PrefBlog

David Dodge made an interesting speech in London, England. Of most immediate interest was his hawkish monetary stance:

I want to be absolutely clear on one point: The actions that we took to provide liquidity to support the smooth operation of financial markets did not in any way signal a change in our monetary policy. In fact, it was a step in maintaining our monetary policy stance by keeping our target for the overnight rate at 4 1/2 per cent, which we judged appropriate for keeping inflation on target over the medium term.

… but the theme of the speech was transparency:

In this complex process, transparency about the underlying credit was often lost. Because the originators of the loans intended to securitize them rather than leaving them on their balance sheets, they lacked the incentives to carefully assess the creditworthiness of the borrower. And investors often lacked the ability, or did not make the effort, to see through the complexity of the instrument. Thus, investors were unaware of the creditworthiness of the root asset and the potential difficulties with the liquidity of the instrument itself. Compounding the problems was the fact that the models upon which these structured products were valued assumed that they could be readily traded in a liquid market.

So far so good – especially the bit about liquidity. Liquidity killed portfolio insurance in 1987, but people never learn!

Moreover, the complexity and lack of transparency in many of the structured products added to the market dislocations. It was extremely difficult for investors to peel back the layers of these securities and derivatives to determine, with confidence, both the creditworthiness of the assets backing a particular security and the market value of the security itself. Even supposedly sophisticated investors became extremely uncertain and that, in turn, led to fear.

So far, so good. But now he skates over to an unrelated point:

In my view, there is a clear case for transparency more generally in the operation of all financial markets. In most countries there are fairly clear rules requiring transparency in the operation of mutual funds, so investors can tell what they are purchasing. Hedge funds, by their nature, are less transparent. But there is also, I believe, a clear case for increased transparency, at least with respect to their objectives, operating procedures, and governance.
…
Let me now say just a few words about the importance of transparency in government-sponsored institutions, whether domestic or international. I will begin with a few words about sovereign wealth funds, which control increasingly large amounts of money and are significant global financial forces. Some of these funds, such as the public pension funds in Canada, already adhere to very high standards of transparency. But in other cases, there is often insufficient transparency in the operation of these funds. Too often, the objectives behind these funds are not clearly defined, and this can lead to misconceptions about their motives, particularly those that have their origins in foreign exchange reserves. As is the case with private pools of capital, high standards of transparency for reporting and governance, as well as objectives, would be helpful for these public pools of capital.

So he begins with the idea that maybe it would be a good idea if PMs had some vague idea about what they’re buying … and ends with a desire to poke his nose into sovereign wealth funds? Mark my words … something’s up. We’re not being set up for the Bank of Canada to form the nucleus of a national securities regulator, are we? And not even Harper & Flaherty would politicize the Bank of Canada by influencing Dodge to help advance a political agenda?

Be afraid. Be very afraid.

The recession probability continues to be debated – with some amusing 1998 headlines:

• Market Watch: Bracing For Mortgage Losses
• Despite Late Rally, Dow Ends A Bad Week Lower
• Shift To Capital Markets From Banks Brings Tumult
• Crisis Goes Beyond The Balance Sheet
• Banks Tighten Some Loan Terms
• Commercial-Mortgage Issuers Are Locked In A Deep Freeze
• Recession Fears Dominate
• Market Turmoil Hits Luxury Home Sales
• Heavy Spenders Take A Break
• Decade of Moral Hazard
• Emerging-Market Investors Get Full-Fledged Drubbing

… which goes to show two things:

• Plus ça change, plus c’est la même chose
• You can always count on newspapers and markets to get extremely excited about things.

The laissez-faire approach of the Bank of England has been compared to the more activist approach of the Fed:

The change in LIBOR is going to hurt bank profits, but the BoE is hanging tough:

“The provision of such liquidity support undermines the efficient pricing of risk by providing ex-post insurance for risky behavior,” King said today in written testimony to the U.K. Parliament’s Treasury Committee. “That encourages excessive risk-taking, and sows the seeds of a future financial crisis.”

