PrefBlog

Pump up the volume! It has been a weekend of massive bank (almost-) failure and state intervention.

Details are still sketchy, but Citigroup is taking over Wachovia:

Citigroup Inc., the biggest U.S. bank by assets, will acquire banking operations of Wachovia Corp. for about $1.6 billion after shares of the North Carolina lender collapsed under the weight of overdue mortgages.

The all-stock deal equals about $1 a share for the Charlotte-based bank, ranked sixth by assets in the U.S. All depositors will be protected, according to the Federal Deposit Insurance Corp., which helped broker the takeover by Citigroup. The New York-based bank plans to cut its own dividend in half and raise $10 billion in capital as it takes on Wachovia’s senior and subordinated debt.

The FDIC states:

Citigroup Inc. will acquire the bulk of Wachovia’s assets and liabilities, including five depository institutions and assume senior and subordinated debt of Wachovia Corp. Wachovia Corporation will continue to own AG Edwards and Evergreen. The FDIC has entered into a loss sharing arrangement on a pre-identified pool of loans. Under the agreement, Citigroup Inc. will absorb up to $42 billion of losses on a $312 billion pool of loans. The FDIC will absorb losses beyond that. Citigroup has granted the FDIC $12 billion in preferred stock and warrants to compensate the FDIC for bearing this risk.

Dealbreaker has the Citi Investor Presentation.

The status of the Canadian subsidiary, Congress Financial Capital Company, is not entirely clear at the moment; they raised CAD 400-million in 2005; but since they are (via intermediaries) 100% owned by Wachovia Bank National Association I am assuming (pending confirmation from the company) that their debt is covered under the deal, but I note that S&P put the issue on Watch-Negative this afternoon; its current S&P rating is A+.

In the meantime, the Europeans were busy:

European governments stepped in to rescue Fortis, Bradford & Bingley Plc, and Hypo Real Estate Holding AG as tremors from the U.S. credit crisis reverberated around the world.

The U.K. Treasury seized Bradford & Bingley, Britain’s biggest lender to landlords, while governments in Belgium, the Netherlands and Luxembourg threw an 11.2 billion-euro ($16.3 billion) lifeline to Fortis. Germany guaranteed a loan to Hypo.

… and the Fed is revving up the helicopters:

The Fed increased its existing currency swaps with foreign central banks by $330 billion to $620 billion to make more dollars available worldwide. The Term Auction Facility, the Fed’s emergency loan program, will expand by $300 billion to $450 billion. The European Central Bank, the Bank of England and the Bank of Japan are among the participating authorities.

The question remains: How many helicopters?

Nouriel Roubin loathes TARP:

Indeed, the plan also does not address the need to recapitalize those financial institutions that are badly undercapitalized: this could have been achieved by using some of the $700 billion to inject public funds in ways other and more effective than a purchase of toxic assets: via public injections of preferred shares into these firms; via required matching injections of Tier 1 capital by current shareholders to make sure that such shareholders take first tier loss in the presence of public recapitalization; via suspension of dividends payments; via a conversion of some of the unsecured debt into equity (a debt for equity swap). All these actions would have implied a much lower fiscal costs for the government as they would have forced the shareholders and creditors of the banks to contribute to the recapitalization of the banks.

As I noted on September 25, I would prefer a system whereby Treasury would buy senior preferred shares in distressed – but still solvent – banks, with a punitive coupon and the proviso that no dividends be paid on shares junior to the new issue until the issue was retired.

Via Dealbreaker comes a link … it appears that Richard A. Posner holds the same views:

A more palatable approach would be for the government to drive a Warren Buffett style hard bargain, in which, rather than buying anything from banks, the government would invest in them in a form, such as purchase of newly issued preferred stock, or bonds with a long maturity, that would augment the banks’ capital and thus enable banks to make more loans. That would avoid conferring a windfall on the banks by overpaying them for their bad securities; no one thinks Buffett is conferring a windfall on Goldman Sachs. After the industry was back on its feet, the government could sell the bank stocks or bonds that it had acquired.

… although I will note that his implication that long-term bonds are, or are equivalent to, capital is at best imprecise.

And in the end TARP failed:

Markets plunged as the House rejected, by a vote of 228 to 205, the $700 billion measure to authorize the biggest government intervention in the markets since the Great Depression. The Dow Jones Industrial Average fell 564 points, or 5 percent to 10,579, at 3:05 p.m. New York time.

The defeat of the legislation set off a scramble among the plan’s backers for additional support before another vote, which likely won’t come until later in the week.

