Miscellaneous News

Tax Status of CPD Distribution

The Internet is aflame with queries about the tax status of the CPD distribution!

Even Financial Webring Forum members have taken time out from their busy schedule of complaining about how useless and expensive investment advice is to ask for investment advice (note to LTR of FWF: I don’t mean anything by that personally. I just think the concept is funny.)

So, because I am such an incredibly nice person, because I like to help out competitors who can’t be bothered to post a simple one pager on their website for the benefit of their clients, and mainly because I’m hoping that the goodwill thus earned will generate a flood of subscriptions to PrefLetter (or, even better, to the fund I manage in competition with CPD), I’ll take a stab at explaining the situation.

We must organize our materials: first the Claymore Tax Information Guide, which confirms that, of the distributions in 2007, $0.3682 was dividends and $0.2720 was return of capital. It is this “return of capital” that is causing consternation. There is some concern that the capital of the fund is being eroded; but, subject to the explanation from Claymore being accurate and there being no silly bookkeeping errors, this is not the case.

Second, we look at Claymore’s explanation (via FWF; since the post is verbatim, from a reliable poster and makes sense, I’ll accept it):

CPD does not and did not pay any distributions above its cash flow. The yield is exactly the yield on the underlying portfolio, less MER. The ROC component of the distributions is due to the structural timing of asset inflows. During the 2007, the fund saw strong asset inflows. When we get a new “creation of units” the fund’s Designated Brokers (DB’s) give the fund the basket of preferred shares, plus any cash in the portfolio from dividends paid on the Prefs since last distribution. The cash received is not allocated as “dividends paid” but rather just cash. So from an accounting perspective, this means the cash is then treated as ROC when we pay it out, even though it represents dividends paid on Pref.

Example would be $1 mm Pref. You received $10,000 in dividends on Monday. So you now have $1.01 mm in portfolio. The next day the DB buys into the fund buy delivering $1mm of Pref position, plus $10k cash. So portfolio is now $2.02 mm, with double shares outstanding.

We pay out the earned yield on portfolio of $20k to shareholders, 50% would be treated as dividends earned on portfolio, 50% treated as ROC. But 100% is actual yield.

Hope this helps clarify this. Please feel free to pass along to the blog sites discussing this. If you have any further questions, please don’t hesitate to call us or ask.

It would appear that the explanation has something to do with the creation of units … so we’ll dig up the prospectus to see how that works:

For each Prescribed Number of Units issued, a Designated Broker or Underwriter must deliver payment consisting of, in the Manager’s discretion, (i) one Basket of Securities and cash in an amount sufficient so that the value of the securities and the cash received is equal to the NAV of the Units next determined following the receipt of the subscription order; (ii) cash in an amount equal to the NAV of the Units next determined following the receipt of the subscription order; or (iii) a combination of securities and cash, as determined by the Manager, in an amount sufficient so that the value of the securities and cash received is equal to the NAV of the Units next determined following the receipt of the subscription order.

And we’ll have a look at the current basket of securities. We note that the CPD, as of 2008-4-10, had a cash component of $0.084735, representing roughly 0.48% of its NAV.

First, let’s make some simplifying assumptions: we’ll assume that there is one issue held in the fund, priced at $25 on every ex-dividend date and paying $0.25 every quarter.

At the start of the cycle, we’ll assume the fund balance sheet looks like this::

Balance Sheet after fund payout
Item Asset Liability
Cash $0.00  
Securities $25.00  
Due to Shareholders   $0.00
Shareholders’ Equity   $25.00

Just before the underlying goes ex-dividend, the fund position is

Balance Sheet before underlying Dividend
Item Asset Liability
Cash $0.00  
Securities $25.25  
Due to Shareholders   $0.00
Shareholders’ Equity   $25.25

Next, the underlying security pays its $0.25 dividend and the price drops correspondingly:

Balance Sheet after underlying Dividend
Item Asset Liability
Cash $0.25  
Securities $25.00  
Due to Shareholders   $0.00
Shareholders’ Equity   $25.25

Next, a week or two later, the fund declares its dividend:

Balance Sheet after fund dividend declared
but before payout
Item Asset Liability
Cash $0.25  
Securities $25.00  
Due to Shareholders   $0.25
Shareholders’ Equity   $25.00

And then pays it out:

Balance Sheet after fund payout
Item Asset Liability
Cash $0.00  
Securities $25.00  
Due to Shareholders   $0.00
Shareholders’ Equity   $25.00

Which is back where we started, but the fund has paid its unitholders $0.25 dividend in the course of the cycle. The income statement for the fund looks like this:

Income Statment
Dividends Received $0.25
Dividends Paid ($0.25)
Fund Profit $0.00

The complicating factor is clients. Damn clients! This would be such a great business if there weren’t any damn clients! For our purposes, a “client” of the fund is a major broker, who can create and destroy units by delivering the underlying security. More particularly, for our purposes, we’ll assume that units have been created AFTER the underlying security has paid its dividend but BEFORE the fund has paid its dividend. In other words, we start here:
:

Balance Sheet after underlying dividend
before fund payout
Item Asset Liability
Cash $0.25  
Securities $25.00  
Due to Shareholders   $0.00
Shareholders’ Equity   $25.25

So the broker comes to the fund and says “Yo! What do I have to deliver for you to give me a unit?”. After a look at the books, the manager says “One share of the underlying and $0.25 cash.”. So this happens and then the books look like this:
:

Balance Sheet after unit creation
Item Asset Liability
Cash $0.50  
Securities $50.00  
Due to Shareholders   $0.00
Shareholders’ Equity
two shares!		   $50.50

and the income statement looks like this (pay attention, this is important):

Income Statment
Dividends Received $0.25
Dividends Paid $0.00
Fund Profit $0.25

The fund wants to pay out sufficient dividends to its shareholders that it is not liable for any tax – in fact, the prospectus makes this committment:

On an annual basis, each Claymore ETF will ensure that all of its income (including income received from special dividends on securities held by that Claymore ETF) and net realized capital gains have been distributed to Unitholders to such an extent that the Claymore ETF will not be liable for ordinary income tax thereon.

