PrefBlog

American GDP grew at an annualized rate of 3.9% in the third quarter, but economists were not impressed. On a positive note, ADP Employment data was stronger than expected, which implies that next Friday’s jobs number shouldn’t be disastrous, at any event.

In other words: we’re confused! So what else is new?

The Fed cut to 4.50% today, as expected. When the market is unanimous, the Fed usually listens. Accrued Interest looks to the future and sees the potential for future cuts measured in terms of bank rescue rather than broader inflation/economic concerns.

The more things change … in 1993, the US had the steepest yield curve since the Civil War, as the Fed was busy bailing out the banks’ profitability (this was in the aftermath to the S&L crisis, remember). Then, in 1994, the music suddenly stopped and Orange County, among others, couldn’t find a chair. It will be most interesting to see how this cycle unfolds!

Well, thank heavens that month’s over! There have been a huge variation of the returns in the HIMIPref™ indices over the past month and the fund was unfortunate enough to have identified a broad pricing discrepency just as the panic got started. Returns this month are not a complete disaster, I hasten to add, but will have underperformed the index.

Mind you, the yield on the fund’s holdings is now well above the index and credit quality is great … so the faster that things normalize, the happier I’ll be! Results should be published on Saturday November 3, or Sunday at the latest.

There were thirty other index-included $25.00-equivalent issues trading over 10,000 shares today.

US Consumer confidence was reported to be way down today, while housing prices declined at an accellerating rate. Geez, this is sounding a lot like my September 25 post! Perhaps I should just keep a template full of gloomy news and copy-paste!

There was some very interesting news regarding the overall credit crunch today: it seems that Federal Home Loan Banks in the states are making massive loans to the marketplace, financing them by issuing their own paper:

Countrywide Financial Corp., Washington Mutual Inc., Hudson City Bancorp Inc. and hundreds of other lenders borrowed a record $163 billion from the 12 Federal Home Loan Banks in August and September as interest rates on asset-backed commercial paper rose as high as 5.6 percent. The government-sponsored companies were able to make loans at about 4.9 percent, saving the private banks about $1 billion in annual interest.

FHLBanks are kind of interesting. They are regulated not by the Fed, but by the Federal Housing Finance Board,

an independent agency within the executive branch of the federal government.
…
The Finance Board consists of a five-director board—one of whom is the Secretary of Housing & Urban Development (HUD) or the Secretary’s designee. The other four directors are appointed by the President and subject to Senate confirmation. 

In other words, it’s all political. They trumpet their 4.41% Capital to Asset ratio, but there is no indication that I can find – even in the Annual Report for FHLB Atlanta – of how this may be expressed in standard Basel Agreement terms, like “Tier 1 Capital Ratio”. I don’t know. I don’t know very much about this aspect of the US Financial system … and I’m willing to listen carefully to those who do … but this seems to me to be another grossly under-capitalized source of moral hazard, in addition to the GSEs.

A summary article in Voxeu led me to a CEPR Policy Insight which in turn was based on a lecture given 2007-10-1. Recycling of all kinds is very fashionable nowadays! At any rate, Axel Leijonhufvud has joined the debate regarding whether the Fed (and central banks in general) should target inflation alone, or should also pay attention to (potential / perceived) asset bubbles. He argues that the absence of US inflation in the early part of this decade was due not so much to the availability of cheap Chinese labour as it was to the willingness of the Chinese (and others) to accumulate dollar reserves.

So the trouble with inflation targeting in present circumstances is that a constant inflation rate gives you absolutely no information about whether your monetary policy is right.
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It is a simple observation that the experience of Japan shows that inflation targeting will not by itself protect you against financial instability. The present criticism goes a step further. Inflation targeting might mislead you into pursuing a policy that is actively damaging to financial stability.

He criticizes SIVs, but I find his arguments a little facile. He does not distinguish between liquidity risk and credit risk (he’s not alone there!) and claims that they circumvent the Basel rules. The well-informed readers of this blog will know that while they used to circumvent Basel in the States, liquidity guarantees are now charged against capital. There is, of course, continuing controversy over whether the liquidity guarantees are expensive enough; I suspect that they’re not; and I have good reason to believe that the issue is currently under intense scrutiny by regulators world-wide. But he doesn’t actually say this.

