PrefBlog

US Inflation numbers were announced today and seem relatively benign – while the headline number ticked up for the month and trailing year, the core rate remained steady at 2.1% for the year. Housing starts continued to decline to the horror of many so it would appear that, whatever else we have to worry about, a superheated US economy is not the greatest concern! As the Bank of Canada said yesterday when announcing that the bank rate would be unchanged:

the outlook for the U.S. economy has weakened because of greater-than-expected slowing in the housing sector. The Bank has revised down its projection for U.S. growth to 1.9 per cent in 2007 and 2.1 per cent in 2008. U.S. growth is expected to pick up to 3 per cent in 2009.

What’s going to happen in the US? Brad Setser is worried:

The August TIC Data was really bad.  Even Fox Business News would have trouble putting a happy face on it.

The net outflow in August – from a combination of foreign investors reducing their claims on the US and Americans adding to their claims on the world – was around $160b.   Most of that — $140b – came from the private sector, but the official sector also reduced its claims on the US.  The total monthly outflow works out to a bit more than 1% of US GDP.   Annualized, that is a 12% of GDP outflow.    To put a 12% of GDP outflow in context, it is roughly the magnitude of the private outflow from Argentina in 2001, at the peak of its crisis.

Meanwhile, there is on sub-prime securitization:

Many of the mortgages underpinning this housing expansion were resold. They were securitized – meaning a loan would become a tradable asset – and packaged – meaning many loans were put together to form a single asset. The resulting bundles, called credit derivatives, were then sold worldwide, most of them with high AAA ratings because the large number of loans that they included meant a very small risk on any single one of them.

As PrefBlog’s readers will know, that’s not how it works. The number of loans is basically irrelevant – you want to have enough diversification that you’re eliminating asystemic risk and reflecting the asset class’ systemic risk, but after that you’re simply increassing the size of the pool. The AAA ratings are only available through subordination.

The number of loans is basically irrelevant – you want to have enough diversification that you’re eliminating asystemic risk and reflecting the asset class’ systemic risk, but after that you’re simply increassing the size of the pool. The AAA ratings are only available through subordination.Ordinarily, of course, I’d make a snarky comment about the writer … but Angel Ubide is the Director of Global Economics at Tudor Investment Corporation. Well, I won’t be putting any money into that firm until I see some clarification!

A much more informed review is available on Econbrowser, where James Hamilton has put together some fascinating graphs and asks the question:

So here’s my question– why did the “most sophisticated” investors apparently become less and less sophisticated as time went on?

It depends on how you define “sophisticated”, doesn’t it? I suggest that

• if one performs a regression between trailing long term performance and assets under management, you’ll find little correlation
• regress trailing short term performance and AUM, high correlation
• AUM and future performance, little correlation
• trailing change in AUM and future performance, high negative correlation

The investment business is NOT, generally speaking, about returns.

The MLEC (or “Super-Conduit”) that was discussed yesterday and Monday got some public disclosure of its rationale today:

Cheyne Finance Plc, the structured investment vehicle managed by hedge fund Cheyne Capital Management Ltd., will stop paying its debts, a receiver from Deloitte & Touche LLP said.

Deloitte is negotiating a refinancing of the SIV or a sale of its assets, according to an e-mailed statement today. Cheyne Finance’s debt with different maturities will now be pooled together, rather than shorter term debt being repaid sooner, Neville Kahn, a receiver from Deloitte said today in a telephone interview.

“It doesn’t mean we have to go out and fire-sell any assets, quite the opposite in fact,” Kahn said. “The paper that falls due today or tomorrow won’t be paid as it falls due.”

I discussed Cheyne on August 28. Meanwhile the debate regarding the advisability of the Super-Conduit / MLEC / Whatever continued to rage. Naked Capitalism heaped scorn on the idea; but it seems to me that his initial opposition to the scheme is what’s driving his arguments:

the biggest one being pricing of the assets to be sold to the MLEC, since the interests of current SIV owners and prospective funding sources seem hopelessly in conflict

Well, sort of. Conflict is what makes a market, after all – buyers and sellers are always in conflict. My suggestion is that the conflict will be resolved by the prospective funding sources riding roughshod over the current SIV owners/investors, who will be forced to take a hit; I suggest that current SIV owners will be forced to pay off their ABCP holders and leave their junior tranche holders with nothing … or not much, anyway.

