PrefBlog

Accrued Interest has reluctantly called a bottom in the credit markets:

But yeah, if you stick a gun to my head, I’d say we’ve seen the wides in credit spreads. Not because the economic problems are solved, but because liquidity has improved to the point that people are willing to be opportunistic. That will put a lid on how far investment-grade names will move before yield hungry investors come in. Issuers will be able to come to market with new issues, and the wheels of the credit market will continue to churn.

Meanwhile, today is the day that the CBOT officially attempts to find out why the basis on grain futures isn’t going to zero during the delivery period, as mentioned April 17. Naked Capitalism republishes a NYT article on the issue which suggests:

Mr. Grieder’s crop insurance premiums rise with the volatility. So does the cost of trading in options, which is the financial tool he has used to hedge against falling prices. Some grain elevators are coping with the volatility and hedging problems by refusing to buy crops in advance, foreclosing the most common way farmers lock in prices.
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Futures, for example, are less reliable. They work as a hedge only if they fall due at a price that roughly matches prices in the cash market, where the grain is actually sold. Increasingly — for disputed reasons — grain futures are expiring at prices well above the cash-market price.

When that happens, farmers or elevator owners wind up owing more on their futures hedge than the crops are worth in the cash market.
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John Fletcher, a grain elevator operator in Marshall, Mo., started pressing the C.B.O.T. to address the flaws of futures contracts almost two years ago — even before his futures hedge on a million bushels of soybeans failed to fully protect him last September, hitting him with a cash loss of $940,000.
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Frustrated over the flawed futures contract, Mr. Fletcher is voting with his feet. Last year, he entered into a contract with A.I.G. Financial Products, a leading sponsor of commodity index funds, which allows him and the index fund to hedge their risks without using the C.B.O.T.

Instead of using futures or options, A.I.G. simply buys the commodity directly from Mr. Fletcher, who stores it for a fee and buys it back six months later. His storage fee is lower than the one built into the C.B.O.T. contract, so A.I.G. pays less for its stake in the market. And he has a hedge he can rely on.

In a strong indication that Canadian banks are using their strong balance sheets to sniff around in the States, BMO has announced:

a definitive agreement today to acquire Chicago-based Griffin, Kubik, Stephens & Thompson Inc. (GKST). The acquisition will make BMO Capital Markets the sixth-largest bank qualified municipal bond dealer in the United States and the largest in Illinois, greatly accelerating BMO’s national presence in the municipal bond market.

Good for them! It would appear that the BNS / National City rumours discussed on April 11 have come to nothing:

Cleveland-based National City, Ohio’s biggest bank, agreed yesterday to sell a $7 billion stake to a group led by Corsair Capital LLC.
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National City agreed to sell the Corsair stake at a discount to market price, and increased the size of the offering after finding strong demand. The move, which may dilute existing shareholders by more than 50 percent, sent the stock plummeting almost 28 percent and drew complaints from investors who asked during a conference call whether there wasn’t “a more palatable alternative.”

The bank had to raise enough capital “to stabilize our debt ratings, beyond a shadow of a doubt,” National City Chief Executive Officer Peter Raskind responded, citing speculation about the bank’s condition. “We had counterparties who were uncomfortable interacting with us. That had to stop.”

Royal Bank of Scotland is also raising capital:

Royal Bank of Scotland Group Plc, the U.K. lender reeling from asset writedowns, will sell 12 billion pounds ($24 billion) of shares to investors in Europe’s largest rights offer and cut the dividend.
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RBS plans to raise its Tier 1 capital ratio, a measure of capital strength, to more than 8 percent from 7.3 percent and the core equity Tier 1 ratio to more than 6 percent from 4.5 percent by the end of the year, the bank said.

Good for them for doing it by a rights offering! It’s much fairer to existing investors, although I suppose it’s a little more expensive and slower.

Merrill has also joined the parade:

Merrill Lynch & Co., the third- biggest U.S. securities firm, plans to raise at least $7.3 billion by selling bonds and preferred shares after writing down the value of $6.5 billion of assets.