Brad Setser has discussed Bernanke’s assertion that a savings glut will continue to keep interest rates low. He largely agrees, but puts more weight on official flows.

US Equities were flattish:

Analysts expect third-quarter earnings at S&P 500 companies to grow by 3.7 percent, down from an average estimate of 5.2 percent at the start of August, according to data compiled by Bloomberg. Growth at that rate would snap a streak of 20 straight quarters above 10 percent.

… but Canadian equities looked forward to higher oil prices.

Treasuries were off slightly and Canadas were downright boring.

Volume was fairly light in the preferred market, but Scotia pulled off a good sized cross. I was surprised to see that BAM.PR.M / BAM.PR.N did not exhibit ridiculous behavior on their ex-date … wow! Normal behavior from this pair!

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

There may be some spikes in commercial paper rates shortly as $700-billion in CP needs to be refinanced. There’s also a good chunk in Europe … so we may see some spectactular flame-outs.

We’re not over the hump yet, and won’t be for several months, as forecast by Ed Clark of TD. There are still lots of hedgies that haven’t blown up yet, although Y2K Fund has now halted redemptions:

The fund dropped 30 percent over June and July, according to data compiled by Bloomberg. It had been the best performing non- U.S. hedge fund investing in fixed income in the three years to the end of September 2006, according to Bloomberg data.

Maurice Salem, who founded Wharton in 1993 and runs the firm, didn’t answer calls to his mobile phone. Calls to the company’s offices in London weren’t returned. The Y2K fund was established in 1999.

Wharton’s Trio Finance Ltd. fund, which invests in real estate asset-backed securities, has fallen 46 percent this year, according to Bloomberg data.

Yesterday I mentioned Flaherty’s solution to the sub-prime crisis, namely: let the feds be in charge of capital market regulation. I was very pleased to see that there is at least one other person in Canada who noticed one vital thing about his remarks:

[Quebec Finance Minister] Ms. Jérôme-Forget said Mr. Flaherty has no business using the credit crisis to advance his campaign for a single regulator because there is “absolutely no link” between the subjects.

European Central Bank President Jean-Claude Trichet weighed in on regulatory reform:

Stressing the positive aspects of recent financial innovations to repackage and sell debt, Mr. Trichet nonetheless called the complexity of some debt products “overwhelming.” He said, “instruments and structures that cannot be fully understood even by those who bear the ultimate responsibility of the level of risk taken by financial institutions should not be acquired or set up by banks and investors who are lacking sufficient sophistication in the management of the risks.”

Mr. Trichet also called a dearth of ratings agencies problematic “for the present functioning of global finance” and suggested the agencies work out “benchmarks for improved behavior,” particularly on potential conflicts of interest. But he blamed investors equally: “An important lesson of the current risk re-pricing is that investors must never take the opinion of rating agencies as a substitute for their own credit analysis and due diligence.”

Well … I’d like to hear more about “benchmarks for improved [Rating Agency] behavior” … but three cheers for the rest of his comments! Who knows, if the hedgies take his advice they might last a little longer:

How often do hedge funds fail?
Lacking accurate data on the failure rate of hedge funds, most studies use the number of funds that stop reporting to the Lipper TASS database. According to this proxy, the average lifespan of a hedge fund is 40 months, with a median life of 31 months. Fewer than 15 per cent of hedge funds last longer than six years, while 60 per cent disappear within three years.

Meanwhile, US equities had a great day on hopes of a Fed easing and lots of consumer spending, aided by a Manpower report indicating jobs aren’t as scarce as all that. Canadian equities also rose on hopes that then we can sell them rocks and trees.

However, the Treasury market is now worried that it overshot but even with the rise in yields:

Yields on two-year notes, which are more sensitive to interest-rate changes than longer-term securities, are 131 basis points less than the Fed’s benchmark lending rate, near the biggest difference since January 2001.

Canadas followed.