We now await Son of TARP.

James Hamilton of Econbrowser has a good piece on understanding the TED spread.

There are interesting reports that Treasury repos are being done for fail-money; Dealbreaker notes that failed trades are increasing. Now there’s an indication of a locked up credit market if ever there was one!

Laeven & Levine have an article on VoxEU, Governance of banks, looking forward to the end of the crunch and the new – or changed – regulation that will be coming. They warn:

We find that banks with more powerful owners (as measured by the size of their shareholdings) tend to take greater risks.

This supports arguments predicting that equity holders have stronger incentives to increase risk than non-shareholding managers and debt holders and that large owners with substantial cash flows have the power and incentives to induce the bank’s managers to increase risk taking.

Furthermore, the impact of bank regulations on bank risk depends critically on each bank’s ownership structure such that the relationship between regulation and bank risk can actually change sign depending on ownership structure.

· For example, our results suggest that deposit insurance is only associated with an increase in risk when the bank has a large equity holder with sufficient power to act on the additional risk-taking incentives created by deposit insurance.

· The data also suggest that owners seek to compensate for the loss in value of owning a bank from capital regulations by increasing bank risk.

· Stricter capital regulations are associated with greater risk when the bank has a sufficiently powerful owner, but stricter capital regulations have the opposite effect in widely held banks.

Ignoring bank governance leads to incomplete and sometimes erroneous conclusions about the impact of bank regulations on bank risk taking.

PerpetualDiscounts fell in line with general credit markets today, with an average pre-tax bid-YTW of 6.29% … on the way up it hit that figure on July 9, on the way down on August 5. That’s about 8.81% at the standard 1.4x equivalency factor and Long corporates now yield about 6.5% … so the pre-tax interest equivalent spread to long corporates remains fairly constant at about 331bp.

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

In a post tweaking Republicans for opposition to TARP, Menzie Chinn of Econbrowser passes along the fascinating observation that yield levels for non-financial commercial paper have become incalculable:

On Tuesday, the US Federal Reserve quietly admitted that it had been temporarily unable to calculate yield levels for non-financial commercial paper, issued by AA-rated companies for one to three months.

The problem, it seems, was a dire lack of activity; or, as Morgan Stanley says, “extreme levels of stress and illiquidity”. More specifically, while investors are still purchasing ultra short-term notes – say, for one or two days – on a massive scale, they are reluctant to buy instruments that last longer than a few days. That may be temporary (yesterday yield prices were apparently returning to the AA sector again although they were unusually high). However, even a temporary freeze is remarkable. After all, these non-financial companies typically have nothing to do with Wall Street or toxic mortgage debt.

The data is not to be found in the Federal Reserve Release H.15 for September 22: rates are listed for one- and two-month nonfinancial CP, but for three-month all we get is “n.a.”. The only ray of sunshine I can find is that the outstandings are in line with seasonal norms.

In a classic example of Banks’ advantage in hedging liquidity risk, it has been reported that corporations are drawing heavily on committed lines:

Goodyear Tire & Rubber Co., General Motors Corp., and International Lease Finance Corp. lead companies drawing on so- called revolving loans obtained before the credit crisis began in July 2007. Banks had more than $1.4 trillion in untapped loan commitments as of a year ago, the most on record, according to the Shared National Credit survey by four U.S. regulators including the Federal Reserve.

Corporate treasurers, blocked from accessing capital markets, are turning to the funding as the failure of Lehman Brothers Holdings Inc. sparks concern that other banks may be unable to provide funds. Pressure to find cheaper, longer-term capital is also building as costs rise in the $1.7 trillion short-term debt market. Banks are being forced to come up with the money after swallowing $521 billion of writedowns and losses.

We will have to see some of these borrowers biting the bullet and paying up to issue bonds before the strain on the Fed’s discount window (mentioned yesterday) will start to ease.

The JPM/WM takeover was discussed yesterday. We are told that:

Pressure on WaMu intensified in the last three months as market conditions worsened. An outflow of deposits began on September 15, 2008, totaling $16.7 billion. With insufficient liquidity to meet its obligations, WaMu was in an unsafe and unsound condition to transact business. The OTS closed the institution and appointed the Federal Deposit Insurance Corporation (FDIC) as receiver. The FDIC held the bidding process that resulted in the acquisition by JPMorgan Chase.

I would be most interested in learning what fraction of that $16.7-billion was uninsured deposits. One would imagine the answer would be “all”, but one sometimes imagines rational things in an irrational world!