The firm today began offering $7 billion of senior unsecured notes in its biggest debt offering, luring investors with yields over Treasuries that would be as much as triple what it paid a year ago. Merrill is also selling at least $300 million of perpetual preferred shares that yield about 8.625 percent.

It should be noted, however, that the $7-billion headline number addresses liquidity issues, not equity; the preferred share issue is picayune.

I must say, it’s very pleasant for a fixed income guy to see the equity crowd get hit for a change. The last ten years have been all too often in the other direction.

There might be some adjustment to Regulation FD in the future – this is the source of National Policy 51-201, which states that Credit Rating Agencies may have access to material non-public information. Chairman Cox of the SEC said in testimony to the Senate Banking Committee:

To enhance transparency, the Commission may soon consider new rules that would require the disclosure of information about the assets underlying the mortgage-backed securities, CDOs, and other types of structured finance products they rate. This would allow market participants to better analyze the assets underlying structured securities, and reach their own conclusions about their creditworthiness. This data availability could particularly benefit subscriber-based NRSROs, who could use it to perform independent assessments of the validity of the ratings by their competitors who use the “issuer pays” model.

Further improvements in transparency could be considered in the form of enhanced disclosures about how NRSROs determine their ratings for structured products. This disclosure could include the manner of analysis of the mortgages’ conformance with underwriting standards, and the firms’ procedures for monitoring their current credit ratings.

The Commission may also consider rules requiring the disclosure of ratings information in a way that makes it possible for investors to readily distinguish among ratings for different types of securities, such as structured products, corporate securities, and municipal securities.

This is rather convoluted, frankly. The ratings agencies don’t release material non-public data because it’s non-public. The company or issuer makes the decision (subject to the SEC’s disclosure rules) regarding what’s public and what ain’t. All I can imagine is that the intended purpose of the rules the SEC is considering is to get disclosure by the back door … for one reason or another, the issuer can’t (or won’t) be forced by the SEC to disclose data, but the NRSRO’s will be … thus, if the information is to be kept out of the public domain, the company will have to forgo a NRSRO credit rating, which will (presumably) make the issue a much harder sell. If anybody has a better explanation, say so in the comments!

Following the BoC’s easing to 3.00% overnight rate, TD was the first major to cut Prime, although they were behind CCDQ. The second major was RY, followed by BMO, then BNS.

Another poor day for preferred shares, as PerpetualDiscounts are now yielding 5.73%, interest equivalent (at 1.4x) of 8.02%. Given that long corporates now yield about 6.1%, this represents spread maintenance against the competition.

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

Slowly, slowly, loans are coming off the banks’ books:

Carlyle Group, the world’s second largest private-equity firm, is raising a $500 million collateralized loan obligation to buy high-risk, high-yield debt being sold by banks at discounted prices, according to people with knowledge of the plan.

The CLO is being arranged by Deutsche Bank AG, said the people, who declined to be identified because the terms aren’t public. The fund follows a similar $450 million CLO that Carlyle and JPMorgan Chase & Co. closed this month.

Carlyle, the Washington-based buyout firm run by David Rubenstein, joins Blackstone Group LP and Apollo Management LP in purchasing loans from banks that have struggled to offload the debt after losses on securities tied to subprime mortgages caused investors to shun all except the safest of government bonds. Private-equity firms are emerging as buyers at a time when financial institutions from Goldman Sachs Group Inc. to Citigroup Inc. are willing to sell the loans for as little as 63 cents on the dollar.

Royal Bank of Scotland is doing the same:

Royal Bank of Scotland Group Plc, the U.K.’s second-biggest lender, plans to start a fund to transfer the risk of losses from 1.5 billion euros ($2.3 billion) of high-yield loans, according to three people with knowledge of the proposal.

The fund will earn a return for investors by selling contracts to RBS that protect the bank from losses on 15 loans in euros and pounds and a further six in dollars, said the people who declined to be identified because the discussions are private.

