they’ve gained 8.60%, with yields dropping from 6.63% to 6.13%. So … er … let me see … one month at 6.63% is about 0.55%, call it, so capital gain is 8.60-0.55 = call it 8% on a yield drop of 0.5% … the effective modified duration was about 16 years. Give or take. Remember, HIMIPref™ under-calculates modified duration (which is precisely 1/YTM) as a matter of computational and reporting convenience.

Today’s closing yield of 6.13% is equivalent to 8.58% interest at the standard conversion factor of 1.4x. Long Corporates currently yield a little under 6.1% … I think we can say the spread is maintaining itself around 250bp without anybody fussing too much. That used to be a long-term record!

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

Rumours swirled around Fannie and Freddie today, after a gloomy story in Barrons:

It is growing increasingly likely that the Treasury will recapitalize Fannie and Freddie in the months ahead on the taxpayer’s dime, availing itself of powers granted it under the new housing bill signed into law last month. Such a move almost certainly would wipe out existing holders of the agencies’ common stock, with preferred shareholders and even holders of the two entities’ $19 billion of subordinated debt also suffering losses.

Bloomberg’s rumours are more detailed:

Both Fannie and Freddie slid as much as 12 percent after Barron’s said government officials anticipate the companies will fail to raise the equity capital they need, prompting the U.S. Treasury to step in. Fannie is down 82 percent this year. Freddie has fallen 85 percent.
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A rescue would include preferred stock with a seniority, dividend preference and convertibility right that would wipe out common stockholders, Barron’s reported, citing an unidentified source in the Bush administration. Treasury Secretary Henry Paulson, who received the authority he requested from Congress to help the companies, has said a bailout won’t be needed.
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Standard & Poor’s cut Fannie and Freddie’s preferred stock and subordinated debt ratings by three levels last week to A- from AA-. S&P affirmed the companies’ AAA senior debt rating, reflecting perceived government support.

At the close, Accrued Interest made some good observations:

GSE securities of all types getting hit hard today. Interestingly, both the common and preferred shares are down ~20%. Sub debt some 200bps wider with poor liquidity.
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The ultimate problem here is best described by Merrill Lynch’s Ken Bruce. You can dive into Freddie Mac or Fannie Mae’s balance sheet and make a good case that they don’t need new capital, at least under current forecasts for housing. You’d therefore conclude that if they were a truly private company, they’d best serve shareholders by trying to stick it out. But they aren’t a truly private company. As the perception of their capital strength wanes, policy makers are going to conclude that we are better off nationalizing the GSEs.
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As for wiping out preferred shareholders… Remember that the big preferred shareholders are smaller banks. I don’t think it would make sense for the Administration to bolster one part of the banking system (Fannie and Freddie) at the expense of another part of the banking system (regional banks). And besides, I don’t think its necessary to protect tax-payers interests.
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The trade is to be long senior Agency debt. There is just no way the Treasury allows anything to happen to senior debt holders. I don’t know who is playing in sub notes or preferred shares in here. No amount of investment analysis is going to help you figure what the Treasury’s next move is.

There was some discussion of the Fannie and Freddie prefs on August 8.

There was a great graph published by the Cleveland Fed in a discussion of the Student Loans Market:

Note: The spread is the three-month LIBOR rate minus the three-month financial commercial paper rate.
Sources: The Board of Governors of the Federal Reserve System; Financial Times.

The enormous volatility seems much more illustrative to me of the credit crunch than the more usual graphs of enormous spread increases:

Sunlife issues did very well today – it would appear that nobody noticed they went ex-Dividend today. PerpetualDiscounts had yet another up-day today, but the total return index is still a fraction under the June 30 value of 877.24. The fact that there has been a gain of almost exactly 8.75% since the July 16 nadir – with only one down-day in that period – should really rub it in about just how bad the first half of July was!

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

James Hamilton of Econbrowser takes a brief look at the US Inflation numbers and concludes:

there is a clear need to net out the May-to-July energy price increase– it’s already been reversed. The US national average gas price is back to $3.78/gallon, right where it was in mid-May. Thus, even without any further drop in the price of gasoline– and personally, I do expect further drops– the 4-1/2% number is a better summary of where we stand right at the moment than 5-1/2%.

So no, I don’t think that yesterday’s CPI numbers will cause the Fed to panic. Because yesterday’s news is already way of out of date.

Stephen Foley of The Independent looks at the Fed/SEC turf battle (hat tip: Naked Capitalism):

But [SEC Chairman Christopher Cox] starts an important battle for the soul of US financial regulation several laps behind the Federal Reserve and opponents on Wall Street who see this as the perfect time to take a few teeth out of the SEC.

A blueprint for regulatory reform by Mr Paulson, which envisages the Fed as a super-regulator with only a narrow role for the SEC, was forged out of Wall Street’s frustration with SEC red tape and what investment banks complained was their diminishing competitive advantage over London. Britain, they argued, had a risk-based approach to regulation that was light-touch in day-to-day matters and only descended on institutions regarded as risking damage to the financial system. The SEC, with its raft of rules, would be wrapped into a much-diminished third-tier regulator responsible for protecting investors and market participants from fraud and market manipulation.