There has been a similar revelation regarding a run on Lehman:

Lehman Brothers Holdings Inc.’s brokerage lost more than $400 billion in assets in the months before its parent filed for bankruptcy protection, according to the trustee overseeing customer accounts.

Lehman’s holding company filed for bankruptcy Sept. 15 claiming $639 billion in assets, using four-month-old data. The wholly owned brokerage unit had shrunk to less than $100 billion in assets from $500 billion “a few months ago,” according to a Sept. 19 court statement by James Giddens, the trustee overseeing the settling of Lehman brokerage customer accounts by the Securities Investor Protection Corp.

Dosado and allemande left! The banks continue square-dancing, with rumours that Wachovia has asked Citigroup if they could spend some time together at the social … now that WB’s been spurned by MS.

And here’s a little throwaway line in a virtually unrelated article:

TD Ameritrade said it would spend up to $50 million to offset losses for its customers who have money in the Reserve Primary Fund. Other investors still don’t know the fate of their savings.
…
TD Ameritrade used the Reserve’s Primary Fund as one of its cash “sweep” accounts, a place where consumers could automatically park cash from a maturing certificate of deposit, for example.

In the past, I’ve expressed concern about bank-branded MMFs … perhaps I should have cast my net wider!

PerpetualDiscounts lost ground today, closing with a weighted-average bid-YTW of 6.23%, equivalent to 8.72% interest at the 1.4x equivalency rate. Long Corporates now yield 6.50%, so the pre-tax interest-equivalent spread is now 222bp … narrowing in slightly, but still at very elevated levels.

Massive crosses today by Scotia, with National Bank playing a supporting role. Today was the first day for an October settlement date and there wasn’t too much price movement for these issues … so my guess is that they were all internal crosses. Who wants to spend the weekend matching up the trades to the holdings of one of the big funds?

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

Henry Blodgett of Clusterstock emphasizes a point I made September 23 regarding market value vs. intrinsic value of the securities targetted for TARB purchase in a post Warren Buffet reveals bailout’s dirty little secret:

Bernanke and Paulson want to pay a phantom “hold-to-maturity” price that is above the prices at which the banks are currently valuing their trash assets. The logic is that the banks’ carrying value is somehow artificially depressed by a lack of liquidity. (This logic is weak: If anything, the banks are trying to conceal how badly off they are by overstating the value of the assets).

Hat Tip: Naked Capitalism. Thanks to the miracles of modern hagiography, Mr. Blodgett sees no need to provide analysis supporting his thesis that banks are engaged in a coverup. Mr. Buffet is quoted (irelevantly) in the same post, so it must be true.

Dealbreaker is usually both vulgar and entertaining; on occasion they publish analysis that reflects their roots in the trading community. This is one of those times:

Mark-to-market accounting incentivizes markets to go illiquid when asset prices sink, exactly when liquidity is critical. You create an environment where an institution isn’t just poised to lose the difference between their current mark on the instrument they are selling and the transaction price, but a large multiple of that as that transaction triggers markdowns on the rest of the toxic paper. How do you handle that as a institution holding sludge? Wait. And if you see some sludge that is offered so cheaply that you couldn’t normally resist buying it? Wait, if you are holding similar assets. Liquidity has been frozen up to prevent revealing that many of these institutions might be insolvent at the current market prices. That’s the kind of thing that is going to happen when the institutions likely to go insolvent control most of the liquidity.

In general, huge corrections like this usually only reverse when prices get so low that value investors and their ilk creep out and cant help but start buying. The problem here is that there isn’t enough price discovery to tempt them out, or that the normal buyers (Goldman, etc.) face mark-to-market triggers that prevent them wanting any transactions at all. Buffett seems mercifully free of both constraints.

The opportunities TARP affords for this sort of unsupported assertion is one reason why I don’t like the plan and would prefer to see Treasury – if necessary – purchasing senior preferred shares with a punitive distribution and a proviso that shares junior to the new issue get no dividends while the issue is outstanding. If Treasury buys so much as a nickel’s worth of sub-prime paper, debate over side-issues will overwhelm any practical benefits. Even if they make a collosal profit, the move will be decried as ‘too risky but lucky!’ and condemned on grounds of idealogical impurity.

There are reports that TARP will be approved, one way or another, complete with politically driven executive compensation limits and maybe even a 25bp tax on stock trades. Fearless prediction: TARP will fail for the same reason MLEC failed: a politically satisfactory backstop makes no business sense for the participants.

