PrefBlog

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

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

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

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

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

Update, 2007-09-07

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The author does not believe a US recession is imminent.

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

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

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

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

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

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

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

The losers will be replaced:

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

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

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

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

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

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

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

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

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

Update, 2007-09-07

Well, I’ll tell everybody straight off: there ain’t no indices being published today. I don’t have time; I’ll have to update tomorrow.

Bush’s profferred help for hapless homeowners is attracting considerable comment. Willem Buiter takes the view that “A rate cut is unnecessary. Congress will swiftly augment the Bush bail-out, adding a fiscal stimulus worth, say, 0.5% of GDP. The anticipation of relief on both the fiscal and monetary side is likely to be enough to normalise credit conditions.” Most importantly:

By subsidising excessive and imprudent borrowing, it reinforces the moral hazard faced in the future by low and middle income Americans pondering the size of the mortgage they can enforce (if the market-friendly President Bush is willing to bail us out today, would a more market-sceptical President Barack Obama or President Hilary Clinton not do so again tomorrow?)
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There is a reasonable prospect that Federal legislation and Federal regulation and supervision of the housing finance industry will be changed in such a way as to reduce the likelihood of the excesses, the mis-selling and the misrepresentations that became rampant especially during the past 5 years or so.
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It is, unfortunately, quite likely, that the legislative and regulatory changes we will get will amount to a Sarbanes-Oxley-style regulatory overshoot, that is, regulation of the ‘if it moves, stop it’ variety. This will discourage future lending to low-income or credit-impaired would-be homeowners even when such lending is fundamentally sound.

Tom Graff also worries about the moral hazard issues.

Meanwhile, at the Jackson Hole conference, sub-prime and related issues continued to be front and centre. Professor Hamilton of Econbrowser argues, in effect, that moral hazard has already happened; that the Government Sponsored Enterprises (GSEs) in the States that guarantee mortgages are woefully undercapitalized and are viable only due to an implicit government guarantee.

While I think that preserving the solvency of the GSEs is a legitimate goal for policy, it is equally clear to me that the correct instrument with which to achieve this goal is not the manipulation of short-term interest rates, but instead stronger regulatory supervision of the type sought by OFHEO Director James Lockhart, specifically, controlling the rate of growth of the GSEs’ assets and liabilities, and making sure the net equity is sufficient to ensure that it’s the owners, and not the rest of us, who are absorbing any risks. So here’s my key recommendation– any insitution that is deemed to be “too big to fail” should be subject to capital controls that assure an adequate net equity cushion.
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It also might be useful to revisit whether Fed regulations themselves may be contributing to this misinformation. Frame and Scott (2007) report that U.S. depository institutions face a 4% capital-to-assets requirement for mortgages held outright but only a 1.6% requirement for AA-rated mortgage-backed securities, which seems to me to reflect the (in my opinion mistaken) assumption that cross-sectional heterogeneity is currently the principal source of risk for mortgage repayment.

A tax on GSE mortgages has been proposed, but I’ll need a bit more convincing on that matter! I like the regulation of capital better – it fits into the existing regulatory framework in a better way, allowing for more efficient use of capital. 

Professor Taylor – of Taylor-rule fame – argues instead that the culprit is loose Fed policy in the 2003-05 period. He was supported by Martin Feldstein, who feels the Fed should act more proactively on asset bubbles – such as, it is now clear, US housing – on the grounds that the rewards for correctly identifying an asset bubble in real time outweigh the risks of being wrong. This has very immediate implications for the correct Fed response to a housing-led slowdown: should the Fed assume the worst, and avoid a recession at the risk of easing too much, or should it react to data from the real economy as it arrives? After all, there has been minimal indication of damage in the manufacturing sector, but there are some indications consumers are running scared.

It certainly sounds as if the conference was fraught with interest! The basic debate can be cast as:

“Rick is basically saying, ‘We can’t lean, but we can clean up,”’ White said, referring to Mishkin by name and raising his voice to make his point. “I think we can make equally strong arguments for `You can lean and you may not be able to clean up.”’

For now, count me among the ‘wait for data to come in’ and ‘regulate capital usage of the GSEs’ camps. For now.

There has been plenty of damage to economic sectors closer to the epicentre of the financequake. Novastar is cutting back sharply on new loans and is desperately trying to survive on its servicing income. This role may achieve higher prominence (and fees, undoubtedly) now that regulators are urging loan workouts. First Data, a junk credit, is going to have to pay through the nose for loans.

Brad Setser continues his attempt to understand China’s USD holdings … an interesting and potentially lucrative specialty! The Chinese have not yet weighed in regarding Credit Rating Agency regulation, but Josh Rosner has. This last one is interesting because it’s the first balanced (which is to say, non-hysterical) approach to the topic I’ve seen. Mr. Rosner wants the following reforms (bolded; my comments in italics):