And hedge funds are still pulling in money! I’m certainly not about to declare the credit crunch over, but this is a good sign:

Some investors expect the current credit crisis will create opportunities for managers who trade distressed bonds and loans. Such funds attracted $8 billion in the quarter. Investors allocated $8.2 billion to equity hedge funds and $6.5 billion relative-value strategies, which try to profit from price discrepancies between securities.

The biggest outflows in the quarter were from funds that trade the securities of companies going through mergers, which lost a net $4 billion. Investors pulled $1 billion out of macro funds, which chase macroeconomic trends by trading stocks, bonds, currencies and commodities. The funds were the best performers in the first quarter, rising 4.7 percent.

In a further sign that the banks are serious about repairing their balance sheets, Citigroup is issuing $6-billion hybrids, although it’s not entirely clear to me whether these are prefs or Innovative Tier 1 Capital, as if there’s any difference anyway:

Citigroup Inc., the biggest U.S. bank by assets, plans to sell $6 billion of hybrid securities to bolster its balance sheet after reporting almost $16 billion in writedowns.

The perpetual, preferred shares may pay a fixed rate of 8.4 percent for 10 years, according to a person who declined to be named because terms aren’t set. If not called, the debt will then begin to float, the person said.

This follows hard on the heels of JPMorgan’s monster deal. How much is enough, already? The Reuters tally grows daily:

Financial companies around the globe have scrambled to raise capital to offset massive write-offs. Below are the 15 largest capital infusions announced by financial institutions since the credit crisis began, totaling more than $150 billion.

The Bank of England is going forward with the bond lending programme discussed briefly on April 17 … it is, in fact, a bond LENDING programme, with quite rational terms:

The measures, backed by Prime Minister Gordon Brown’s government, mimic a swap of $200 billion of securities by the U.S. Federal Reserve last month as central banks around the world struggle to prop up financial markets.
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Financial institutions will retain responsibility for losses from the assets they loan to the Bank of England. The swaps will be for a period of one year, renewable for up to three years. Only assets existing at the end of 2007 can be used in the swap.

The Bank of England won’t announce how much money has been tapped until the borrowing window closes in six months.
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Assistance will come at a price. Banks will have to pay a borrowing fee to participate in the plan and the value of the securities they receive will be less than that of the mortgage- backed bonds they hand over to the Bank of England.

“The Bank of England’s actions do seem to be quite punitive,” said James Nixon, a director of Societe Generale SA in London. “The sense yet again from the Bank of England is that it will provide an absolute backstop to the financial system, but won’t make any effort to ease the market’s liquidity.”

The market fell – probably in response to the RY new issue as the RY issues were conspicuous by the presence in the list of poor performers … several issues lost just less than the 1% loss qualifying for mention on the list. Volume was average, as far as recent history goes.

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

Willem Buiter writes a gloomy piece on financial activity, If it’s broke, fix it, but how?. Hat tip to Naked Capitalism, who commented on the piece … but quite frankly, NC’s commentary can’t be taken seriously:

3. Prohibit Level 3 assets; allow only Level 1 and strictly defined and audited Level 2 assets. This means regulators will not have anything overly arcane to assess; they ought to be able to get a clear picture of risks, processes, and exposures if they are dogged.

4. Prohibit these regulated institutions from lending, providing other funding, or investing in concerns that have Level 3 assets

This is the sort of populist nonsense that betrays complete lack of understanding of the issue. In the first place bonds of virtually all kinds are Level 2 assets – even off-the-run government bonds are marked off half a dozen or so benchmarks. A liquid corporate issue might trade a few times a week – and every time (other than in the highly liquid distribution phase) it will be done at a ballpark guess of a spread to governments (by “ballpark guess”, I mean “what the trader thinks he can get away with”). Things like municipals in the States … well, have a gander at what Accrued Interest had to say on the issue.

Level 3 assets? Let’s talk about preferred shares, just for a moment, to lend some credence to the idea that this blog is about prefs. Say I have to value an issue that has something approximating a current coupon … maybe the new NA issue, for instance. If I price NA.PR.M based on the yield of the two other prefs from this issuer, then it’s a level 2 asset. However, this is a really bad mark – it makes no allowance for convexity. If, however, I adjust the “static”, level 2 price in any way to account for the “dynamic” effect of convexity, then my poor little NA.PR.M become level 3 assets … “convexity” is not an observable input.