He also claims that the “SIVs were, like hedge funds, highly-leveraged” … I don’t know exactly what he means by this; he may be considering only the very bottom tranche as equity and ignoring the tranching effects of mezzanine notes; it’s not clear. He speaks very highly of NN Taleb and the Black Swan phenomenon, feeling that the concept is not adequately reflected in risk management at large financial institutions. His final conclusion is that the fact that no big exogenous shock caused the current crunch shows that the world financial system is not well understood … which is comforting indeed to those of us employed by it!

In Canada, the most economically illiterate government since Trudeau elected to cut the GST to 5% and reduce the national debt by a mere $22-billion over the next five years while reducing other taxes as well. Perhaps the boomers will all die off without having ever paid for their government services! Interest on public debt is forecast to remain in excess of $30-billion annually; it’s currently 14% of federal revenue.

I have not yet seen any indication on whether there are any implications for interest-equivalency of dividends in the tax changes. Probably not, since it hasn’t been trumpetted.

It was a good day for preferreds today – good volume and the PerpetualDiscount index was actually up 0.1759% on the day, its third up day this month. Before breaking out the champagne, note that today’s gain is less than yesterday’s loss, so the index is still down on the week.

The spread between BAM.PR.M and BAM.PR.N widened some more, on good volume.

There were thirty-two other index-included $25.00-equivalent issues trading over 10,000 shares today.

Well! There I was, all set to attend David Berry’s contested hearing with RS, having spent all weekend choosing overly ripe tomatoes to hurl at any disingenuous Scotia executives with the effrontery to show up … and now I find that it’s been postponed! I have no idea what’s going on. Maybe RS has gotten a little embarrassed about being used as a pawn in a contract negotiation. Maybe somebody’s realized that if Jesus Christ Himself was subjected to the same level of scrutiny as Scotia has inflicted on Berry, then there’d be equal cause for firing, mudslinging and character assassination. Stay tuned!

Possible Fed moves this week are being discussed all over, with the consensus calling for a 25bp cut to 4.50% (and Bill Gross of PIMCO is calling for 3.50% in the near future). There is more than one report that the Fed is unhappy with such certainty, but I’m not convinced that this is the case. The Fed is adept at manipulating opinion; if they were truly unhappy with the forecasters, they would send a few hawks out to make speeches about the dangers of hyper-inflation. Poole has been given a lot of attention in the past few months; the WSJ has grilled him about his high profile.

The Super-Conduit debate continues, with a report that:

the banks will earn 1% on structured investment vehicles of less than $5bn, and 1.5% for SIVs over $15bn
…
The prospectus also details what SIVs will receive for selling their assets to M-LEC. Qualifying SIV holders will be eligible for up to 94% of the value of the assets they sell in cash, or 89% cash and 5% in senior capital notes, in the form of medium- term notes, that will participate in part of the upside when the assets mature.

I have not yet seen this report confirmed by more usual sources – but I’m looking! I guess my reaction is dependent upon the interpretation of the word “value” in the above paragraph. If we can presume that “value” means “recent trading prices in small lots”, then I believe I have every right to refer to Super-Conduit as Vulture Fund … but if “value” means something else, then we’re back to uncertainty. We shall see!

Well … PerpetualDiscounts were whacked again today – and the Question Regarding BAM.PR.N I received today makes me wonder if we have reached the point of self-feeding gloom-and-doom, otherwise known as capitulation. Long Term corporate bonds yield about 5.8%, according to Canadian Bond Indices … at 5.65% Dividend, the perpetual discounts have an interest equivalent of 7.91%.

Ah well. Remember why you bought them! In the absence of default – which, for the the companies in the indices, seems no more likely than ever – I’m willing to cash the dividend cheques for quite some time.

There were twenty-eight other index-included $25.00-equivalent issues trading over 10,000 shares today.