So how much should it pay? Should it pay out the precise $0.25 received? Then the balance sheet will look like this::

Balance Sheet after unit creation
and dividend payout of $0.25
Item Asset Liability
Cash $0.25  
Securities $50.00  
Due to Shareholders   $0.00
Shareholders’ Equity
two shares!		   $50.25

In such a case, three things have happened:

  • The NAVPS is now $50.25 / 2 = $25.125, an increase from the base case, despite the fact that the market hasn’t moved
  • Joe Shareholder, who’s owned one share all along, got only $0.125 dividend instead of the $0.25 he was expecting
  • The fund now has $0.25 cash that it should reinvest, but holy smokes, that’s going to be an expensive proposition!

Claymore has decided they don’t want to do this. Keep the dividends constant! So they pay out the expected $0.25 dividend per share to their shareholders and the balance sheet looks like this:::

Balance Sheet after unit creation
and dividend payout of $0.50
Item Asset Liability
Cash $0.00  
Securities $50.00  
Due to Shareholders   $0.00
Shareholders’ Equity
two shares!		   $50.00

The good parts about this are:

  • The dividend rate of $0.25 per period has remained constant, just like the market
  • The NAVPS of $25.00 has remained constant, just like the market. The bad part is what has happened to the income statement:):
    Income Statment
    After Unit Creation
    And Payout of $0.50
    Dividends Received $0.25
    Dividends Paid $0.50
    Fund Profit (loss) ($0.25)

    Oooh, yuck! A loss! And I’m not even sure what the tax status of that loss is … I honestly don’t know whether this could be recovered. I do know, however, that the fund’s shareholders as a group are paying tax on the $0.50 dividend paid out by the fund.

    It’s much more efficient to restate the dividend as return of capital; the balance sheet will be unaffected, but the income statement will now look like this:

    Income Statment
    After Unit Creation
    And Payout of $0.25 dividend
    and $0.25 return of capital
    Dividends Received $0.25
    Dividends Paid $0.25
    Fund Profit (loss) $0.00

    And … the moment you’ve all been waiting for … the characterization of payouts:

    Payout Summary
    After Unit Creation
    And Payout of $0.25 dividend
    and $0.25 return of capital
    Dividends $0.25
    Return of Capital $0.25
    Total Payout $0.50

    I hope this helps. Ask any questions in the comments.

Issue Comments

GPA.PR.A On Credit Watch Negative by S&P

S&P has announced:

placed its ratings on the issue of Global Credit Pref Corp.’s preferred shares on CreditWatch with negative implications (see list). The CreditWatch placement mirrors the CreditWatch action on the credit-linked note (CLN) to
which the issue of preferred shares is linked.
Standard & Poor’s will continue to monitor the underlying portfolio and expects to resolve the CreditWatch placement within a period of 90 days and update its opinion.

Global Credit Pref Corp.
Ratings Placed On CreditWatch Negative
To From
Preferred shares
Global scale: B+/Watch Neg B+
Canada national scale: P-4(High)/Watch Neg P-4(High)

(Related CLN: The Toronto-Dominion Bank C$48,031,000 Portfolio Credit Linked
Notes)

The follows the downgrade to P-4(high) less than a month ago.

Originally issued at $25.00, the NAV is now $11.92 according to the sponsor. Ouch! It is currently quoted at 11.01-35, 4×3.

GPA.PR.A is not tracked by HIMIPref™. Many thanks to the Assiduous Reader who brought this to my attention!

Market Action

April 10, 2008

Not much today!

Prof. Stephen Cecchetti (regularly quoted on PrefBlog) has written a review of the Fed’s actions in fighting the credit crunch, in both full and ultra-condensed versions. It’s nice to have all the actions and numbers in one place, but there’s nothing particularly new or startling in the piece. He concludes:

In the heat of a financial crisis, the central bank is the only official body that can act quickly enough to make a difference. Politicians are not well-equipped to take actions literally from one day to the next. So, while we might want to reassess the role of the central bank once the crisis is over, for now it is difficult to fault the Federal Reserve’s creative responses to the crisis that began in August 2007. Let’s just hope that they work.

A complicating factor is that only five of the seven governor’s seats are filled; all in all, the crunch will be fodder for learned papers and theses for many, many years to come.

California was able to refinance some auction debt:

California is offering general obligation bonds to institutions such as mutual funds and insurers today after collecting $898 million of orders from individuals, according to Tom Dresslar, spokesman for state Treasurer Bill Lockyer. Denver International Airport also plans to refinance auction-rate securities by selling $445 million of fixed-rate bonds.
…
Long-term municipal bonds have risen four of the past five days as investors buy tax-exempt securities whose yields have exceeded those on benchmark Treasuries.
…
The gains drove yields on top-rated, 30-year municipal debt to 4.80 percent, the lowest in six weeks, according to Municipal Market Advisors. That still exceeds the 4.35 yield on the 30- year U.S. Treasury bond.
…
Municipal bonds dropped in late February after hedge funds liquidated some of their holdings in the tax-exempt market, as asset values fell and funding costs rose.
…
Such leveraged investors typically buy fixed bonds, fund their purchases by issuing lower-yielding variable-rate notes to money-market mutual funds, and then hedge their investments with interest-rate contracts.

Such a strategy by hedge funds will involve basis risk – if they buy a long-term bond and sell an interest-rate swap against it, they will be receiving LIBOR plus a spread. If this spread exceeds the spread they’re being paid on their own commercial paper, they’re happy … otherwise, not so much. It’s all part of the arbitrage that exists because borrowers want long-term funding and lenders want short term risk … and it works … usually.