They (the current SIV sponsors and junior debt-holders) are between a rock and a hard place. I suspect that many of them are in a negative carry situation – this may be the reason why the Cheyne receiver has suspended redemptions – and if ABCP investors move to the new conduit, this will only get worse, if they’re able to finance at all. They will then be forced to give up all their equity in the SIV just to get out, by selling to the Super Conduit at the lowest possible prices – as suggested by the Financial Times:

Thus, if the M-LEC is to produce a genuine solution to the current financial woes, it is imperative that it buy assets at genuine, clearing prices – not artificial prices created by banks. If not, investors will retain nagging fears that prices have further to fall.

And, to repeat myself, it is my suggestion that the Super Conduit has been conceived as a vulture fund – that will seek to profit from the utter helplessness of the current SIVs. Another way of looking at it, perhaps, is as a cram-down: the senior note (ABCP) holders will get back their full amount (which might include Super-Conduits junior notes instead of cash); the junior note-holders will get Super-Conduits junior notes (if anything). I suggest that the current SIV junior noteholders will be forced to go along with the idea, because the ABCP holders always have the option of walking away as their notes mature … the current SIV junior noteholders are going to get what we in the investment management business refer to as “screwed”. And serve ’em right.

See my example with respect to the DG.UN holders (who are the junior noteholders of that particular SIV) yesterday.

Accrued Interest also discussed this issue today, but opined that operating as a vulture fund necessarily meant accepting second-rate assets. I’m not sure that’s the case … I suggest that Super Conduit aims to purchase first-class assets at second-class prices, using the power of (projected) lower funding costs and better liquidity guarantees.

I will be fascinated to see how this unfolds. There is no doubt that sub-prime is resulting in a big heap of losses; but it is my contention that market values have grossly over-compensated for these losses. Readers with good memories will remember the IMF Report which I have discussed previously:

Spreads have since widened across the capital structure, especially on lower-rated ABS and ABS CDO tranches, but also on AAA-rated senior tranches (Figure 1.9). Implied losses based on these spreads total roughly $200 billion, exceeding the high end of estimated realized losses by roughly $30 billion—an indication that market uncertainty and liquidity concerns may have pushed down prices further than warranted by fundamentals (Box 1.1). While many structured credit products were bought under the assumption that they would be held to maturity, those market participants who mark their securities to market have been (and will continue to be) forced to recognize much higher losses than those who do not mark their portfolios to market. So far, actual cash fl ow losses have been relatively small, suggesting that many highly rated structured credit products may have limited losses if held to maturity.

I’ll suggest that the discrepency between mark-to-market and hold-to-maturity values is even bigger today.

Meanwhile, back to sub-prime for a moment, Treasuries were up a lot today, helped by S&P’s mass downgrade of 2007-vintage RMBS:

Standard & Poor’s Ratings Services today lowered its ratings on 1,713 classes of U.S. RMBS backed by first-lien subprime mortgage loans, first-lien Alternative-A (Alt-A) mortgage loans, and closed-end second-lien mortgage loans issued from Jan. 1, 2007, through June 30, 2007. These classes are from 136 subprime transactions, 128 Alt-A transactions, and 19 closed-end second-lien transactions. The downgraded classes represent approximately $23.35 billion of original par amount, which is 6.28% of the $371.9 billion original par amount of these three types of U.S. RMBS rated by Standard & Poor’s between Jan. 1, 2007, and June 30, 2007, and 4.71% of the approximately $495 billion original par amount of all U.S. RMBS rated during this period.

In addition, we placed the ratings on 646 other classes from 109 transactions backed by U.S. RMBS first-lien subprime mortgage loans and U.S. RMBS first-lien Alt-A mortgage loans issued during the same period on CreditWatch with negative implications. We expect to resolve the CreditWatch placements within the next few weeks, and anticipate that the results of that review will be similar to the rating actions announced herein.

Finally, we affirmed the ratings on securities representing $245.1 billion original par value of U.S. RMBS backed by these three types of mortgage loans issued during the same period.

There’s a lot more detail in the S&P press release – read it all!

In preferred news, the PerpetualDiscount index actually rose today, making just the second trading day since September 19 that it has been in the black. It was aided in part by BAM.PR.M (which has been inaccurately “Distressed Preferred”) now bid at 20.45 to yield 5.87% while the virtually identical BAM.PR.N closed at 19.50 bid to yield 6.16%. Sometimes I despair of this market, I really do … especially since the fund swapped into the Ns when the spread was at a huge $0.35! *sigh* Oh well, sanity will return sooner or later. It always does.