One may well wish to impose a regime on regulated capital that allows the firm to assign a range to the unobservable inputs and have them use whichever end of the range is least favourable when valuing their securities for regulatory purposes. One may well wish to increase the capital requirements for level 2 and level 3 assets. But to speak of strict controls and prohibitions is simply a sign of hysteria.

Anyway, back to Prof. Buiter. He leads with an assertion that we have achieved the worst of two worlds:

I believe that the Western model of financial capitalism – a convex combination of relationships-based financial capitalism and transactions-based financial capitalism – has, in its most recent manifestations (those developed since the great liberalisations of the 1980s), managed to enhance the worst features of these two ideal-types and to suppress the best.

These worlds are defined as:

Transactions-based financial capitalism emphasizes arms-length relationships mediated through markets (preferably competitive ones), is strong on flexibility, encourages risk-trading, entry, exit and innovation. It is lousy at endogenous commitment: reputation and trust are not a natural by-product of arms-length relationships. Commitment requires external, third-party enforcement.

Relationships-based financial capitalism emphasizes long-term relationships and commitment. It has, however, compensating weaknesses. Investing time and other resources in building up relationships with customers creates an insider-outsider divide that is very difficult to overcome for new entrants. It also encourages, through the interlocking directorates of the CEOs and Chairmen (seldom women) of financial and non-financial corporations, a cosy coterie of old boys for whom competitive behaviour soon no longer comes naturally. At its worst, it becomes cronyism of the kind that was one of the key ingredients in the Asian crisis of 1997.

I think I will be referring to these definitions a lot in the future! Relationships-based financial capitalism describes the standard business model of a stockbroker or retail-level financial advisor. Transactions-based financial capitalism describes the standard business model of an asset manager. But remember – these are my characterizations, not Dr. Buiter’s.

Importantly, virtually everybody will claim that they want and need the latter, but most retail (and a hefty chunk of institutional) clients will go for the former when it comes time to sign a cheque.

So … now we’ve defined some terms, what’s the problem?

It is clear where the problems are. In the past 20 yearns, the financial sector has, starting as a useful provider of intermediation services, grown like topsy to become an uncontrolled, and at times out-of-control, effectively unregulated, hydra-headed owner of licenses to print money for a small number of beneficiaries. The sources of much of these profits turned out to be either a succession of bubbles or Ponzi schemes, or the pricing of assets based on the belief that risk disappeared by trading it. This belief that there is a black hole in the middle of the financial universe that will attract, absorb and annihilate risk if the risk it packaged sufficiently attractive and sold a sufficient number of times is closely related to the firm conviction of every trader I have ever met, that he or she can systematically beat the market. The fact that all traders together are the market did not constrain these beliefs.

This is a rather breathtaking condemnation and, quite frankly, I do not find much support for these assertions in the text. I can hypothesize, however, using the assumption that the explanation of the huge amount of CDO assets on the Merrill Lynch books (discussed on April 16) is correct (and making a few interpretations). In this case, we would say that the CDO-syndicator is using the worst of the transactions model: he didn’t care about the firm, as long as he could get the stuff off his books and onto the trader’s books. The trader, bullied into inventorying paper he didn’t think he could sell, agreed to the deal due to relationships model: he was making good money as a Merrill trader, and refusing the urgent request of the big powerful syndicator could jeopordize his position. If this is the case, it reflects a failure on the part of Merrill’s management to ensure that such asymmetric viewpoints are minimized.

Could it be true? Well, it’s plausible. And I like it a whole lot more than the everybody-is-stupid-except-me model.

Naturally, the first thing that comes to mind after Dr. Buiter’s assessment of the industry is MORE RULES!

It would be part of the solution if we could find and keep the right regulators and design and implement the right regulations.

