PrefBlog

Sometimes I wish that this blog would get more comments. At other times, I’m glad that I don’t have to make the decision ten times per day on whether a particular comment is so ad hominem that I have to zap it. Today is one of those other days!

Menzie Chinn of Econbrowser posted a graph for which the general outlines have been known for a long time by those who are following the subprime debacle:

…and it triggered a lot of nastiness in the comments when a (purported – I haven’t checked!) market professional asked, essentially, ‘What’s the big deal?’.

It continually surprises me to see just how much bitterness there is out there against investment managers. But – that’s the Internet! As far as graphs go, I like the one from Moody’s showing mortgage delinquency rates:

Bear Stearns has agreed to a deal with CITIC whereby CITIC will take equity in Bear Stearns and Bear Stearns will, essentially, provide vendor financing. This should calm some fears about the future independence and financial viability of Bear Stearns going forward, and a joint-venture deal in Hong Kong with CITIC might even be profitable!

whereby CITIC will take equity in Bear Stearns and Bear Stearns will, essentially, provide vendor financing. This should calm some fears about the future independence and financial viability of Bear Stearns going forward, and a joint-venture deal in Hong Kong with CITIC might even be profitable!whereby CITIC will take equity in Bear Stearns and Bear Stearns will, essentially, provide vendor financing. This should calm some fears about the future independence and financial viability of Bear Stearns going forward, and a joint-venture deal in Hong Kong with CITIC might even be profitable!Naked Capitalism has again done a good job of collecting media references to the Super-Conduit … and it looks like my speculation regarding the operation of this vehicle as a Vulture Fund is both right and wrong. Wrong because that’s not what the primary sponsors have in mind. Right because if it ain’t, there won’t be any secondary sponsors:

One key concern is over the process by which it is proposed that the fund will decide on prices to offer SIVs for their securities. The lead banks are proposing that prices should be determined according to quotes provided by dealers for small volumes of the particular security rather than large trades. Critics say this means prices will be artificially high. “Banks are being asked to finance a vehicle full of overvalued assets which is not very attractive,” said one banker. Critics believe it would be better to work with true market prices – however painful.

I will now speculate that buying good assets from distressed SIVs is exactly how the RBS / Cheyne deal will unfold … but we will see! Accrued Interest has clearly been puzzling over the sponsors’ motivations as much as I have … he has introduced the rather Machievellian possibility that it is actually a rescue of the bank Money Market Funds.

The fair value estimate for the TD 5.25% Perpetual New Issue has been updated to $24.05 as of the close today.

Perpetuals continued to decline today. Holders of the Royal Bank issues should note – before they have a heart attack at 9:31 tomorrow – that today, 10/22 was the last day of cum-dividend trading; tomorrow, 10/23, will be the first day of ex-dividend trading for the current dividend.

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

 The box-score for today is:

• Fear: 1 Treasuries way up
• Greed: 0 Equities way down
• Analysis: What?

In more interesting news, the media has reported somebody saying something intelligent about regulation:

“If you intervene in the system, the vultures stay away,” [Former Fed Chairman Greenspan] said. “The vultures sometimes are very useful.”

“When it breaks, it’s very abrupt and you just have to wait it out,” he added.

This was in an interview with Emerging Markets, which was in turn linked by the WSJ.

More rules will not stop market booms, busts or outright fraud. They can – sometimes – mitigate and contain the effects; I have previously suggested that rules for the capital treatment of liquidity guarantees be reviewed with an eye to ensuring the banking system, as a whole, can withstand bigger shocks than this piddly little liquidity crisis. But there are far too many people around who rush to revise the rule book every time something bad happens. Life sucks. Get used to it.

Specifically, Greenspan was opining on Super-Conduit:

But Greenspan argued that that a delicate market psychology could be speared by the move. “It could conceivably make [conditions affecting investor psychology] somewhat adverse because if you believe some form of artificial non-market force is propping up the market you don’t believe the market price has exhausted itself.

“What creates strong markets is a belief in the investment community that everybody has been scared out of the market, pressed prices too low and they’re wildly attractive bargaining prices there,” he said.

“If you intervene in the system, the vultures stay away,” he said. “The vultures sometimes are very useful.”

Well, I’ve speculated that Super-Conduit is the vulture; and that the aim of the exercise is to wipe out the junior note-holders of the shakier SIVs to leave only the strong still standing. This got a little support in an unsubstantiated, anonymous comment on Accrued Interest:

From Total Securitization:

“Citigroup Won’t Use Super SIV To Save Its Own

Citigroup officials, reacting to claims that the master liquidity enhancement conduit it is creating with JPMorgan and Bank of America will be used to specifically rescue Citi’s more than $80 billion SIV exposure, is expected to announce that it will not utilize the fund at all.”

