PrefBlog

At last, a normal, quiet day in the summer! I had almost forgotten what those were like!

The big news, as far as I’m concerned, is the release of Fed statistics that illustrate the continued delevering of the financial system; the amount of outstanding US ABCP down over 4% on the week:

More than half of the $1.1 trillion in outstanding asset- backed paper comes due in the next 90 days, according to the Federal Reserve. Unless they find new buyers, hundreds of hedge funds and home-loan companies will be forced to sell $75 billion of debt, according to Zurich-based UBS AG, Europe’s largest bank.  

Those sales would drive down prices in a market where investors have already lost $57 billion, based on Merrill Lynch & Co.’s broadest index of floating-rate securities backed by home- equity loans. That may hurt the 38.4 million individual and institutional investors in money market funds, the biggest owners of commercial paper. Top-rated commercial paper is one of the world’s safest assets.

In Europe, the asset-backed commercial paper market is almost closed, Reynold Leegerstee, team managing director for Moody’s Investors Service, said on a conference call today.

My guess is that we’re going to see some more blow-ups, perhaps even large and exciting blow-ups. Paribas is re-opening the redemption window for the famous three funds that accellerated the panic; but there will be redemptions on the order books now for many funds and more to come when investors get their statements.

The lock-up in the ABCP markets is going to lead to exciting times (and bargains!) as financing intermediaries are forced to dump their holdings on the market for whatever they can get; such are the perils of leverage and term mismatching and the Fed’s pushing of the discount window (and other techniques, such as a lifting of the cap on Citigroup’s loans to customers via Citigroup Global Markets) is intended only to ensure that there is a market; they don’t care whether or not it’s a good and friendly market.

But so far, I’d say, so good. The damage has largely been confined not just to the financial system, as opposed to the real economy, but to hedge funds – and it is their function to absorb risk and trade it for return. It’s far too early to celebrate – assuming that the worst is over, effects won’t show up until Christmas – but right now we’re hearing of hedge fund redemptions being stopped and large financial institutions taking write-downs; we’re not learning of huge corporations bouncing their payroll cheques. But we’ll see! Things can always get worse and there’s still a lot of tension in the corporate bond market.

TD Bank released its results today and claimed that its underwriting of the BCE / Teachers deal is a really good piece of business. Well gee, if the salesman says it’s good, maybe we should all rush out and buy some, eh? There’s another one that we’ll just have wait and see about … at today’s close of 39.67, BCE common is still 7.2% below deal price, so those who are confident the deal will get done as described still have lots of chance to make some good money … at a higher yield than ABCP paper!

In other news we have another argument that it’s all Greenspan’s fault; an explanation of Countrywide’s financing requirements; and a discussion of Treasury’s problems with the IMF.

US equities were quiet, as were their Canadian counterparts. Treasuries barely moved and Canadas were boring, although some flattening was seen, reversing some recent trends. A quiet summer day, in fact.

Things were just as quiet in the preferred share market at it drifted up in lazy trading. Just how much up and how lazy is, however, something you’re going to have to wait for, since I’ve run out of time and will have to update the tables tomorrow.

Update, 2007-08-24

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

Well, the press is certainly champing at the bit to announce a return to normalcy!

In the best news of the day HSBC Canada issued a press release that included the paragraph:

HSBC Investment Funds (Canada) Inc., manager of the HSBC Mutual Funds, and HSBC Investments (Canada) Limited, manager of the HSBC Pooled Funds, confirm that there is no exposure to third party asset backed commercial paper within any of these Funds.

Finally! Some explicit recognition in all this mess that there is a difference between the corporation’s interest and the subsidiaries fiduciary function. It isn’t much and it isn’t any kind of proof that all is well with separation of function at HSBC Canada (any more than the press releases that aroused my ire in the past two days are any kind of proof that there’s anything wrong at National Bank and Industrial Alliance) … but the more that such a distinction is mentioned in public, the more willing I am to believe that the distinction is part of corporate culture.

All this Independent Review Committee stuff has to be good for something, right?