• ratings for structured securities use a different scale—say, numbers instead of letters—to differentiate them from ratings for corporate and municipal bonds. Cosmetic. Possibly useful if it can be shown that such securities have a genuinely different risk/reward profile than regular bonds, but it raises the spectre of different scales for each sector of the economy.
• He believes the agencies need to step up the training for analysts Training is a motherhood issue. Every time there’s a train wreck, we hear more calls for increased training of engine drivers. I’m OK with requiring some kind of registration for credit analysts, but (having fulfilled my regulatory educational requirements) I’m extremely dubious about the potential for this having much value.
• and should be compelled to re-rate transactions regularly rather than monitor them haphazardly. “Haphazardly” is rather a loaded word and I’d like to see more details about why it was chosen. This strikes me as micro-management.
• Furthermore, he thinks efforts should be made to distance the agencies from Wall Street. He proposes that any ­ratings-agency employee involved with a structured-finance deal for a Wall Street firm should have to wait a year before being able to join that firm. Such a waiting period already exists for auditors. No, no, a thousand times no! In the first place, acting as a credit analyst is simply an advisory function; there is no legal force to the analysts’ work. I definitely support such rules for employees of regulators – they have all the power of the State behind them when they exercise their function – but to extend this to credit analysts is going too far. They are advisors, only advisors, and should not be subject to employment restrictions that are any more stringent than those that exist for other advisors.

Redemption demands have led one fund to close, but the managers are now trying to put together a vulture fund. An internal Deutsche Bank unit is being shut down. And so the wheel spins…

US equities had a great day on speculation the Fed will cut two notches to 4.75% at their next meeting; Canadas were also strong on hopes fears that hurricanes in the Gulf will be destructive.

It was a quiet day for Treasuries, with some steepening; Canadas followed.

I hope to update the indices, performance and volume tables tomorrow.

Update, 2007-09-07

A rousing day in the markets to cap a tumultuous month!

There will be some kind of assistance – not a bailout, honest – for delinquent mortgagees:

Under Bush’s plan, the FHA during the fiscal year beginning Oct. 1 would help in 80,000 more refinancings than under current programs, FHA Commissioner Brian Montgomery said in a conference call with reporters. The agency plans to help 240,000 homeowners refinance during the period, compared to about 100,000 during the fiscal year ending Sept. 30, he said. FHA intends to increase refinancings to more than 600,000 within the next three years.
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In the first quarter of this year, the FHA serviced about 3 million mortgages, 12 percent of which were delinquent or in foreclosure. Nationwide, the Washington-based Mortgage Bankers Association reported about 44 million mortgages in existence with an overall delinquency rate of 4.8 percent.

I’ll admit, I’m not entirely sure how much difference this will make … but one can be sure that the Democrats will find some way of trumping it as the Primary and Presidential cycle continues.

At the conference at Jackson Hole, Bernanke made it clear that the Fed would give some kind of assistance – not a bail-out, honest – to the financial system:

“The Federal Reserve stands ready to take additional actions as needed to provide liquidity and promote the orderly functioning of markets,” Bernanke said. He also made clear he won’t rescue investors from bad decisions.

Bloomberg has published the full text of the speech, complete with references. The WSJ has published some reactions to the remarks. In the meantime, inflation news is also good which may provide a veneer of respectability to a rate cut at the next FOMC meeting.

James Hamilton at Econbrowser has reported on the conference but, in my mind, was trumped by one of the commenters, a reader with the sobriquet “Constantine”:

If memory serves, the 1st edition of Shiller’s Irrational Exuberance came out in March 2000. The 2nd edition with expanded coverage of the housing market followed in 2005.

As soon I get word of a 3rd edition going to press, I’m going to fuckin’ liquidate everything I own.

Thanks, Constantine! It’s been a long month – I needed that.

The WSJ is reporting on the conference and has provided more detailed reviews of today’s papers: Should the Fed Target Housing; The Tension between Traditional Economics and Bubbles; and After the Mortgage Revolution the Terror – the last of which highlighting the authors’ view that:

the revolution has still been positive: “mortgage markets that are linked to capital markets are better for consumers and investors, than mortgage systems where the price and allocation of mortgages is determined by the government.”

Thank heavens … it hasn’t been often lately that I’ve seen an endorsement of the free market. I was also heartened to see that The Economist and I are in agreement:

But what look like incredibly sophisticated strategies on the surface can still be very simple at heart. Investors have been doing what banks have done over the centuries, borrowing short and lending long. Or, to put it another way, they have borrowed in liquid form and invested the proceeds in illiquid assets.

They also provide a link to what looks – at a very quick glance – to be a fascinating paper:Market Liquidity and Funding Liquidity, which I may review here … sometime …

Creative destruction in the mortgage business is continuing:

Citigroup Inc., the largest U.S. bank, agreed to buy the wholesale mortgage origination and servicing businesses of ACC Capital Holdings, operator of Ameriquest Mortgage Company and once the nation’s biggest subprime home lender.

Truly, one of the greatest pleasures in life must be access to cash in a buyers’ market!

US equities rose to the point where they were actually up on the month – which I will admit I find shocking. I’m glad, sometimes, that I’m not an equity guy. Canadian equities also rose but are down on the month.

Treasuries finished August’s wild ride with an upwards shift of 4-5 bp, but the big story is the month’s massive steepening of about 18bp.  Will it continue or reverse? Place yer bets, gents, place yer bets … the wheel spins again starting Tuesday.

Mutual funds’ retail cash flows show a move into junk bonds and a slackening of the move out of investment-grade. together with the equity data, it would appear that greed is beginning to triumph over fear!

It was another light day for preferreds – there seems to be some interest in BAM.PR.N at the current price, since it has been in the volume leaders table very often lately.

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