Well, it ties in with my thought on Super-Conduit; but I don’t have a subscription to Total Securitization, so I’ll have to wait for those remarks to be reported elsewhere.

Cheyne and Rhinebridge officially defaulted on their commercial paper today:

Rhinebridge has $791 million of commercial paper and a portfolio with a face value of $1.1 billion, S&P said. The market value of the assets is now 63 percent of face value, having fallen $69 million since Oct. 16 alone, S&P said. Revaluations of CDOs of asset-backed securities have caused a “dramatic” fall in value, the rating company said.
…
Cheyne Finance’s managers said its assets are worth 93 percent of face value, enough to pay back all of its $6.6 billion of senior debt, S&P said. CDOs of asset-backed securities make up 6 percent of Cheyne Finance’s holdings.

The SIVs aren’t the only outfits being affected by the market revulsion to all things sub-prime – after announcing mark-to-market write-downs of $1.3-billion, Wachovia has discussed its earnings:

“Next line addresses other structured products [Total of $438MM]. Here we have the marks on warehouse positions and trading inventory, both of which we hold in trading portfolios. This includes the positioning Ken referred to in reference to sub prime mortgage exposure and AAA rated securities. $308 million is associated with sub prime securities [Their slides say $347 of the mark was related to subprime of which $308 was AAA subprime]. Basically there, we never would have expected that you see AAA securities trade so far so quickly from par.”

The same comments thread on Accrued Interest yielded the following revealing exchange:

Anonymous: IF my money market funds invest in this SIV I will sell them and buy one that doesn’t. Plain and simple.

Accrued Interest: A **TON** of investors have moved into government money market funds to ensure they don’t own any ABCP over the last 2 months. I think that’s the right move. Money Market funds aren’t a place to take any risk at all as far as I’m concerned.

In other – No Analysis Necessary. As soon as the dreaded words of power are spoken – SELL! It is no wonder that, as I mentioned yesterday:

asset-backed commercial paper backstopped by real assets and a full bank credit backstop yielding more than unsecured commercial paper issued by the same bank—in other words, the real assets as collateral viewed by market participants as a negative rather than a positive,

To how many people does this make sense? Stick yer hands up!

I’ve said before that the danger of the credit crunch has not passed – that we’ve got a long way to go before we’re out of the woods (and, I hasten to add, I am not suggesting that market timing is the investor’s answer; analysis and diversification is the investor’s answer). Some of the specific risks to markets over the next six(?) months are outlined at the WSJ

This may be a little off-topic; but I want to point out that the benefits of diversification are everywhere:

The Utah scientists are trying to sell farmers on the idea that more bee diversity is needed, which was a hard sell because farmers had to pay more for wild bees. Now that honeybee prices are rising, farmers are more willing to try other species, James says.

Getting back to Canada and economic news for a moment, the Canadian CPI numbers were released today, and:

It was the highest year-over-year increase in the all-items index since May 2006, and the sharpest acceleration since February of this year.

Gasoline prices were the primary cause of an increase in the 12-month variation of the Consumer Price Index (CPI) in most provinces.

The year-over-year increase in gasoline prices (+12.7%) owed more to a sudden drop in last year’s prices than to any significant developments in the most recent month. Indeed, on a month-to-month basis, gasoline prices barely budged, rising a mere 0.8% from August to September 2007.

Of particular interest is:

On a year-over-year basis, consumer prices increased at a faster pace than the national average in only four provinces in September: New Brunswick (+2.9%), Manitoba (+2.8%), Saskatchewan (+3.8%) and Alberta (+4.6%).

In other words, inflation (such as it is) remains fairly well localized to the petro-provinces (with the exception of poor old Brunny). This suggests – to me – that there is nothing much in this report that would lead anybody to expect a rate-hike in the near future. Mind you, there are many who believe that the level was sufficiently high that we shouldn’t expect any lowering, either:

The Canadian dollar jumped 0.98 of a cent to 103.68 cents US – a level last seen in mid-1976 – after going as high as 103.71 cents US on expectations the higher CPI reading means the Bank of Canada won’t be lowering interest rates any time soon. The bank stood pat on interest rates Tuesday.