… which immediately runs into the problem …

regulators involved in intrusive and hands-on regulation are virtually guaranteed to be captured by the industry they are meant to be regulating and supervising. This regulatory capture need not take the form of unethical, corrupt or venal behaviour by the regulators or members of the private financial sector. It could instead be an example of what I have called cognitive regulatory capture, where the regulator absorbs the culture, norms, hopes, fears and world-view of those whom he regulates.

Sure. Especially with revolving-door regulation being such a popular model. There is another problem:

regulators will serve their own parochial, personal and sectional interests as much as or even instead of the public good they are meant to serve. No bank regulator wants a bank to fail on his or her watch. As a result, either excessively conservative behaviour will be imposed by the regulator on the regulated bank or other financial intermediary (ofi), that is, we will have if-it-moves-stop-it-regulation, or the regulator will mount an unjustified bail out when, despite the regulator’s best efforts at preventing any kind of risk from being taken on by the regulated entity, insolvency threatens.

This is especially the case if, for instance, one takes the editorial stance of the Globe and Mail seriously. They decided that Canadian ABCP was a problem indicative of a failure of regulation, then decided that since OSFI is a regulator, they are at fault. This started with misrepresentation of a speech and continues with wild charges of loopholes, as mentioned on April 11. Despite the fact that you don’t really need more than a handful of functional brain cells to dismiss the charges as nonsense, these gross distortions can’t be a lot of fun for a regulator to endure, and will lead Our Beloved Government to impose MORE RULES!

Anyway, Prof. Buiter has the intellectual honesty to admit:

I don’t know the solution to this conundrum.

I suggest, as I have suggested before, that regulations need tweaking. So the off-balance-sheet vehicles weren’t as off-balance-sheet as they might have been? Make the sponsors consolidate them for regulatory capital purposes if they are intimately involved in the vehicle – e.g., by being the selling agents of the SIV’s paper, or having their name on the fund, or by getting miscellaneous fees from the SIV. Allow a reduced hit due to first loss protection. Lots of details will emerge through discussion. If they’re sponsoring a money market fund (same thing, opposite direction), they should take a charge. It would seem that rules on the assets to capital multiple need to be reviewed, since a lot of the problem was the zero risk weight assigned to synthetic-AAAs by the regulatory authorities.

And for heaven’s sake, let’s approach regulation with the idea that the objective is to mitigate and contain harm, not to eliminate it. How many times must I repeat? Risk is Risky!

When will people learn? You can’t regulate fear and greed. Ask a Chinese or Russian pensioner how well that idea works out! As long as we have fear and greed, we will have booms and busts. And as long as we have stupidity, we will have people being hurt – sometimes badly – through over-exposure to a single class of risk.

From the oh-hell-I’ve-run-out-of-time-here’s-some-links Department comes a speech by David Einhorn of GreenLight Capital, referenced by another blog. Einhorn is always thoughtful and entertaining, although it must be remembered that at all times he is talking his book. The problem with the current speech is that there is not enough detail – for instance, he equates Carlyle’s leverage of 30:1 which was based on GSE paper held naked with brokerages leverage, which is (er, I meant to say “should be”, of course!) hedged – to a greater or lesser degree, depending upon the institution’s committment to moderately sane risk management. But there are some interesting nuggets in the speech that offer food for thought.

Accrued Interest speculates that European credit strains make short-dollar a risky trade:

So rising Libor may say more about tight liquidity in Europe than in the U.S. A combination of tough liquidity in Europe and among smaller banks would explain the divergence between CDS spreads and Libor spreads.

To me, this sends two cautions. First, it should remind anyone who thinks the liquidity crunch is over, that it ain’t. Liquidity does seem to be improving in the U.S. bond market, which is a very positive sign. So maybe the worst case scenario has been taken out. But this will be a long process.

Second, it should caution those who are short the dollar. If the next phase of the credit crunch hits Europe as hard as it hits the U.S., then we may see the Bank of England and the European Central Bank get more aggressive with rate cuts.

Barclays PLC disagrees. Takes two to make a market!

No real direction in the preferred share market today – and not much individual issue price volatility either. Volume returned to levels that are normal for now, but would have been labelled light last year.

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