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

Controversy continued regarding the US ABCP Super-Conduit mentioned yesterday. Noriel Roubini dislikes the plan, but bases his reasoning on a somewhat dubious assumption:

Indeed, if we assume that many of the assets held by the SIVs are of low quality, the attempt to avoid losses that would be incurred by selling these assets in secondary markets would not be possible.

Sadly, his alternative to what he perceives as regulatory interference in the market is simply more interference; different interference:

The right solution would have been to punish the banks that created these dangerous schemes in the first place by forcing them to take the losses on their illiquid and/or impaired asset; or to bring such asset on balance sheet and take the capital charges or liquidity charges required to do that.  Forcing the banks to sell the asset and take the losses would have helped to create secondary markets for these illiquid assets; thus, while losses would have occurred this would have reliquified a frozen market.

Meanwhile, Naked Capitalism supports my hypothesis that the super-conduit is not so much of a bail-out fund as a vulture fund, although he doesn’t yet know it!

If you want a rescue program, you don’t lard it up with fees beyond what is necessary for costs and risk assumption. In this case, that would mean market fees for any credit enhancement provided by third parties, plus a mechanism for recovery of costs (and we mean real costs) of establishing and running the entity. That means no debt placement fees, since the old SIV owners were capable of doing that for themselves. If the spin is that this vehicle is being established to prevent a possible crisis, then it behooves the organizers to do so on a cost recovery basis. Anything else raises questions about the real motives (including are the fees yet another way to shore up Citigroup?).
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The MLEC, by cherry picking assets, will make thing worse for the remaining SIVs

How do I see this working? Let’s say we have an SIV with $100 “good” assets, $5 “bad” assets, financed with $100 ABCP and $5 subordinated or equity financing. The asset pool is earning $7 annually, but due to increased spreads in the ABCP market, it’s costing them $8 to finance and operate. So the sponsors have no equity and negative carry; they’d love to get out of the business, but they would only be able to realize $80 if they sold out. That’s too much, so they struggle along.So along comes a friendly super-conduit. “Hi! I’m from the Big Bank, and I’m here to help you!”. Super-Conduit offers $95 for the “good” assets. Accepting the offer will let the sponsors get out of the business gracefully, so they accept. Super-Conduit can finance with a positive carry AND make a fat capital gain on maturity of the assets AND eliminate competitors, so everybody’s happy.

Is this the case? I don’t know; I don’t have access to all the details on the assets. But most of the underlying remains highly rated – it’s only the speculative junior tranches of ABS that are genuinely impaired.

Could it be the case? Most certainly. I’m going to let you in on a little secret here: investment management has nothing to do with managing investments. It’s all about selling. Huge pools of capital are controlled by guys who, frankly, don’t really know what they’re doing. If they do know how to do it, guess what? Their clients have to be kept happy. Look at what happened in August – US T-bills dipping to three percent and change, simply due to a public relations effort on the part of money-market funds desperate to have a higher quality portfolio than the next guy, even if it meant giving away money.

I’m sure there were quite a few portfolio managers and traders executing those purchases while holding their noses; knowing that what they were doing was best defined as “panic”, but either having been given the orders, or having to provide window dressing for the paying customers.

As far as I have been able to make out, the current crisis has everything to do with fear and greed, and nothing to do with analysis. The super-conduit will make boatloads of money for its sponsors and Treasury will achieve its objective of a functioning ABCP market.

As an example of how this might work, and to get a ballpark idea of the numbers, let’s  look at Global DIGIT (DG.UN) again. This is cheating, because DG.UN has sub-prime exposure through derivatives, but let’s look anyway. There are about 9.75-million units outstanding, supporting $1.4-billion in ABCP via the net asset value (NAV). The NAV is most recently estimated as $7.92; the units are trading on the TSX at a little less than $3.00.

So lets say Super-Conduit comes along and says – ‘I’ll bail you out, with enough to pay the unitholders $3.50. Or you can just wait until the ABCP holders bankrupt you. Choose!’

So Super-Conduit makes the loan of $1.4-billion and pays the unitholders $34-million. That’s an immediate profit of $43-million  (about 3% of the loan) AND the $1.4-billion is in a comfortable positive-carry situation. To me, this sounds like good business.