All this talk of inflation inevitably leads to the Fed. James Hamilton of Econbrowser attended a St. Louis Fed conference and reports that a hot topic of conversation was whether the Fed should operate according to a few simple and mechanical rules. Well, I haven’t read the papers yet, but my gut reaction is: “Sort of”. There should be enough mechanical rules so that Fed action is reasonably predictable; but none so binding as prevent reaction to special cases. Of course, there’s always going to be a lot of pressure to declare a special case so, as Poole said in his concluding remarks, central bankers need to be people of unquestionable integrity.

Mainly, though, I liked the graph:

Actual path of fed funds rate (black line), path predicted by a Taylor Rule that uses actual values of inflation and GDP (blue line), and path predicted by a Taylor Rule that uses forecasts of inflation and GDP (red line). Source: Orphanides and Wieland (2007).

Look carefully! Do you see the bit that has Greenspan blamed for the housing bubble? He was relying on forecasts, wasn’t he?

Another day of heavy volume for preferreds – and, er, yields were up! Yes, hold that thought firmly in your minds … yields, and therefore expectations of future returns, were up!

This is starting to get somewhat annoying. According to Canadian Bond Indices, long corporates are up 1.64% on the month, but prefs are getting killed … CPD is down a little over 1.5% month-to-date, perpetualDiscounts are down about 2.8%. Yield on long corporates is around 5.9% … about the same as it was on October 10, when I looked at spreads on One Bull Checks In. Since then, the perpetualDiscount yield has increased from 5.42% to 5.49%, and return for this index has been -1.28% (this doesn’t work out nicely with the Modified Duration in the range of 14.7 because of rounding errors and the obscuring effects of averages and outliers).

I think retail is mistaking preferreds for common again! And with things like CM.PR.D yielding 5.81% at the bid (interest equivalent of 8.13%) … well, they can mistake preferreds for common all they like, I guess!

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

ABCP is in the news nowadays – and the Fed reports that outstandings are down another $11-billion over the week, as the unwinding / delevering continues. The total outstanding is now down about 21% from the July month-end figure.

The WSJ has published an article blaming the mess on London bankers, a piece of revisionism to which Naked Capitalism takes violent exception. Naked Capitalism has also reviewed the failure of Cheyne discussed here yesterday; the S&P Pre-sale report for Cheyne, dated May, 2005, has, perhaps, been accidentally left on the Web. Brad Setser applauds Naked Capitalism and points out that, for all the talk of globalization, a lot of US money is simply making a round-trip via London/Offshore right back to the US.

I can present some more support for my conception of Super-Conduit as Vulture Fund:

AAA-rated mortgage-backed securities selling at 85 or 90 cents on the dollar

asset-backed commercial paper backstopped by real assets and a full bank credit backstop yielding more than unsecured commercial paper issued by the same bank—in other words, the real assets as collateral viewed by market participants as a negative rather than a positive,

3-month LIBOR (the interbank deposit rate in London for dollars) as high as 100 basis points above the fed funds rate target—certainly possible if the monetary authorities were in the process of tightening monetary policy aggressively, but nearly inconceivable given the widely held expectation that the central bank would likely be cutting interest rates,

Treasury bill rates rising and falling 100 basis points in a single day, and

nearly a failed Treasury bill auction—total bids were barely sufficient to cover the amount the Treasury was offering. This near-miss occurred despite the fact that money market mutual fund investors were fleeing to rather than away from Treasury securities.

And, reported in the context of a $1.2-billion whoopsee by Rhinebridge Plc:

SIVs worldwide have been forced to sell about $75 billion of assets in the past two months to repay maturing debt as investors balked at buying securities linked to money-losing subprime mortgages.
…
As of late August, 79 percent of Rhinebridge’s holdings were in the U.S. and 80 percent in mortgage-backed bonds, Fitch Ratings estimated in an Aug. 22 report. Eighty-three percent of the assets had the highest-possible AAA rating, Fitch said.

Even Warren Buffett has opined on Super-Conduit!

Buffett said he was skeptical about the U.S. Treasury’s plan to create an $80 billion fund to buy distressed assets from structured investment vehicles linked to home lending.

“I don’t see any way that pooling a bunch of mortgages, changing the ownership, is going to change the viability of the mortgage instrument itself — whether people can make the payments,” he said. “It would be better to have them on the balance sheets so everyone would know what’s going on”

I hesitate to question the wildly popular Oracle of Omaha publicly, but I don’t see Super-Conduit as being merely a vehicle to change ownership – I see it as a matter of wiping out the old equity-holders and injecting new equity while keeping the note-holders happy and senior.