Bernanke gave a speech today reviewing the situation. There will be more rules!

the Federal Reserve has used its authority under the Home Ownership and Equity Protection Act to propose and seek comment on new rules that, for higher-cost loans, would strengthen consumer protections. The rules would restrict the use of prepayment penalties and low-documentation lending, require the use of escrow accounts for property taxes and homeowner’s insurance, and ensure that lenders give sufficient consideration to borrowers’ ability to repay. In addition, for all mortgage loans, we have proposed rules regarding broker compensation methods and the ability of appraisers to provide judgments free of undue influence, as well as rules regarding the accuracy of advertisements and solicitations for mortgage loans and the timeliness of required disclosures. We also plan to propose a revised set of required mortgage disclosures based on the results of a program of consumer testing already under way.

… and pension boards might have to do something at their meetings …

Some investors, such as public pension funds, are subject to government oversight, and in these instances, the PWG will look to their government overseers to reinforce implementation of stronger due diligence practices. When investors employ advisers, the mandates and incentives given to these advisers should be structured so as to induce a more careful and nuanced evaluation of the risks and returns of alternative products.

Another “key priority” is:

analytical weaknesses and inadequate data underlay many of the problems in the ratings of structured finance products. Beyond improving their methods, however, the credit rating agencies would serve investors better by providing greater transparency. Credit rating agencies should, for example, publish sufficient information about the assumptions underlying their rating methodologies and models so that users can understand how a particular rating was determined. It is also important for the credit rating agencies to clarify that a given rating applied to a structured credit product may have a different meaning than the same rating applied to a corporate bond or a municipal security.

Different rating scales is a cosmetic change … but publishing assumptions is a little fishy. What if the assumptions relate to regulation FD? The only real problem with the credit rating agencies is that investors cannot reproduce their work without access to the material non-public information to which the agencies have access.

With respect to bank supervision:

Prudential supervisors in the affected financial markets began joint work late last summer to identify common deficiencies on which they and the firms should focus. The supervisors concluded that the firms that suffered the most significant losses tended to exhibit common problems, including insufficiently close monitoring of off-balance-sheet exposures, inadequate attention to the implications for the firm as a whole of risks taken in individual business lines, dependence on a narrow range of risk measures, deficiencies in liquidity planning, and inadequate attention to valuation issues.
…
The PWG also will be asking U.S. regulators, working together and through international groups such as the Basel Committee on Banking Supervision, to enhance their guidance in a variety of areas in which weaknesses were identified. I expect, for example, to see work forthcoming on liquidity risk management, concentration risk management, stress testing, governance of the risk-control framework, and management information systems.

It will be most interesting to see what they come up with respect to liquidity risk management. The banks don’t like the idea … liquidity is a chancy thing!

On the regulatory front RS has a contested hearing about some allegations that are remarkable for their triviality. I truly hope that there’s a lot of back-story to the case that isn’t specified … the potential fine of $3-million seems far out of proportion to the wrongdoing. For heaven’s sake, shouldn’t these trade cancellations have resulted in an automatic penalty of $1,000, end of story? The stenographer at the hearing will cost more than the clients were harmed – even if you agree that the clients were harmed.

A quiet day today. A number of issues traded over 100,000 shares, but volume was highly, highly concentrated in these issues.

Note that these indices are experimental; the absolute and relative daily values are expected to change in the final version. In this version, index values are based at 1,000.0 on 2006-6-30
Index Mean Current Yield (at bid) Mean YTW Mean Average Trading Value Mean Mod Dur (YTW) Issues Day’s Perf. Index Value
Ratchet 5.16% 5.19% 27,944 15.24 2 0.0204% 1,089.0
Fixed-Floater 4.80% 5.30% 62,279 15.13 8 -0.0524% 1,038.8
Floater 5.09% 5.13% 71,252 15.31 2 +0.8386% 818.7
Op. Retract 4.85% 3.82% 83,595 3.48 15 +0.0001% 1,047.4
Split-Share 5.38% 5.99% 90,177 4.09 14 -0.2446% 1,028.5
Interest Bearing 6.18% 6.21% 65,762 3.90 3 +0.1023% 1,097.2
Perpetual-Premium 5.90% 5.23% 205,039 2.99 7 -0.0050% 1,020.8
Perpetual-Discount 5.66% 5.68% 299,769 14.04 63 +0.0840% 920.4
Major Price Changes
Issue Index Change Notes
IAG.PR.A PerpetualDiscount -1.2042% Now with a pre-tax bid-YTW of 5.66% based on a bid of 20.51 and a limitMaturity.
FTU.PR.A SplitShare -1.1338% Asset coverage of 1.4+:1 as of March 31, according to the company. Now with a pre-tax bid-YTW of 8.76% based on a bid of 8.72 and a hardMaturity 2012-12-1 at 10.00.
SLF.PR.A PerpetualDiscount +1.1158% Now with a pre-tax bid-YTW of 5.49% based on a bid of 21.75 and a limitMaturity.
BAM.PR.K FloatingRate +1.1230%  
HSB.PR.D PerpetualDiscount +1.8427% Now with a pre-tax bid-YTW of 5.56% based on a bid of 22.66 and a limitMaturity.
Volume Highlights
Issue Index Volume Notes
CM.PR.A OpRet 163,200 National Bank crossed 162,000 at 25.70. Now with a pre-tax bid-YTW of 3.52% based on a bid of 25.71 and a call 2008-11-30 at 25.50.
TD.PR.R PerpetualDiscount 130,200 Now with a pre-tax bid-YTW of 5.66% based on a bid of 24.98 and a limitMaturity.
MFC.PR.B PerpetualDiscount 115,353 TD crossed 65,000 at 22.10, then another 45,000 at the same price. Now with a pre-tax bid-YTW of 5.32% based on a bid of 22.05 and a limitMaturity.
PWF.PR.G PerpetualPremium 114,500 Anonymous bought 10,000 from Anonymous at 25.25 … which was a cross if it’s the same Anonymous! Now with a pre-tax bid-YTW of 5.56% based on a bid of 25.21 and a call 2011-8-16 at 25.00
PWF.PR.H PerpetualDiscount 79,490 Now with a pre-tax bid-YTW of 5.79% based on a bid of 24.87 and a limitMaturity.