Willem Buiter, writing in VoxEU, sees the problem as being one of insolvency, not illiqudity:

As the full horror story of the bad investments and bad loans made by so many American banks has gradually been revealed, it is clear that the US banking sector faces an insolvency crisis and not just an illiquidity crisis. The number of impaired mortgages is exploding, and not just in the subprime and Alt-A categories, but across the whole residential mortgage spectrum. Impaired commercial and industrial mortgages are rising fast. Bad loans to the construction industry and to developers are mushrooming. ABS backed by automobile loans, by credit card receivables are tottering in growing numbers as are many other unsecured household loans. With the economy slowing down and probably entering recession soon, even exposures to the non-financial corporate sector will become more vulnerable.

In a nutshell, the US banking sector needs recapitalisation.
…
That leaves just two sources of capital. The first is the US federal government. It could inject capital into US banks, say by purchasing preference shares. I would uncouple such a capital injection from Paulson’s toxic asset purchase plan. The market illiquidity problem is related to but not the same as the banks’ capital deficiency problem. The government could implement a system-wide capital injection by specifying maximum leverage ratios (or minimum capital ratios) for various categories of financial institutions. It could then inject capital in return for preference shares to bring all these leverage ratios down to the maximum levels (all the capital ratios up to the minimum levels).
…
Finally, there is my preferred solution to the capital deficiency problem: the compulsory conversion of some of the banks’ debt into equity. Again, this could be done by the government specifying maximum leverage ratios (or minimum capital ratios) for various categories of financial institutions. Different kinds of debt then would be mandatorily converted into equity (preference shares or ordinary shares) with the proportion of each category of debt to be converted into stock inversely related to the seniority of the debt. These proportions would have to satisfy the requirement that all leverage ratios be brought down to the maximum levels (all capital ratios up to the minimum levels).

It’s a very well written article in Mr. Buiter’s inimitable style. But although his concerns about solvency may well be justified, he presents no evidence that this is indeed the case. In any event, I have grave concerns about due process with respect to his mandatory conversion programme … this is insolvency restructuring stuff, usually carried out when the institution has, in fact, been proved to be insolvent. And, until somebody can show me otherwise, I will continue to believe that rumours of widespread insolvency in the US financial sector are greatly exaggerated.

In a speech available on the BoC website, Carney applauded TARP, albeit with very little discussion of its merits and alternatives:

Similarly, private asset sales have been limited by the complexity of the underlying assets, the ongoing impairment of securitization markets, difficulties in supplying financing to leveraged buyers and the desire of investors to “time the market.” In sum, banks have an increasing need for capital, but it has become more difficult to raise it.

In this environment, the U.S. government’s initiative to buy distressed assets is critically important. The plan announced by Treasury Secretary Paulson and being developed through discussions in the U.S. Congress is bold and timely. The size and breadth of support provided by this measure will help firms “rightsize” their balance sheets, re-liquefy closed markets and establish market prices for these distressed assets. This should eventually encourage private buyers to re-enter the market and complete the deleveraging process. A well-executed program will undoubtedly speed the resolution of this crisis and limit its economic cost.

But how urgent is the problem? Well, judging by the action at the discount window, pretty damn urgent!

Commercial banks and bond dealers borrowed $217.7 billion from the Federal Reserve as of yesterday, more than double the prior week, as the financial crisis worsened and private funding dried up.

Loans to commercial banks through the traditional discount window totaled $39.3 billion as of yesterday, up from $33.4 billion, the Fed said. Borrowing by securities firms totaled $105.7 billion, up from $59.8 billion. Under a new emergency program announced Sept. 19, banks borrowed $72.7 billion as of yesterday to buy commercial paper from money-market mutual funds.

The figures are from the Fed’s H.4.1 Statistical Release. It’s not clear to me, however, how much of that borrowing is happening because the banks can’t get funding anywhere else, and how much is because it’s cheap credit. We can assume that the AIG need is real, though!

The three-month London Interbank Offered Rate in dollars was 3.77 percent today, the highest since January. Commercial banks can take out up to 90-day loans from the Fed at 2.25 percent. Primary dealers pay the same rate for overnight loans. The AIG loan accrues interest at three-month Libor plus 8.5 percentage points.

In 2001, the discount rate was a half-point below the Fed’s benchmark federal funds rate. In 2003, the Fed reset the discount rate at 1 percentage point above federal funds. The Fed reduced the spread to a half point in August 2007 and to a quarter point in March 2008.