However, the Super-Conduit plan seems to be having trouble attracting supporters; this may be an indication that the potential players see it more as Citibank bail-out than as a vulture fund; or it may simply indicate that potential players would rather be vultures all by themselves. Without disclosure of every nuance of the negotiations, it’s hard to guess! 

Nouriel Roubini writes a very gloomy assessment of the chances for a major 1987-style stock market collapse and concludes:

To avoid such a meltdown, we need many reforms: better regulation and supervision of mortgages and of financial institutions, including the lightly or unregulated hedge funds; more transparency on who is holding which risky assets; better risk management by investors; avoidance of a bailout of reckless lenders and investors; a more competitive market for ratings as the small set of only three rating agencies seriously misread very complex and risky instruments; and hopefully a modest and soft—rather than hard—landing for the U.S. economy.

In other words: it would be a really wonderful world if only there were more rules in it! I won’t reiterate my past arguments against Regulation Nirvana; I’ll just say again that regulators should ensure there is a solid banking system at the core of financial operations, then let the rest of us play with it as we will. And strengthen the concept of fiduciary responsibility, so that those who recklessly violate Prudent Man rules end up wearing the losses.

Default Risk has published a paper on Equity Implied Ratings:

Fitch’s Equity Implied Ratings and Probability of Default (EIR) model is estimated to provide a view of a firm’s credit condition given its current equity price and available financial information.

This is an enhancement that I have been longing to bring into HIMIPref™ … perhaps someday!

There aren’t many bank runs nowadays and some credible analysis of the Northern Rock run is getting done. Two major conclusions: Northern Rock was overleveraged and UK Deposit Insurance is inferior. Deposit insurance in the UK covers:

100% of the first £2,000 (about $4,100) and 90% of the next £33,000 (about $ 67,500)

Various forms of deposit insurance were reviewed by BIS in 1998; I am somewhat surprised to learn that deposit insurance is something of a novelty in Europe:

While most commentators see some merit in the idea of deposit insurance, there is more disagreement as to whether deposit protection schemes should be explicit or not. Most commentators seem to accept the former position. One part of the argument is that, in the middle of a crisis, olicymakers will be forced to offer explicit protection to everyone. Thus, the costs to taxpayers may be very high. In contrast, Demirgüç-Kunt and Detragiache (2000) seem to argue that poor design can make the explicit protection route even more costly. This design issue is returned to below. Explicit deposit insurance schemes are certainly much more widespread than they used to be. The first nationwide system was introduced in 1934 in the United States, but other countries only began to follow in the postwar period. This trend accelerated in OECD countries in the 1980s, culminating with the introduction of limited deposit insurance in the European Union in 1994.

The argument against deposit insurance is moral hazard:

Erlend Nier and Ursel Baumann find, in a cross-country study, that enhanced disclosure by banks seems to induce banks to limit their risk of default by keeping higher capital buffers for given asset risk. Their results also suggest that market discipline is stronger for banks that are funded by uninsured liabilities and weaker for those that benefit from wide deposit protection schemes or other safety nets. The latter may therefore be introducing a degree of moral hazard.

I don’t buy it. The average retail investor is doing well if he can balance his chequebook – how can he be expected to analyze the soundness of a bank during a crisis? He’s going to know nothing and know he knows nothing; he will therefore withdraw his deposits and contribute to a run.

The North American system of providing full deposit insurance on amounts up to $100,000 per institution per person is a good solution; but as I have previously mentioned, the CDIC doesn’t have enough cash in the till to be credible during a genuine crisis. They should have at least enough to recapitalize their largest member completely and the Royal Bank has capital of about $26-billion. And further, not a single dime of the CDIC’s reserve fund should be invested in Canada!

Menzie Chinn of Econbrowser continues to worry about the prospects for the national debt:

… following her assault on the implausible economic assumptions of the Bush administration:

But real change in American fiscal policy will not happen until they become very close to hitting the wall. And, for all the dollar drama, they’re a long way from that point. It will be interesting to see if record lows against the Euro become an issue in the 2008 elections. Oil at USD 90 ain’t going to help the economy much!

Remember the Moody’s mass downgrade of October 11? In a fascinating development, Global DIGIT (last mentioned October 16, with a full post regarding its suspension of dividends) has announced:

As at October 3, 2007, the reference portfolios of Global DIGIT contained 8 of the securities downgraded by Moody’s.

The total exposure to downgraded instruments is $463-million – out of a total portfolio of $1.4-billion. Whoopsee!

Very good volume in the preferred share market today, but the perpetual indices resumed their descent.

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

Update: Typographical error on RY.PR.G yield corrected. Revised number is approximate.