How may such interuptions in the smooth functioning of capital markets be avoided in future? Well, I’ve already given one possibility: increase the capital charge on Global Liquidity Guarantees, preferably on a sliding scale based on bank capital, to decrease the attractiveness of issuance. Other adjustments to this charge could include a charge for the term mis-match between the guarantee’s assets & liabilities … it seems reasonable that if a conduit has 8-year liabilities, a guarantee of financing via 1-2 year FRNs is less risky – given staggered maturities – than a guarantee of financing via 30-day paper. One may also wish to increase the charge when the bank is thinly capitalized to begin with; that is, pay more attention to what will happen if the guarantee is actually triggered. There is news today that:

the Bush administration will review accounting rules for the off-balance sheet units that large U.S. banks set up to invest in assets including mortgage-backed securities.

In somewhat related US brokerage news, there are reports that CITIC will buy a piece of Bear Stearns – which has lost a lot of value due to sub-prime contagion and the blow-up of two of its hedge funds – while Merrill Lynch’s CEO O’Neal is facing criticism due to its quarterly loss, which is in no small part due to its investment in a sub-prime mortgage originator last year. This is happening while Morgan Stanley is bulking up its mortgage servicing unit via a purchase from an originator that is desperately trying to survive. Sub-prime is casting a long shadow!

Good volume in the preferred share market, but no returns as the slide continued.

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

The Web is alive with commentary on the plan to create a super-SIV, which would hold about $80-billion in non-sub-prime ABS, finance with commercial paper and be guaranteed by the super-major banks – notably Citigroup, which took a beating today on credit concerns.

The Wall Street Journal has used the word “Bailout” in describing this plan; James Hamilton at Econbrowser asks:

The reality is that someone must absorb a huge capital loss. The question we should be asking from the point of view of public policy is, Who should that someone be?

My answer is: the shareholders of Citigroup.

Accrued Interest has taken a more nuanced view:

if the assets are valued correctly, a significant loss will still be realized by the sellers, because even very strong non-resi ABS have widened significantly in recent months. The losses might only be like 1-2% of par, … We’ll see how well the assets are indeed valued. Call me highly skeptical.
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SivieMae will supposedly have a limited life, although I’m skeptical on that as well, perhaps as short as 1-year.
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Here we have some banks, particularly Citigroup, who were using off-balance sheet vehicles to increase their leverage. … Those that choose to stay away from the SIV structures were still dragged down by the liquidity crunch.
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Now squint your eyes a little and what do you see? One bank paying another bank a fee to avoid reporting their complete assets and liabilities on their balance sheet.

I find it rather surprising that this move should arouse so much interest, frankly. $80-billion in financing is a big deal, but not an incredible deal. What interests me much more about the deal is the banks motivations. Liquidity guarantees are charged to the banks’ risk-weighted assets at a 10% CCF. If the banks actually have to implement those guarantees – either directly or through buying the commercial paper – then it gets charged at a 100% CCF.

Naked Capitalism notes:

Citi can provide funding for however many days and weeks until the conduit is functioning, but it seems highly unlikely that this entity will be up and running before Citi starts feeling squeezed.

I have previously speculated as to the adequacy of the 10% number, suggesting that:

perhaps something like … “10% on the first capital-equivalent, 15% on the next, 20%…” might permit the market to operate efficiently while keeping the number of lines under control.

However, Citigroup’s Tier 1 Capital Ratio has declined to 7.4% in 3Q07, from 8.6% in 1Q06. That’s a hell of a drop, and it has occurred even as Shareholders equity increased from $114.4-billion to $127.4-billion. Note that HSBC had a Tier 1 ratio of 9.3% at June 30, 2007, while Bank of America was at 8.64% at year-end and 8.52% at the half. Bank of America, it will be recalled, recently purchased LaSalle Bank as part of the ABN AMRO deal for USD 21-billion. Bank of America has issued a press release stating:

consortium of leading global banks today announced an agreement in principle to create and provide liquidity support to a master conduit to enhance liquidity in the market for asset-backed commercial paper and medium-term notes issued by structured investment vehicles (“SIVs”).
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Bank of America Corp. (NYSE: BAC), Citigroup Inc. (NYSE: C), JPMorgan Chase & Co. (NYSE: JPM) and several other financial institutions have reached an agreement in principle to create a single master liquidity enhancement conduit (“M-LEC”). Once established, M-LEC will agree, for a set period of time, to purchase qualifying highly-rated assets from certain existing SIVs that choose, in their sole discretion, to take advantage of this new source of liquidity. Access to such liquidity is intended to allow participating sellers to meet pending redemptions and facilitate asset-backed commercial paper rollovers.