CDOs (Collaterallized Debt Obligations) were in the news today, as Bloomberg reported that Moody’s cut a batch of ratings. The Bloomberg story doesn’t mention some important context, presumably since that would make the story less interesting. According to the unexpurgated press release:

it has downgraded $33.4 billion of securities issued in 2006 backed by subprime first lien mortgages, representing 7.8% of the original dollar volume of such securities rated by Moody’s. Of the $33.4 billion downgraded securities, $3.8 billion remain on review for further downgrade. Moody’s also affirmed the ratings on $258.6 billion of Aaa-rated securities and $21.3 billion of Aa-rated securities, representing 74.7% and 52.0% of the original dollar volume of such securities rated in 2006, respectively.
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The Aaa- and Aa-rated securities that have been placed on review for possible downgrade are generally not expected to move by more than three notches. The most heavily impacted securities were originally rated Ba, Baa, or A. Rating migrations have been much more severe for the more deeply subordinated tranches of 2006 subprime deals.

Accrued Interest, which has an excellent primer on CDOs, has made a rather breathtaking suggestion:

the ratings agencies simply shouldn’t rate CDOs at all.
…
Furthermore, the ratings agencies could still model CDO deals in their Monte Carlo simulators for a fee. Investors could then run the Monte Carlo themselves, inputting default and recovery rates, default patterns, and correlation as they see fit. Rather than getting one or two perspectives on what the default/recovery/correlation patterns should be, investors could impose their own stresses.

I’ve discussed the results of such simulations in the post Loan Default Correlation.

Sadly, Accrued Interest’s suggestion doesn’t have a chance of working. As I keep reiterating here, investors (as a group, with lots of exceptions) do not want to do any analysis. And they don’t want to spend any money on useless, profitless credit analysis, or any time understanding what it is they’re doing. They want to buy something that goes up because it’s good.

There are no possible regulations that will enforce this. Adding more rules will not make this a better world. All market regulators should have a form letter: “Yeah, you’re #$%^! bankrupt because you’re #$%^! stupid.” to be sent by the busload to complainers. They should also be much more willing to pull investment management licenses on the basis of incompetence.

This last thing is hard to do. If my investment theme is that demographics are going to cause a boom in granola, I tell all my clients this, they give me money and I promptly blow it all levering up granola futures 100:1: this doesn’t necessarily make me incompetent. Wrong, yes, but being wrong is simply part of the investment management game (which is why my other theme in this blog is the chaotic nature of financial markets). If, however, they inspect my records and find that my carefully estimated granola consumption growth rate was a little off because I used “15” as a factor rather than as a percentage … well, then I’m incompetent and should be civilly liable and should lose my license.

Investment managers should be held strictly accountable for adhering to the Prudent Man Rule. But you know something? I think a lot of investment funds are run in the same way as Greek pension plans:

Board members of Greek pension funds are appointed by the government, labor unions and employers, often on a part-time basis, without specific professional or educational qualifications. The country has about 200 pension funds with assets of more than $44 billion, according to finance ministry estimates.

Quis custodiet ipsos custodes? While specific professional or educational qualifications are nice to have, I’m not as impressed by them as the reporter seems to be … but they are, at least, an indicator. With respect to the particular Greek Tragedy reported, I agree with:

C. Kerry Fields, a professor of business law at the University of Southern California’s Marshall School of Business in Los Angeles, said JPMorgan appears to have acted lawfully in its handling of the sale to North Asset Management and bears no responsibility for what happened later.

“The foolish people are the buyers because they paid so much,” Fields said.

What’s needed on pension boards are people with the guts to ask questions, the intelligence to Think Useful Thoughts about the answers and the ruthlessness to fire those who don’t measure up. Those are the qualifications I like.

On another front, Naked Capitalism reviews the political pressure for a Fannie Mae / Freddie Mac bail-out. We can only hope that this pressure is successfully resisted – as has been argued by James Hamilton of Econbrowser:

it is equally clear to me that the correct instrument with which to achieve this goal is not the manipulation of short-term interest rates, but instead stronger regulatory supervision of the type sought by OFHEO Director James Lockhart, specifically, controlling the rate of growth of the GSEs’ assets and liabilities, and making sure the net equity is sufficient to ensure that it’s the owners, and not the rest of us, who are absorbing any risks.