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

The Economist points out that mark-to-market accounting (which is a hallmark of securitization) can be destabilizing; it can turn bankers from rather dry borrow-short-lend-long types into market speculators. I believe we are seeing this effect in the CPDO market where the deleterious effects of spread widening on capital have been observed, but the benefits of realizing on those spreads over the mid-term have not yet materialized.

It is also possible that cooler heads will prevail and avoid rushing for the exits – a possible example is:

Washington Mutual plans to hold more loans for investment, citing potential for strong risk-adjusted returns.

And it would appear that some shops have resolved their funding issues:

Thornburg Mortgage Inc., the home lender that sold $20.5 billion of mortgage bonds at a loss last month to ease a cash shortage, now plans $3 billion to $4 billion of purchases to take advantage of low prices.

The AAA-rated securities could yield 1.25 to 2.25 percentage points over Thornburg’s cost of funds, President Larry Goldstone said in an interview. That compares with an average of 0.5 points for securities now in the Santa Fe, New Mexico-based company’s portfolio. The purchases will occur “over the next month or two,” presuming mortgage markets begin to stabilize, he said.
…
Goldstone said $546 million of fresh capital from a preferred-stock sale last week will help the company pounce on opportunities that cash-starved rivals can’t afford.

Some of my more fanatical readers may remember my post about BSABST 2005-1, in which I attempted to demonstrate that the S&P downgrade of one particular ABS wasn’t as scary as it sounded when one looked at the actual dollar values. I’m a little late reporting this, but I’ve found a S&P press release about subprime that puts a little meat on those bones:

Our July 2007 downgrades affect around 1% (by value) of the US subprime first lien mortgage tranches we rate:
• 85% of the ratings downgraded were BBB and below (ie, the weakest quality subprime securities)
• no AAA ratings on these securities were downgraded
• between July 1 and August 24, 2007, S&P received reports of only three defaults from approximately 15,000 current first lien subprime mortgage tranches rated by S&P globally (two of the defaulted tranches were issued in 2002, the other was issued in 2004).

We’ll see how it all turns out. We’ll probably find that the ratings agencies acted in a less than perfect way – I haven’t yet found an analytical system or an analyst who’s perfect. But I’ll bet a nickel that in ten years we’ll be saying that the pendulum of sentiment swung from “Everything is perfect” to “The world is about to end” and that hedgies as a group are attempting to deflect criticism of their own performance towards the agencies; aided by the regulators, who can’t stand to see anything happen in the capital markets that doesn’t involve a kow-tow to the regulators; abetted by the reporters, who don’t care what they say as long as it sells papers; and encouraged by the politicians, who need to show Concern and Judicious Thought.

Like, for instance, Flaherty:

Finance Minister Jim Flaherty says the summer credit crunch is indisputable proof of the need for a single Canadian securities regulator: one that could better guard against, and fend off, shocks buffeting this country’s capital markets.

Such nonsense – and Flaherty doesn’t do anything but wring his hands at the horrifying idea that something might happen in this country without federal regulation.

Regulation of the securities markets in Canada can clearly be improved – see my summary of sales restrictions applying to my firm, for instance – but not, I believe, in terms of the end product. There will be the same good points and bad points about the effects of the application of regulation whether we have one regulator or five hundred. The effects of regulatory unification will be noticable only in the cost – in terms of actual dollars, time and elimination of basically arbitrary selling restrictions – and should be pursued for that end alone.

There is considerable debate regarding what the Fed should be doing at their September 18 meeting. James Hamilton view is:

They can clearly communicate they’re not panicked by the market or bullied by the politicians by waiting until the scheduled September 18 meeting before announcing a cut, and even then one or two members could cast a dissenting vote. Markets would see a 25-basis-point cut delivered in that manner as a splash of pretty cold water. If next month’s data show the same trends as last week (some comforting and some alarming numbers), the Fed could cut another 25 basis points at the end-of-October meeting, adding another dissenting vote. That would leave them free to move any way they want, up or down, in December.