Now: why?

All the comment so far is to the effect that this is a bail-out of Citigroup. Is it? Is it really?

Citigroup’s Tier 1 ratio is low for a global bank, but it not yet anywhere close to the point where they have to make room for extra Fed Inspectors. Given Citigroup’s exposure to the SIV market of about $100-billion, they clearly have the most to gain from a re-normalization in ABCP … but are they really afraid of financing or are they afraid of spreads?

I’m not going to stick my neck out too far here. I haven’t studied the market in detail, I’m not hearing the gossip. But I will suggest that there’s a reasonable chance that the consortium is pulling a JPMorgan.

We all remember, of course, the Panic of 1907. In the denouement to that crisis, Morgan stuck it to a fellow banker, purchasing a big whack of stock extremely cheaply – and I’m afraid I cannot remember the name of the company off-hand. I don’t think it was the US Steel deal; US Steel had to be bullied into buying whichever it was they bought. This was Morgan’s bank buying common equity in something else, a railroad, perhaps, if memory serves. At any rate, once Morgan had become convinced the world was not going to end, he got down to the serious business of sticking it to the competition.

Update: I am remembering two different versions of the same incident. Geisst claims that “Morgan agreed to rescue Moore & Schley if it would sell him its holdings in Tennessee Coal & Iron at $45-million, considerably less than the market price…. US Steel acquired the stock, Moore & Schley and the Trust Company of America were saved, and the steel trust became larger and more influential than ever. … Almost all were in agreement that the deal found remarkably little resistance given that Morgan made at least a $650 million profit”. The story in Bruner & Carr is more complex, and has US Steel resisting the importunities to take over TC&I. For sources, see The Panic of 1907

So how about this scenario? The ABCP market could really use a helping hand, and this consortium is going to provide it. A decline in spreads will benefit Citigroup. And note, from BofA’s press release:

Once established, M-LEC will agree, for a set period of time, to purchase qualifying highly-rated assets from certain existing SIVs that choose, in their sole discretion, to take advantage of this new source of liquidity. Access to such liquidity is intended to allow participating sellers to meet pending redemptions and facilitate asset-backed commercial paper rollovers.

We know, from the continuing decline in US ABCP that I have been gleefully documenting every Thursday for the past month or so, that there are some US conduits that are on the ropes. And Canadian conduits, of course, are on the mat, but there’s no indication as yet whether these conduits will be eligible to sell assets to the consortium.

I suggest that the following hypothesis at least be considered: the consortium is willing to extend itself to bail out the non-bank conduits. With every expectation of making an obscene profit from the deal.

As support for this idea, I’ll go back to the Naked Capitalism post:

That takes us to the problem of the assets that will go into the MLEC. As the New York Times tells us:

To maintain its credibility with investors from whom it would raising money, the conduit will not buy any bonds that are tied to mortgages made to people with spotty, or subprime, credit histories. Rather, it will buy debt with the highest ratings — AAA and AA — and debt that is backed by other mortgages, credit card receipts and other assets.

Huh? The market is objecting to the crappy assets in the SIVs, not the better quality ones. It would seem more logical to take the lousy assets, issue a guarantee, and seek funding for them, and let the banks keep the good assets in existing SIVs, which ought to be marketable once the dodgy assets are excised. The banks are on the hook for the SIVs, anyhow, since they are having to fund the SIVs via backup credit lines, so any mechanism that enables them to get third party funding advances the ball.

My point exactly. Everybody’s screaming bail-out here, worried about Citigroup’s finances and deeply suspicious of Treasury’s involvement … but the actual structure looks a lot more like a vulture fund than anything else to me – with, perhaps, Citigroup as weak sister, but still a member of the family … especially as it benefits so directly from tighter spreads on ABCP in general.

I’ll look up the details on the 1907 Morgan thing shortly.

Good volume in prefs today; perpetuals continued to slide.

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

Update: I have updated the reference to Morgan in the body of the post.