Fannie Mae & Freddie Mac (the “GSEs” – Government Sponsored Enterprises) walk like banks and talk like banks … but they are not regulated like banks because grandstanding politicians such as Charles Schumer want to have all the fun of providing services to constituents without having to bother with trivial little details like paying for them (which in this case means, one way or the other, ensuring that the GSEs are capitalized like banks).

We have seen in recent months how a problem that’s relatively small (US Sub-prime mortgages) in the grand scheme of things (the world financial system) can act as a flashpoint for a major paradigm shift (if that metaphor makes any sense). Let’s not increase the potential for a major bankruptcy by allowing the GSEs to lever up even further beyond the bounds of prudence.

On a somewhat related note, I was amused to see the tone Bloomberg adopted when reporting the continued decline of American home ownership:

Homeownership in the U.S. dropped for a fourth consecutive quarter, the longest decline since at least 1981, suggesting more Americans will miss their best chance of building wealth.
…
“Owning a home in this country has been a principal source of wealth creation for low- and moderate-income people,” said Nicolas Retsinas, director of Harvard University’s Joint Center for Housing Studies in Cambridge, Massachusetts. “In the absence of home equity, families will inevitably spend less.”

Homeowners accumulate wealth faster than renters, with median net wealth for owners at $184,400 in 2004, compared with only $4,000 for renters, according to Federal Reserve figures.

Given the glee with which they regularly point out that everybody (except gullible investment managers) knew all along that housing was a bubble created by the Evil Credit Rating Agencies, the emphasis on these data is surprising! But they redeem themselves with an interesting factoid towards the end of the article:

Out of 297 townhouses in Springfield, Virginia, for sale last week, almost 80 were in the process of foreclosure or offered at a price lower than the mortgage balance, so-called short sales, said [Re-Max real estate agent Steve] Hawkins.

Two years ago there would have been about 50 such units offered in the same Washington suburb, with none in foreclosure, he said.

The long-term trend is clearly in homeowners’ favour – but, as the the WSJ reports, houses haven’t been doing too well lately:

On September 24 I noted that the US was testing pandemic preparedness, stressing the system with a simulated 49% absentee rate. The results are in and analysis is under way:

When asked “based on the lessons learned from the exercise, how effective are your organization’s business continuity plans for a pandemic,” 56% answered “moderately,” the next highest group was “minimally,” at 28%. Only 12% said their business continuity planning was very effective.

I have previously noted the various controversies about inflation measurement – but look at Argentina’s measurement problems:

Argentina’s benchmark inflation-linked bonds have tumbled 24 percent this year, making the country’s debt market the worst performer in the world, according to data compiled by JPMorgan Chase & Co. and Bloomberg.
…
Merrill Lynch & Co., the world’s biggest brokerage, estimates prices may be rising at a 17 percent annual pace, double the official rate.
…
Daniel Fazio, head of the employee union, said in February that a Kirchner political appointee had statisticians eliminate some details from the index and violate secrecy laws that prohibit the release of information during the data-gathering process. The union said federal prosecutor Carlos Stornelli is investigating the allegations. The prosecutor’s office has declined to comment.

I continued to work through the BoE Financial Stability report, but was sidetracked by a desire to investigate their “Box 2” further. What a great report that is! Crammed with information and references, but well written with a bias towards explaining the implications of important ideas from a policy perspective.

There’s a fascinating report that the credit rating agencies are being investigated for corrupt practices:

[Connecticut Attorney General Richard] Blumenthal’s office is investigating complaints that the ratings companies rank debt against issuers’ wishes, then demand payment, he said today. The state also is probing whether the companies threaten to downgrade debt unless they win a contract to rate all the issuer’s securities, as well as the practice of offering ratings discounts in return for exclusive contracts.

Quite the laundry list of charges! ‘Ranking debt against the issuers’ wishes’ is hardly a problem; ‘Demanding payment’ is not a problem [hint: say ‘No’]; ‘offering ratings discounts in return for exclusive contracts’ is not a problem; the only allegation that, if proven, is actually a Bad Thing is the threat to downgrade if they don’t get a contract for the entire issued portfolio.