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

Update: Late update here from the PrefBlog Looking Gift Horses in the Mouth Department. Remember PIMCO’s Bill Gross’ comment yesterday?:

For Pimco’s Gross that’s not enough. “If Washington gets off its high `moral hazard’ horse and moves to support housing prices, investors will return in a rush,” he wrote in a note to investors published Feb. 26. Gross, who runs the $122 billion Total Return Fund from Newport Beach, California, didn’t return calls seeking additional comment.

Apparently, Pimco’s Gross Holds Most Mortgage Debt Since 2000:

Pacific Investment Management Co.’s Bill Gross lifted holdings of mortgage debt in the world’s largest bond fund to the highest since 2000, while putting on the biggest bet against government debt since at least the same year.

The $125.1 billion Pimco Total Return Fund had 59 percent of assets in mortgage debt in March, up from 52 percent the prior month and 23 percent in March 2007, according to data on the Newport Beach, California-based firm’s Web site. The fund’s cash position dropped to 32 percent, the lowest since July 2006, from 34 percent in February.

Regulatory Capital

Cracks Appear in European Bank Sub-Debt Market

Fascinating.

I’ve never been a fan of Banks’ subordinated debt, on the grounds that, while you get paid for term of T, you are taking the risk of a term of T+5 … and the penalty rate of interest that normally gets paid on the last five years means that the only time you will actually have exposure to the T+5 paper is when the issuing bank is under stress, and you’d really, really, not have this exposure. Or, at least, not at your going-in, term T price. Note that Sub-Debt comes in two levels; the ultra-cool European “LT2” means the same thing as the coldly-technical North American “Tier 2B”.

An Italian bank has just allowed its sub-debt to go to T+5:

The market is at risk because one borrower has broken ranks. Credito Valtellinese Scrl ignored the April 30 call date on its 150 million euros ($236 million) of notes. As a result, the bank will pay a penalty interest rate of 160 basis points more than money-market rates — higher than the 100-basis-point premium it paid for the past five years, though still lower than it would probably pay to refinance.
…
There’s another twist to the tale. Because exercising the call option messes with a bank’s capital structure, the repayment has to be sanctioned by regulators. Banca Antonveneta SpA, an Italian lender bought by Banca Monte dei Paschi di Siena SpA last year, has asked the Bank of Italy to agree to its repaying 450 million euros of notes at the April 23 call date.

The authorities, though, may be reluctant to allow firms to weaken their finances in the current environment. Credito Valtellinese’s heresy may swiftly become commonplace.

TD Bank has a good on-line summary of their sub-debt [although some of it is actually Innovative Tier 1 Capital]. Most of their issues carry a penalty rate of BAs+100, although their most recent issue has the T to T+5 portion at BAs+200.

CIBC’s penalty rate is BAs+100.

Scotia’s penalty rate is BAs+100.

RBC’s penalty rate is BAs+100

BMO does not provide a convenient listing … an issue from last year has a penalty rate of BAs+100, while one from last month is CDOR+250

National’s penalty rate is BAs+100

Who knows? We might be in for some interesting times!

Market Action

April 9, 2008

The hills are alive with speculation that the Fed might buy mortgage paper:

The Federal Reserve is considering contingency plans for expanding its lending power in the event its recent steps to unfreeze credit markets fail.
…
The Fed, like any central bank, could print unlimited amounts of money, but that would push short-term interest rates lower than it believes would be wise. The contingency planning seeks ways to relieve strains in credit markets and restore liquidity without pushing down rates.

The Fed is reluctant to heed calls from some Wall Street participants and foreign officials for the Fed to directly purchase mortgage-backed securities to help a market that still is not functioning normally.

Such speculation has even reached Canada (hat tip: Assiduous Reader madequota):

Canadian Finance Minister Jim Flaherty said on Wednesday he expects Group of Seven finance ministers to adopt the Financial Stability Forum report with “perhaps some amendments.”
…
One of the many options is a plan to recapitalize banks and repurchase mortgages, with the possible use of taxpayer money.

… but US participation in such a plan seems a little dubious:

“The use of public balance sheets may be needed to help financial and housing markets,” Simon Johnson, the IMF’s chief economist, said at a news conference on the fund’s report today in Washington. Fund economists anticipate a 14 percent to 22 percent slide in U.S. house prices.

The Bush administration has opposed using government funds to purchase mortgages or mortgage-backed securities, as proposed by some U.S. lawmakers.

… although some big players favour the idea:

A March 13 proposal by Senator Christopher Dodd and Congressman Barney Frank that the Federal Housing Administration insure refinanced mortgages after lenders reduce the loan principal to make payments more affordable to homeowners “is the next step,” Senator Charles Schumer, a New York Democrat, said in a Bloomberg Television interview on March 19. It’s a “broader step, but not as broad as [Resolution Trust Corp. (RTC)],” he said.

For Pimco’s Gross that’s not enough. “If Washington gets off its high `moral hazard’ horse and moves to support housing prices, investors will return in a rush,” he wrote in a note to investors published Feb. 26. Gross, who runs the $122 billion Total Return Fund from Newport Beach, California, didn’t return calls seeking additional comment.

An RTC-like entity may not be “the best idea, but maybe it’s the idea that gets us through this,” said New York Life Investment Management’s Girard. “The likelihood of it happening has certainly increased.”

A certain amount of impetus for the idea comes, apparently, from the Bank of England. A recent speech by PMW Tucker of the BoE outlines the central banks’ conundrum:

The serious puzzle which that underlines is why there is a dearth of buyers for the supposedly undervalued paper. With the terms and availability of financing from banks and dealers having tightened, levered funds are hardly likely to be the US Cavalry. But it is interesting that there has not been more interest from investment institutions with ostensibly long holding periods, which are largely unlevered and are not exposed to liquidity risk from borrowing short and lending long. What we commonly hear from contacts is that investment managers do not want to be caught out if asset prices fall further before they recover. But no one can seriously believe that they can spot the bottom of the market, and short-term horizons should not weigh heavily in longer-term investment institutions. All of which suggests that there may be structural impediments. Those could include some combination of the reasonable difficulty that some asset managers experience in assessing the quality of securitised assets; and mandates and accounting policies that may have the effect of shortening asset managers’ time horizons.