In Canadian ABCP news, NAV Canada (beloved of all those who pay for airline tickets) announced that it:

holds approximately $368 million of non-bank R-1 (high) rated ABCP allocated among its reserve funds and accounts required by its debt indentures.  The Company has approximately $130 million of cash and cash equivalents not affected by the problems in the non-bank ABCP market.

It is, of course, cheap and easy to point out investment mistakes in hindsight, so I’ll try to show a little restraint … but that means about three-quarters of their cash is held in non-bank Canadian ABCP. They may wish to review their diversification policies.

Amidst fears that liquidity infusions are being hoarded by the top-tier banks four major banks were jawboned by the Fed into using the discount window and letting the credit trickle down. Bernanke is using a more targetted approach than Greenspan used for the 1998 LTCM crisis … we shall see how it all turns out! If he can get away with it, there will be less bleeding of easy credit into the real economy and less chance of a renewed asset bubble. At present, the Fed appears to be defending a 5% Fed Funds rate but Bernanke’s got lots of time to decide whether or not to make the de facto easing de jure. The futures traders appear to believe in a three month ease, then back to the anti-inflation grind.

There is still a lot of stress in the global system despite a pause for breath in US markets. Investors should remember the Fed doesn’t really care about them. We can only hope that the politicians do not succeed in getting the Fed to bail out mortgagors, but it is election time in the US, after all, so there’s bound to be a lot of showboating.

Meanwhile, the default statistics on securitized loans mentioned yesterday are being confirmed by statistics on mortgages held directly. Lenders are reacting ruthlessly to the changed climate, with three lenders firing 3,700 employees. Remember “creative destruction”? This is the nasty second part, and we’ve only just begun:

two European mortgage-securities funds had their credit ratings slashed to junk from AAA by Standard & Poor’s because debt market turmoil curbed access to short-term financing.

Even more seriously, Wall Street bonuses are threatened. On the other hand, in late-breaking news it was announced that Bank of America’s putting $2-billion into Countrywide. So things are – very slowly and jerkily – working as they should.

At least one hedge fund is experiencing knock-on effects of the credit crunch. Stratus has 25% of its assets in Sentinel, which suspended client redemptions on August 14 – which may, in fact, have more to do with fraud than liquidity.

The Chinese have bought up a huge amount of high-quality housing debt over the past few years.

Here’s a good question to ask your friendly neighborhood US Equity Quant: “how do you distinguish between the various levels of financial instrument valuation“? Without having to gain access to the quantitative code and other trade secrets, you should be able to come to a reasonable judgement of skill level by the answer to that question!

US Equities had a very good day as traders decided the world might still exist at the time today’s trades settle. Canadian equity roared upwards, but is still down a bit more than 7% from the July peak. We shall see what happens if Tom Graff’s musings on the potential for re-pricing of as-yet unsettled private equity takeovers should prove to be prophetic with respect to the Teachers’ / BCE deal.

Treasuries fell, with the 2-10 spread flattening 6bp. Some investment grade issuers raised funds, reducing reliance on short term credit, for instance:

XTO Energy Inc. reopened a bond sale yesterday, raising $1 billion to pay down commercial paper, according to a regulatory filing. Fort Worth, Texas-based XTO yesterday sold five-year, 10- year and 30-year bonds.

After all … look at the alternative:

Asset-backed commercial paper yields rose to the highest in almost seven years after H&R Block Inc., the biggest U.S. tax preparer, said a unit tapped $850 million in credit lines because it couldn’t sell the short-term debt.

Canadas fell, with the 2-10 spread flattening by 7.4bp, in what was hailed as an indication that the market has been pricing in too catastrophic a disaster.

It was a quiet and calm, but none-the-less positive day for Canadian preferreds. There was good volume and a confluence of prices with BAM.PR.M / BAM.PR.N, so it may be that those issues are normalizing after recent wild oscillations … subject to “normalizing” being a meaningful word, that is!