I find the idea a little hard to swallow, frankly. Transition matrices are holy and I don’t think the agencies would put them at risk in order to make an extra nickel or two. It might possibly be a deliberate mis-interpretation (either by the rating agency salesman or the issuer) of a threat to downgrade unless more information is made available to the agency … but we will see. It’s worthwhile to note the recent General Electric / DBRS kerfuffle, reported on the DBRS site as:

Given the level of investor interest, DBRS believes it is important to provide clarity as to its decision to withdraw the ratings on General Electric Company (GE), GE Capital Canada Funding Company (GE Capital Canada), Heller Financial Canada and Heller Financial, Inc.

DBRS had recently been in discussions with GE to ensure that DBRS would continue to receive adequate resources, including time and attention, from GE to support DBRS’s ratings and that there would be no issue with DBRS assigning ratings to GE Capital Corporation (GECC), the guarantor of GE Capital Canada.

Ultimately, GE decided that it was not fully supportive of adding a third rating agency for GECC, and GE formally requested that DBRS withdraw all ratings related to GE.

It’s easy to see how a bad relationship could quickly get worse given worst-case interpretations of such negotiations. But we’ll see!

In technical news that some (wierdos) might find of interest, the NYSE is eliminating rule 80A, which was enacted as part of the volatility damping package deemed necessary after the crash of 1987:

Rule 80A (a) and (b) require that, for any component stock of the S&P 500 Stock Price IndexSM, whenever the NYSE Composite Index® (“NYA”) advances or declines by a predetermined value from its previous day’s closing value, all index arbitrage orders to buy or sell (depending on the direction of the move in the NYA) must be entered as either “buy minus” or “sell plus”.
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The Exchange is making this change since it does not appear that the approach to market volatility envisioned by the use of these “collars” is as meaningful today as when the Rule was formalized in the late 1980s. Rule 80A addresses only one type of trading strategy, namely index arbitrage, whereas the number and types of strategies have increased markedly in the last 20 years and may as well contribute to the increase in or lack of volatility.

The rule has been applied 15 times on 13 days this year; the peak was 1998, with 366 occurances on 227 days.

And, holy smokes, I almost let an entire post go by without mentions SIVs! Naked Capitalism provides a round-up and some commentary; still quite convinced (perhaps correctly – who knows?) that Super-Conduit is a nefarious plot of some kind that is unlikely to attract investors.

The TD New Issue announced October 9 now has an estimated fair value of $23.76. It will not be a happy opening!

By one definition, Great-West and SunLife Financial are now distressed companies: GWO.PR.I closed at 19.90-98, 12×3 on volume of 47,085; SLF.PR.E closed at 19.92-18, 4×3, on volume of 11,750. I wonder what the Globe will have to say about this tomorrow?

Month-to-date, the PerpetualDiscount index is down 4.93% (on the week, it’s down 2.18%) and has gained on only two of nineteen trading days. On the other hand, the PerpetualPremium index has managed to grovel back over its 6/30 starting figure of 1,000.00, and is down only 1.89% on the month. On the other hand, there’s some very strange things going on in that index. What the HELL is CU.PR.B doing, being bid at 26.12 for a pre-tax bid-YTW of 5.17, when PWF.PR.I has the same coupon and a redemption schedule that differs by one month and one day, AND has a one-notch higher credit rating (DBRS) to put it into widows-and-orphans grade … and is bid at 25.31 to yield 5.71%?

However, as a participant on Financial Webring said today:

No, it’s because the market is an ass. Preferreds are retail driven with about half of the purchasers not even aware what they’re buying. We see it on this board all the time. They got lumped into the whole subprime/ABCP mess in my opinion by boneheads who think they have a connection to it. Down goes the price…………

Ah, Grasshopper, when you can take the pebble from my hand, it will be time for you to trade.

The market will normalize eventually. It always does. But DAMN, the waiting can be aggravating – and it probably wouldn’t irritate me so much if HIMIPref™ hadn’t indicated valuations were severely out of whack a little too early!

There were thirty-two other index-included $25.00-equivalent issues trading over 10,000 shares today.