… which, to a certain extent, underlines the difference between asset management and the selling of asset management capability that I whine about from time to time. According to Mr. Tucker, at any rate, there is undervalued paper out there that is known to be undervalued. Asset managers, however, are constrained from buying it because all their clients know that it’s all worthless garbage and will fire them if they do. Even if their clients – who are largely pension funds – are OK with the idea, the pension funds might expect difficulties from their clients, the beneficiaries, should this paper be bought and the prices move down a penny. So we have a coordination problem and overall conditions get worse.

Willem Buiter has no problems with the idea in principle:

If the central bank, or some other government agency, were to act as Market Maker of Last Resort and buy the impaired asset at a price no greater than its fair value but higher than what it would fetch in the free but unfair illiquid market, such a purchase would not be a bail-out. It would also be welfare-increasing.

The central bank is especially well placed to play this role because, as long as the distressed/impaired assets are denominated in domestic currency, the central bank will never become illiquid or insolvent by purchasing them.

Should, despite the fact that the impaired asset was purchased at a price below its fundamental value, the central bank eventually make a loss on the asset, recapitalisation of the central bank by the Treasury (that is, the tax payer) may well be necessary, or at least desirable, if the only alternative is self-recapitalisation by the central bank through monetary issuance.

This possibility of a capital loss and fiscalisation of this loss does not mean that the transaction ex-ante involved a subsidy by the central bank to the owner of the impaired asset, or a bail-out of the owner.

A subsidy is present only if the expected, risk-adjusted, rate of return for the central bank on the purchase of the impaired asset is less than the central bank’s opportunity cost of funds. There is no economic subsidy if the price paid to the seller exceeds what the seller would have received from a sale in the free but illiquid market, as long as the central bank expects to earn an appropriate risk-adjusted rate of return on the purchase.

… but he has not, as far as I know, actually advocated taking that step right now in this instance.

I don’t see a need, at this point, for the central banks to take that ultimate step. The success of regulation – yes, I used the word “success” and I have used it advisedly! – is shown by the fact that the system is still functioning at all. No major players have gone bankrupt (although some may wish to quibble about Bear Stearns) and capital ratios – while certainly lower than optimal and under strain – remain relatively strong.

At this moment, as I’ve said before, I think Bernanke’s got it right in acting as a lender of last resort. My only quibble is that I would like to see a penalty rate applied when lending to investment banks against mortgage collateral … say, maybe, discount rate + 25bp … or maybe a little bit more, just to ensure that the borrowers have a negative carry on the deal and feel some (well, OK, let’s make it “a lot of”) pain, without actually going bankrupt. Additionally, it should be made clear that the facility will be cancelled as soon as the situation has stabilized sufficiently that one or two of them can go bankrupt without causing systemic collapse.

Along these lines, there are reports that Citigroup is biting the bullet and selling $12-billion in loans at a big loss, just to get them off the books.

On a lighter note, the Fed has pointed out that a stunning proportion of the populace is financially illiterate. He feels that financial literacy should be a requirement for a high school diploma … well, first I want to know what will be thrown overboard to make room for such a thing. Make the information available and make it part of optional courses – sure, I have no problems with that.

The market moved up strongly today, with volume continuing fair.

Note that these indices are experimental; the absolute and relative daily values are expected to change in the final version. In this version, index values are based at 1,000.0 on 2006-6-30
Index Mean Current Yield (at bid) Mean YTW Mean Average Trading Value Mean Mod Dur (YTW) Issues Day’s Perf. Index Value
Ratchet 5.17% 5.21% 28,567 15.22 2 0.0000% 1,088.8
Fixed-Floater 4.80% 5.31% 63,337 15.11 8 +0.9912% 1,039.4
Floater 5.13% 5.17% 72,219 15.24 2 +0.0031% 811.9
Op. Retract 4.85% 3.71% 83,631 3.32 15 +0.0839% 1,047.4
Split-Share 5.36% 5.87% 90,443 4.09 14 +0.0449% 1,031.0
Interest Bearing 6.18% 6.14% 65,528 3.90 3 +0.0684% 1,096.0
Perpetual-Premium 5.90% 5.23% 210,830 2.99 7 +0.3100% 1,020.9
Perpetual-Discount 5.66% 5.69% 303,187 14.04 63 +0.3321% 919.6
Major Price Changes
Issue Index Change Notes
HSB.PR.D PerpetualDiscount -1.2866% Now with a pre-tax bid-YTW of 5.66% based on a bid of 22.25 and a limitMaturity.
RY.PR.G PerpetualDiscount +1.0224% Now with a pre-tax bid-YTW of 5.51% based on a bid of 20.75 and a limitMaturity.
TD.PR.P PerpetualDiscount +1.0593% Now with a pre-tax bid-YTW of 5.51% based on a bid of 23.85 and a limitMaturity.
RY.PR.D PerpetualDiscount +1.1203% Now with a pre-tax bid-YTW of 5.50% based on a bid of 20.76 and a limitMaturity.
CM.PR.G PerpetualDiscount +1.5138% Now with a pre-tax bid-YTW of 5.94% based on a bid of 22.80 and a limitMaturity.
TD.PR.O PerpetualDiscount +1.5277% Now with a pre-tax bid-YTW of 5.22% based on a bid of 23.26 and a limitMaturity.
CIU.PR.A PerpetualDiscount +1.6497% Now with a pre-tax bid-YTW of 5.57% based on a bid of 20.95 and a limitMaturity.
BCE.PR.R FixFloat +2.1277%  
BCE.PR.G FixFloat +2.1739%  
BCE.PR.Z FixFloat +2.7273%  
Volume Highlights
Issue Index Volume Notes
BMO.PR.I OpRet 272,800 Nesbitt crossed 20,000 at 25.25; TD bought 48,700 in three tranches from Nesbitt at 25.26. Now with a pre-tax bid-YTW of 1.48% based on a bid of 25.21 and a call 2008-5-9 at 25.00.
SLF.PR.B PerpetualDiscount 152,170 Nesbitt crossed 150,000 at 21.70. Now with a pre-tax bid-YTW of 5.56% based on a bid of 21.70 and a limitMaturity.
RY.PR.K OpRet 109,247 TD bought 82,500 from Nesbitt in three tranches at 25.30; “Anonymous” bought 17,500 from Nesbitt at the same price. Now with a pre-tax bid-YTW of -0.59% based on a bid of 25.26 and a call 2008-5-9 at 25.00.
BCE.PR.A FixFloat 100,800 CIBC crossed 46,000 at 24.00; Nesbitt crossed 50,000 at 24.05.
TD.PR.Q PerpetualDiscount 93,260 Scotia crossed 50,000 at 25.00. Now with a pre-tax bid-YTW of 5.60% based on a bid of 24.99 and a limitMaturity.