Now, I don’t want it to seem as if I’m defending the SEC and its regulatory approach – for one thing, I’m simply not familiar enough with the issues. But although there are some very good arguments to be made that central banks should combine the regulatory and lender of last resort functions, I’m not sure how well this works in practice. Particularly when applied to investment banking – which is supposed to be wilder and riskier than regular banking, by design! – this simply places too much power in the hands of a single agency. Many nations separate the regulatory and lending functions (Canada, to name but one) without huge problems; it seems to me that separation of function is Good.

After all, isn’t this what the regulators are always telling us about separation of function when they pontificate? Bookkeepers should not cut cheques. Internal Audit should not sell IPOs. And lenders should not be regulators.

We may, eventually, be getting towards the end of the ABCP legal saga:

Investors in the frozen $32-billion asset-backed commercial paper market will find out on Monday what will happen to the money they put into the troubled paper when an appeals court renders its decision.

The Ontario Court of Appeal says it will release its decision on the restructuring plan on Monday at 5 p.m. ET.
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An Ontario Superior Court judge accepted the plan, but the decision also left open a 21-day window for individual and corporate investors to file appeals on the case.

Several corporations with the paper filed appeals claiming that the plan wrongfully granted immunity from litigation to the banks, brokers and the rating agency involved in ABCP.
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The decision will be posted on the court’s website …

The Canadian Press reporter was good enough to note that the decision will be posted on the court’s website, but got the address wrong. The announcement is here.

PerpetualDiscounts continued their recovery today, but the total return index remains a hair below its level of June 30. The weighted average yield to maturity for these issues is currently 6.13%, compared to 6.07% on June 30 and a high of 6.63% on July 16.

The fund is doing quite well this month; trading volume has been quite heavy since mid-July (when chaos and confusion reigned unchallenged in the sector) and these relative-value trades are starting to pay off handsomely. How handsomely? I’d better keep my mouth shut, but I will say that I’m feeling a lot happier halfway through August than I was halfway through July!

Volume was light today.

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

Accrued Interest comments on the extraordinary new-issue concession for Citigroup 5-years:

The new issue was sold at a yield spread of 337.5bps over the 5-year Treasury. Prior to the announcement of the new issue, Citigroup’s 5.5% bond due in April 2013 was bid at +275.
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First, this is an extreme concession for a plain vanilla debt sale of a Aa3 rated bank. In 2006, the concession might have been 5 or 10bps at the most for a new issue. Alternatively, Baa-rated Deutsche Telecom recently brought a new 10-year issue, and the concession was around 15bps. This tells you that while there are buyers of Citigroup debt, they pretty much have to give it away.

Second, at a spread to Treasuries of +337.5, the deal has a very large negative basis to credit default swaps. This means that buyers of Citi bonds could also buy CDS and realize an arbitrage. Citi CDS closed Tuesday at 160bps and 5-year swap spreads closed at +98.5.

Meanwhile, in an incident that doesn’t have the credit rating agencies looking all that good, Bluepoint’s gone BK:

Wachovia Corp.’s BluePoint Re Ltd. unit, which insures structured finance and municipal transactions, filed for bankruptcy protection, citing defaults on securitized mortgages.

BluePoint filed a petition in Manhattan yesterday, saying it has more than $100 million in debt.
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Wachovia, the fourth-biggest U.S. bank, reported a $330 million charge in the second half of 2007 related to BluePoint’s losses on credit default swaps on collateralized debt obligations, or CDOs. BluePoint decided to liquidate after failing to negotiate a restructuring with banks including UBS AG that were counterparties to its swaps, according to court papers.
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BluePoint Re, the smallest reinsurer in the bond-insurance industry according to Moody’s Investors Service, had its credit rating cut 14 levels to Ca from A2 by the agency yesterday. Moody’s had lowered its rating two notches from Aa3 on July 11.

The only possible excuse I can find for such a swift downgrade is found in Moody’s press release:

In contrast to most other financial guarantors, BluePoint Re is much more exposed to liquidity risk in its CDS contracts due to payment and settlement terms, including market value termination rating triggers that take effect below the single-A rating level.

… but it doesn’t look good! S&P said:

it lowered its financial strength and financial enhancement ratings on BluePoint Re Ltd. to ‘R’ from ‘A’. An insurer rated ‘R’ is under regulatory supervision because of its financial condition.

According to a S&P request for comment, the lowest 3-year projected rating for an issue currently rated A is B:

Under the proposal, when assigning and monitoring ratings, we would consider whether we believe an issuer or security has a high likelihood of experiencing unusually large adverse changes in credit quality under conditions of moderate stress (for example, recessions of moderate severity, such as the U.S. recessions of 1960 and 1991 and the European recession of 1991 or appropriate sector-specific stress scenarios). In such cases, we would assign the issuer or security a lower rating than we would have otherwise.

I don’t like the proposal, by the way. I prefer a volatility modifier.

Yet another day of recovery for PerpetualDiscounts; their total return index has returned to above that of July 2, but still below the June 30 close. Average yield is 6.14%, equivalent to 8.60% interest (with the 1.4x equivalency factor), which is long corporates +250bp.

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