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

Another nervous day

Continuing the recent pattern, Yvon Charest, Industrial Alliance’s President and Chief Executive Officer, gave his portfolio managers a kick in the teeth by usurping their responsibilities. They’re just plain flat out buying the ABCP in their mutual funds – there is no indication as to whether the portfolio managers want to sell (and look, I know that’s a pretty good bet, OK? That’s not the point). Mr. Charest’s track record as a portfolio manager was not disclosed; we can expect unit-holders not to care until conflicts of interest are resolved in a way they don’t like and a newspaper headline tells them to care.

If Mr. Charest wants to play at “Portfolio Managers”, there is nothing to prevent him from issuing index-linked PPNs, and doing it all on his own balance sheet. But if there’s to be a separate balance sheet there has to be independence.

There is no indication as yet that anybody besides me thinks this is important; analyst independence is just so 2002.

On the sub-prime front, large bets are being made agains ResCap’s survival – and ResCap is a big player:

At the end of June, ResCap had tapped those [ABCP] markets for about $5.5 billion in financing, according to regulatory filings.

ResCap has about $18.5 billion in committed financing, CreditSights analyst David Hendler wrote in an Aug. 7 note.

Mortgage companies without any sub-prime on their books, such as Ottimo Funding LLC, are experiencing financing difficulties.

The default reports for July have been released and Fitch has placed $92.1-billion under review. Last month they reviewed $118-billion and downgraded $13-billion of it. There are more calls coming out for a review of the ratings agencies, as the politicians seem to have agreed on a convenient scapegoat. There are more calls for increased regulation of banks, as well.

Yves Smith has published a balanced review of the various critiques of Central Bank actions. Put me in the third camp: Realist (although I would prefer “Pragmatist”). The market is faced with a situation in which nobody will even look at riskier or more complicated debt. The central banks must first ensure that the commercial banks can, in fact, make investment decisions with reasonably assured financing. Then they must increase the spread between government and commercial paper to the point where real investors (as opposed to mere dealers) will at least be interested enough to look at it. Finally, once the normal routine of examining credit and making an actual decision between safe-but-low-yielding and riskier-but-higher-yielding securities has been re-established, we can get back to fighting inflation. And don’t worry, once people start looking at risk/reward with a more jaundiced eye, there will be plenty of losers. But if the credit markets lock up and everybody in the world has to dump assets on the market at give-away prices in order to de-lever, we’re talking deflation. And deflation is bad.

Tom Graff seems to be in so-far-so-good camp as well, while James Hamilton applauds the Fed’s methodology thus far.

There is some speculation that the liquidity crisis is over and we can all go home; fortunately there are cooler heads at the Fed:

“Financial market volatility, in and of itself, doesn’t require a change in the target federal funds rate,” [Richmond Fed President] Lacker said at a luncheon of the Risk Management Association of Charlotte. “Policy needs to be guided by the outlook for real spending and inflation.”

And, in boring news about the real economy, the Cleveland Fed reminds us that inflation, while still worrisome, is showing signs of responding favourably to the Fed’s policies of moderate restraint. 

True to form, however, US equities were up on takeover speculation, so it would seem that some are hopeful the whole episode was just a bad dream. Canadian equities followed.

Canadian banks re-affirmed their committment to providing credit support to their own Asset Backed Commercial Paper (ABCP) products. I can only imagine they’re having difficulty rolling the paper and are attempting to (i) reduce their conduit’s cost of borrowing, and (ii) keep the assets & liabilities off their own balance sheets. Given that their cost of funding, as measured by the September BAX on the Montreal Exchange has risen to about 4.6% (and I’ve seen them much higher), I’m sure they’re about ready to try anything. Note that the Canadian 3-month WI T-Bills are at 4.00% … that’s an amazing spread – according to RBC, the spread was 30bp on August 10, 62bp on August 17.

US 3-month T-Bills finally increased in yield but the 2-10 curve steepened anyway – so let’s not say it’s over just yet! The Canadian 2-10 spread steepened again and is now at 30.5bp. Hank Cunningham provides some historical context.

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