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

Miscellaneous News

BCE.com Website Bought by Speculator

OK, so after inadverdently noticing that the BCE buyers’ consortium includes Merrill Lynch Global Private Equity, I was poking around trying to find out when I could have known this had I been paying attention. And, of course, I logged onto www.bce.com first, rather than www.bce.ca

The former site now features a placeholder page supplied by the auctioneer (it sold last month for USD 28,001), so I did a WHOIS search:

Registrant:
Yusuf Okhai
Dunsinane Industrial Estate
Dundee, Tayside DD2 3QF
GB

Mr. Okhai is apparently trying to sell the domain; it is claimed that “BCE” stands for “Better College Education”.

I was convinced that the price of USD 28,001 meant that BCE (the company) had bought the site … wrong again! I expect news of expensive litigation to emerge shortly.

Miscellaneous News

BCE Buying Group includes WHO?????

OK, this post is well behind the times, but something odd is going on.

A BCE press release dated December 14 states:

BCE Inc. (TSX, NYSE: BCE) is today issuing a statement in response to certain rumours in the market regarding the status of its definitive agreement to be acquired by an investor group led by Teachers’ Private Capital, the private investment arm of the Ontario Teachers’ Pension Plan, Providence Equity Partners Inc. and Madison Dearborn Partners, LLC (the Investor Group).

A BCE press release dated December 20 states:

BCE today received formal notice that the Canadian Radio-television and Telecommunications Commission has scheduled a public hearing for February 25, 2008, to review the change in control of BCE’s broadcasting licences to an Investor Group led by Teachers’ Private Capital, the private investment arm of the Ontario Teachers’ Pension Plan, Providence Equity Partners Inc., Madison Dearborn Partners, LLC and Merrill Lynch Global Private Equity.

Merrill Lynch Global Private Equity? When did they join? What are the terms? The BCE FAQs on the deal don’t mention them as principal members of the buying group. It also states:

What will be the level of Canadian ownership of BCE as a result of this transaction?

Immediately after the plan of arrangement is completed, not less than 58% of the equity ownership in BCE will be Canadian. The equity ownership of BCE would be as follows:
Teachers’ – 52%
Providence – 32%
Madison – 9%.
Other Canadian investors – 7%
The level of Canadian ownership cannot change as a result of any syndication of equity.

Somehow, Merrill Lynch Global Private Equity joined the consortium, with a very notable lack of fanfare.

Interesting External Papers

IIF Releases Interim Report

The Institute of International Finance has announced:

A report embracing the critical issues in today’s financial markets has been published by the Institute of International Finance (IIF), the global association of financial institutions. “The leadership of our industry recognizes its own responsibility to restore confidence in the financial markets, solve the problems that have arisen and prevent those problems from recurring in the future. We are fully committed to raising standards and improving best practices in the financial services industry,” stated Dr. Josef Ackermann, Chairman of the Board of Directors of the Institute of International Finance (IIF) and Chairman of the Management Board and the Group Executive Committee of Deutsche Bank AG, speaking on behalf of the IIF’s Board of Directors.

Some of the recommendations are priceless:

The suggestion has been made that some firms would find it useful to have at least as a portion of members of the risk committee of the Board (or equivalent) individuals with technical financial sophistication in risk disciplines, or with solid business experience giving clear perspectives on risk issues, consistently with the overall need for the Board to have the skills necessary to conduct meaningful review of management’s actions to manage risk, as to manage other aspects of the business.
…
Even more basically – but this did not exist at all firms – Boards need to understand the firm’s business strategy from a forward-looking perspective, not just to review current risk issues and audit reports. It should be the duty of senior management to review with the Board how that strategy is evolving over time, and when and to what extent the firm is deviating from that strategy (e.g., when a strategy morphed into heavy dependence on conduits or on structured products).

… whereas some recommendations, to the extent that they have any meaning at all, are dangerous:

Taking the view that consistent achievement of high standards requires a shared sense of norms and yardsticks to help avoid backsliding, the IIF will recommend a suite of best practices to be embraced voluntarily, perhaps in the context of a “code of conduct” to which the world’s leading financial institutions could subscribe. Because there are substantial differences in business models, mix of business, exposures, regulatory oversight and culture, there is unlikely to be a single solution to any issue that would be optimal for all firms and all circumstances. Thus, “best practice” as used here is not a legal obligation but a high standard for firms to apply in developing solutions appropriate to their own situations.

As usually discussed, and as is ideal, “best practice” can mean “Don’t be afraid to learn from others”. Those who have any experience in the matter will know that “best practice” really means “tick these boxes and don’t you dare think about what you’re doing”.

There are a number of recommendations dealing with the issue of managers not talking to each other, which echoes the finding of the International Report on Risk Management Supervision.

The IIF continues to highlight the problem of pro-cyclicity:

Basel II can make a substantial difference to the stability of regulated institutions. One of its main strengths is sensitivity to risk. However, it is important to recognize that as currently structured, the Accord will have procyclical effects, especially as banks reduce internal ratings and adjust models for current events. Therefore, further consideration will be needed as how to mitigate these effects, including broadening the use of through-the-cycle rating methodologies.