If we get stronger confirmation that the August employment and LA home sales numbers are not an anomaly, the Fed should be prepared to make that a 50-basis-point cut for October.

I agree; I’d like to see some language in the statement that they’re still worried about inflation, jobs number or no jobs number … monthly data can vary significantly. As JDH notes, the increase in LIBOR has done a lot of the anti-inflation heavy lifting on the Fed’s behalf.

Brad Setser notes that:

At least part of the dollar’s August rally seems – at least to me – to have been tied to deleveraging (including deleveraging by European banks) rather than safe haven flows.  Selling rubles and Asian equities to pay back borrowed dollars isn’t quite the same as seeking out the dollar because you expect it to rally in times of stress.

… and sees interesting times ahead for countries with currencies tied – explicitly or implicitly – to the dollar.

US equities looked like they were going to have a horrible day until Thornburg announced its plans to rebuild a position in some high-grade sub-prime tranches. Then they recovered, followed by Canadian equities.

Treasuries continued to roar, yields falling 6bp in a parallel shift, but it’s not doing the dealers much good and reports of foreign selling into the rally continue to accumulate. Canadas were listless.

There were a few good sized crosses in the preferred market today, but the increase in volume wasn’t very broadly based. PerpetualDiscounts continued to recover; they have had only one (minor) down day since August 16 and are up 2.05% since that date.

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

Well – a short week, but not entirely devoid of interest!

Today’s big news was that the US Jobs number was negative, which hasn’t happened in a while. Politicians reacted according to their stripe; economists hastily revised downwards their expectations for both growth and rates. Greenspan sounds very happy it’s not his problem. There is general agreement chances of a recession have increased.

I’ve previously mentioned Deutsche Bank’s success at Credit Anticipation in betting against sub-prime. Another winner emerged today:

The $4.5 billion Credit Opportunities fund, started last year, gained 26.7 percent in August, according to a Paulson investor. Credit Opportunities II, a newer $2.3 billion fund, is up more than threefold after a 32 percent return last month.

I feel quite sure that a lot of these massive losses we’re reading about are just hedge funds transferring money back and forth … when you share 20% of winnings and 0% of losses, why not bet the firm?

The Canadian bank-operated ABCP market is having major problems. Three-month BAs are yielding about 5% … ABCP is yielding about about 5.60% … when three-month bills are at 4.04%. That kind of spread is … well, let’s just say that banks are not having a nice time. Mind you, it’s even worse in the States, with bills at 4.07% and financial paper at 5.48% (US ABCP at 6.18%). While we’re on the topic of ABCP, the outstandings in America continue to shrivel, which indicates a ferocious combination of deleveraging and transfer to bank lines. The ‘transfer to bank lines’ part is dangerous – there is some concern regarding the banks’ committments and whether regulators need to step in. I don’t know, frankly, if line committments are added in any way to risk-adjusted capital. They should be! Especially since laying off risk is, to an extent, boomeranging.

Countrywide Credit is having a mass layoff, trying to survive in environment where it’s difficult, to say the least, to securitize mortgages that it originates. Citigroup is reportedly refusing to accept new mortgage clients. But maybe they’re just providing bigger lines to fewer clients.

Centex Corp., a Dallas-based homebuilder and lender, said in a regulatory filing today it replaced a warehouse credit line with a larger one arranged by JPMorgan Chase & Co. that may provide as much as $1 billion. Centex increased the credit line because the global credit crunch made it hard to rely on selling short-term notes to finance mortgages, the filing said.

US equities went splat on the jobs number. Recessions aren’t generally good for profits! Canadian equities also fell.

Treasuries had such a good day on the back of the jobs number it has to be referred to as panic-buying (possibly sending a lot of profit to foreign central banks, since boneheaded fiscal policies have sent a lot of money abroad). Why not, when Fed Fund Futures are predicting a rate of 4.5% by December? Well, perhaps because Fed officials are watching the economy, not markets. Canadas had a super day, with the ten-years’ yield declining about 13bp.

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