We shall see how it all works out. There is opposition to TARP from a group of economists and a group of Republicans. Meanwhile Fortress Investment Group is building a war-chest to go shopping for distressed paper:

Fortress has risen 38 percent in the past two weeks in New York trading as investors anticipate private-equity and hedge- fund firms will profit from financial turmoil by snapping up companies and assets at distressed prices. Fortress rose 51 cents, or 3.9 percent, to $13.50 in New York Stock Exchange composite trading today.

Private-equity firms are shifting from the large leveraged buyouts that dominated Wall Street during 2006 and 2007, raising funds to snap up distressed debt and mortgage securities. Fortress oversees about $35 billion.

… and rumours are floating that JPMorgan will buy up WaMu’s deposits. The will be a major announcement tonight, of some kind anyway:

JPMorgan Chase & Co. (NYSE: JPM) will host a conference call at 9:15 p.m. (Eastern Time) tonight, September 25, 2008. You may access the conference call by dialing 1-877-238-4671 (U.S. and Canada) / 1-719-785-5594 (International) – access code: 814030 or via live audio webcast at www.jpmorganchase.com under Investor Relations/Investor Presentations. Materials and further communication will be available on this website at the time of the call.

A replay of the conference call will be available beginning at approximately 1:00 a.m. on September 26 through midnight, Thursday, October 9 by telephone at (888) 348-4629 (U.S. and Canada); access code: 942856 or (719) 884-8882 (International). The replay will also be available via webcast on www.jpmorganchase.com under Investor Relations, Investor Presentations.

Bloomberg reports that this will happen by fiat of the FDIC. Flash! JPMorgan buys WaMu’s deposits for a premium of about 1%! Now … that’s what I call a bargain. Cash is king! Flash! JPM is marking down WM’s assets by $30-billion (out of $296-billion assets at WM carrying value) as part of the transaction. See page 18 of the presentation.

Covered bonds in the States are not having a nice time:

Bank of America Corp. was the last U.S. bank to issue the bonds, selling $1.5 billion of the securities in June 2007. The spread on the Charlotte, North Carolina-based lender’s three-year notes has widened almost eight-fold to 184 basis points, according to Citigroup Inc. prices on Bloomberg.

The only other U.S. issuer is Washington Mutual, which put itself up for sale last week. Its 6 billion euros ($8.8 billion) of covered bonds were downgraded one level to Baa1, the third- lowest investment-grade ranking, by Moody’s.

The spread on its $2 billion of 4.375 percent bonds due 2014 has surged to 678 basis points, from 26 basis points when the notes were sold in May 2007, according to Royal Bank of Scotland Group Plc prices on Bloomberg.

Speaking of bear markets, how about that California real-estate, eh?:

California home prices tumbled a record 41 percent in August from a year earlier as foreclosure sales pushed down values in the biggest U.S. state.

The median price of an existing, single-family detached home fell to $350,140 and will likely fall further, the Los Angeles- based California Association of Realtors said today in a report. Sales increased 56.7 percent from August 2007 and 1.8 percent from July.

And the sales number! Far be it from me to put any credence in technical analysis, but that’s consistent with mass forced liquidation near the bottom of the market. And, bless their hearts, the guys at Dealbreaker have actually put together some numbers on housing bubble profits:

In summary, our incomplete and work-in-progress calculations figure for something like $2 trillion in fees flowing to various parties in the real-estate, mortgage, securitization and securitization^2 businesses between 2003 and mid-2008. That’s some serious swag, and you don’t have to look very far to see why no one was in much of a hurray to shut any of it down or to rock the boat.

In fact, the Dealbreaker guys did a fantastic job today, highlighting an extraordinarily testy letter from the FDIC to Bloomberg. Let’s have a little more honest reporting and a little less yellow journalism!

I’m searching for the precise metaphor to use regarding the backlash against hedge funds in the UK – should it be ‘shooting the messenger’ or ‘killing the goose that laid the golden eggs’?:

As Lehman Brothers Holdings Inc. filed for bankruptcy and HBOS Plc was pushed into a government-brokered takeover, U.K. regulators and lawmakers found a culprit: the estimated 980 hedge funds that reside in Britain, mostly in London. Harbinger Capital Partners Fund chief Philip Falcone was singled out by the Daily Mirror. The tabloid used a front-page story on Sept. 18 to brand him a “greedy pig” for short selling, or making bets that Edinburgh-based HBOS would lose market value.

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