They make a formal genuflection to the cause celebre du jour:

52. There is a strong sense that externally mandated compensation policies would be at odds with the need to forge competitive, efficient firms that serve the interests of consumer and corporate clients. While recognizing that compensation policies should remain subject to the discretion of the CEO and the oversight of the Board, there is strong support for the view that the incentive compensation model should be closely related by deferrals or other means to shareholders’ interests and long-term, firmwide profitability. Focus on the longer term implies that compensation programs ought as a general matter to take better into account cost of capital, not just revenues. Consideration should be given to ways through which the financial targets against which compensation is assessed can be measured on a risk-adjusted basis. The principle of making the compensation model consistent with shareholders’ interests is well established in some contexts but has been unevenly applied across the industry, especially with respect to compensation of sales and trading functions.

53. Severance pay packages should be tied to performance, consistently with the general principle of alignment with the long-term interests of shareholders.

54. Transparency and proper disclosure to shareholders of compensation policies and criteria, including appropriate alignment of such policies with the firm’s business strategy, is important. Due to competitive issues, disclosure should be focused on principles and process.

There is also some recognition that bank-sponsored conduits are not as off-balance-sheet as might be desired:

Recent events highlight the need for firms to address the proper assessment of nonlegal reputational risk of off-balance sheet vehicles and other potential exposures. Such analysis should include consideration of whether risk of reputation damage could lead a firm to take exposures back onto its balance sheet with adverse liquidity and capital implications. Senior management must be confident that such return of assets would not happen if these exposures are treated as off-balance sheet for regulatory purposes, and Boards should assure themselves that management is properly attentive to this issue. And, on the other hand, supervisors should not take firms’ internal assessment of such risk as necessary grounds to require consolidation for accounting or capital purposes.

The next one’s really going to annoy the Internuts, who are already up in arms about Level 3 “Mark to Make-Believe” accounting … in times like this, when for many instruments there is nothing – nothing! – to be marked to, the Committee seems sympathetic to what will shortly be dubbed Level 4 valuation “Mark to What Looks Good”:

For these reasons, the Committee believes that broad thinking is needed on how to address such consequences, whether through means to switch to modified valuation techniques in thin markets, or ways to implement some form of “circuit breaker” in the process that could cut short damaging feedback effects while remaining consistent with the basics of fair-value accounting. And, while there is no desire to move away from the fundamentals of fair-value accounting, the Committee feels that it is nonetheless essential to consider promptly whether there are viable sound proposals that could limit the destabilizing downward spiral of forced liquidations, writedowns and higher risk and liquidity premia. The Committee is developing specific proposals for consideration in a timely fashion.

My reaction to recommendation #86 is mixed in the extreme!

86. Many investors relied on the rating when making credit decisions. More sophisticated investors were able to make their own assessments to a degree but many less sophisticated investing institutions relied on investment mandates where the rating was the paramount feature. The Committee finds that though rating agencies make their models available to investors, without detailed underlying loan-back data from the banks, additional information on stress testing and the underlying assumptions of the model, it is not possible for investors to verify the accuracy of the ratings models. It would in any case also be beyond the capacity of many investors to validate independently the rating agency models. More detailed loan data needs to be made more readily available and more information on stress testing particularly from a credit perspective will be released by the rating agencies, but for many investors the ratings models will remain a black box. Given this, ratings models should be subject to standards of independent review and external validation (akin to those in Basel II for Internal Ratings-Based Models).

OK … so I like the bit about making more data available. But I don’t really care about whether or not it’s beyond the capacity of many investors to validate independently the rating agency models … if it’s beyond their capacity, they should get competent advice. And I really dislike the idea of subjecting ratings models to independent review and external validation.

Credit ratings are investment opinions, dammit! Take it, leave it, get other independent advice … but don’t get the government or agency thereof involved in validating and reviewing investment advice. That’s a road to ruin if ever I saw one.

Recommendation #88 is full of helpful little hints for investors to abnegate responsibility for their investments and ensure that credit ratings don’t need to be understood as long as all the little boxes are ticked. Recommendation #89 contains such an absolutely priceless phrase that I’m going to quote it without further comment:

For example, the Market Best Practices might suggest that investors, making use of enhanced disclosures suggested elsewhere in this paper:
• Understand vehicles clearly, including the position of rated tranches and cash flows in the structure.

And as we proceed to #91, I’m so highly amused I can barely type:

91. Key issues that need attention at the level of the structured product include:
a. Quality of information provided in offer documents for structured products varies significantly based on the originating firm, country of origination and type of product. Offer documents can range from five pages to more than fifty pages and sometimes are difficult to read.

Awwww … the offer documents are sometimes difficult to read, are they? Awwww. Holy smokes, it should have become apparent by now that what the banks behind the IIF really want is a world of plain vanilla investments that banks can flog for high fees without anybody taking any risk.

All in all, a report more notable for its entertainment value than its contribution to debate.

Market Action

April 8, 2008

Naked Capitalism points out that banks’ balance sheets tend to bloat in times of economic stress (this has been true for a long time – see Banks’ Advantage in Hedging Liquidity Risk) but manages to overstate his case:

A reader pointed us to this Bloomberg story, “Tribune, Dole May Need to Draw Down Bank Credit Lines,” which suggests that these two companies accessing committed credit lines is a harbinger of further demands on bank equity (note that a standby line does not result in a capital charge until the funds are drawn down).

Unfortunately, the helpful note is incorrect: a standby line does indeed result in a capital charge, equal to 50% of the charge that would be applied if the funds were actually drawn, provided this line is irrevokable:

Off-balance sheet items subject to a 50 percent conversion factor:
(1) Transaction-related contingencies, including performance standby letters of credit, shipside guarantees, bid bonds, performance bonds, and warranties.
(2) Unused portions of commitments with an original maturity exceeding one year, including underwriting commitments and commercial credit lines.
(3) Revolving underwriting facilities (RUFs), note issuance facilities (NIFs), and other similar arrangements, regardless of maturity.
…
Off-balance sheet items subject to a zero percent conversion factor:
(1) Unused portions of commitments with an original maturity of one year or less.
(2) Unused portions of commitments (regardless of maturity) which are unconditionally cancellable at any time, provided a separate credit decision is made before each drawing.

Assiduous Readers will remember that liquidity guarantees for ABCP are charged at a 10% conversion factor, subject to certain qualifying rules, and that there are rumblings (supported by me) that this might change.

For further confirmation of this fact, we can look at Citigroup’s Annual Report, page 75, “Components of Capital Under Regulatory Guidelines”, Note 7:

Risk-adjusted assets also include the effect of other off-balance-sheet exposures, such as unused loan commitments and letters of credit, and reflect deductions for certain intangible assets and any excess allowance for credit losses.

According to the most recent FDIC quarterly report:

Unused loan commitments – includes credit card lines, home equity lines, commitments to make loans for construction, loans secured by commercial real estate, and unused commitments to originate or purchase loans. (Excluded are commitments after June 2003 for originated mortgage loans held for sale, which are accounted for as derivatives on the balance sheet.)

This line item (see Table II-A) totalled USD 8.3-trillion in the fourth quarter of 2007, up 10% from 4Q06.

Accrued Interest looks at the US Jobs number as a predictor of stock prices:

Conclusion? During the last recession, unemployment predicted nothing useful to investors. Even had you been given a crystal ball and knew for a fact what future unemployment figures would be, it still wouldn’t have consistently indicated the right market trade. In fact it often would have given you the wrong indication.

True enough, but the last recession was a little funny … the market spent the first 2-3 years of this century unwinding the Tech Wreck … which is not to say that Accrued Interest is wrong, mind you, but rather to point out that there are a lot of factors in this chaotic world, and it is just as wrong to dismiss an indicator out of hand as it is to place blind faith in it. It’s all data.

Volume picked up today, although it can be called “good” only in contrast to recent depressed levels. Not too many price moves.

Note that these indices are experimental; the absolute and relative daily values are expected to change in the final version. In this version, index values are based at 1,000.0 on 2006-6-30
Index Mean Current Yield (at bid) Mean YTW Mean Average Trading Value Mean Mod Dur (YTW) Issues Day’s Perf. Index Value
Ratchet 5.18% 5.22% 28,707 15.20 2 -0.0609% 1,088.8
Fixed-Floater 4.85% 5.39% 62,096 15.02 8 +0.0340% 1,029.2
Floater 5.13% 5.17% 72,102 15.24 2 -2.4196% 811.8
Op. Retract 4.86% 4.19% 82,951 3.52 15 +0.0655% 1,046.6
Split-Share 5.36% 5.92% 91,100 4.09 14 +0.1595% 1,030.5
Interest Bearing 6.19% 6.29% 65,491 3.91 3 -0.0337% 1,095.3
Perpetual-Premium 5.91% 5.44% 206,445 5.87 7 +0.0398% 1,017.7
Perpetual-Discount 5.68% 5.71% 304,416 14.14 63 +0.0128% 916.6
Major Price Changes
Issue Index Change Notes
BAM.PR.K Floater -4.8361%  
ELF.PR.G PerpetualDiscount -2.8424% Now with a pre-tax bid-YTW of 6.35% based on a bid of 18.80 and a limitMaturity.
BAM.PR.G FixFloat -1.0116%  
IAG.PR.A PerpetualDiscount +1.2249% Now with a pre-tax bid-YTW of 5.61% based on a bid of 20.66 and a limitMaturity.
Volume Highlights
Issue Index Volume Notes
TD.PR.R PerpetualDiscount 239,800 TD bought 38,600 from Nesbitt at 24.90; Nesbitt crossed 100,000 at 24.90; TD bought 25,000 from Desjardins at 24.89. Now with a pre-tax bid-YTW of 5.68% based on a bid of 24.89 and a limitMaturity.
BMO.PR.L PerpetualDiscount 128,300 Nesbitt crossed 50,000 at 24.61, then bought 38,000 in two tranches at 24.60 from “Anonymous” (not necessarily the same anonymous). Now with a pre-tax bid-YTW of 5.93% based on a bid of 24.60 and a limitMaturity.
MFC.PR.B PerpetualDiscount 109,165 TD crossed 100,000 at 22.10. Now with a pre-tax bid-YTW of 5.33% based on a bid of 22.00 and a limitMaturity.
NA.PR.L PerpetualDiscount 59,320 Nesbitt crossed 13,400 at 21.07. Ex-Dividend April 9. Now with a pre-tax bid-YTW of 5.88% based on a bid of 20.98 and a limitMaturity.
BMO.PR.J PerpetualDiscount 37,365 Nesbitt crossed 30,000 at 20.09. Now with a pre-tax bid-YTW of 5.70% based on a bid of 20.05 and a limitMaturity.

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

Issue Comments

TOC.PR.B : Ticker Change to TRI.PR.B on April 17

The Thomson Corporation has announced:

new stock ticker symbols for Thomson Reuters that will be effective at the opening of trading on April 17, following the expected close of Thomson’s acquisition of Reuters Group PLC earlier that morning.

Thomson Reuters will have two parent companies, both of which will be publicly listed – The Thomson Corporation, an Ontario company, will be renamed Thomson Reuters Corporation, and Thomson Reuters PLC will be a new UK company in which existing Reuters shareholders will receive shares as part of their consideration in the transaction.

On April 17, Thomson Reuters Corporation common shares will begin trading on the New York Stock Exchange (NYSE) and Toronto Stock Exchange (TSX) under the ticker symbol “TRI”. Thomson common shares will continue to trade under the symbol “TOC” through April 16. The symbol for Thomson’s Series II preference shares that are listed on the TSX will change to “TRI.PR.B” from “TOC.PR.B”.

The CUSIP number for TRI.PR.B will be 884903 30 3.

TOC.PR.B is tracked by HIMIPref™; it has been in and out of the HIMIPref™ indices over the years on volume concerns – it is currently “out” due to volume concerns. Following a credit review, it was affirmed as Pfd-2(low) by DBRS.