PrefBlog

On September 18 I mentioned the investment firm Calyon and its sudden discovery that it had a big position in credit derivatives it didn’t want. Today, the plot thickened:

The Calyon trader fired last month for alleged unauthorized trading that led to 250 million euros ($353 million) of losses said his bosses knew what he was doing and considered him a “golden child” of the New York office.”There was nothing deceptive or rogue,” Richard “Chip” Bierbaum, 26, said in an interview. “My positions were reported on a daily basis. It did not blow up. I expect there were some losses but nowhere near the amounts they are discussing. I was the golden child of credit trading in New York.”

It will be most interesting to see how this unfolds; but when things go wrong, all bureaucrats go into ass-covering mode, integrity be hanged. A trading loss of $353-million is a mere bagatelle anyway.

James Hamilton of Econbrowser writes about the return of backwardation to oil futures. A friend of mine claims that the recent contango in oil futures showed that there was no real North American oil shortage; contango implies that you can buy spot, sell futures, pay storage and make a profit. Therefore, the huge amount of contango in the recent past simply proved that there was so much oil around that the market had run out of places to store it for a few months … therefore no shortage. The current backwardation implies that the market is returning to normal, at any rate – as long as one considers a spot price of USD 80+ normal!

We will probably be hearing a lot about free trade in the next year, as the American presidential cycle ticks over. There are some polls that show the average North American supports free trade; other polls that show the opposite. The Republican front-runners are largely in favour; the Cato Institute considers Hillary Clinton to be an “interventionist” in its classification:

On the basis of their voting records, members of the 107th Congress can be classified in four categories: free traders, who oppose both trade barriers and subsidies; internationalists, who oppose barriers and support subsidies; isolationists, who support barriers and oppose subsidies; and interventionists, who support barriers and subsidies.

Her website does not discuss free trade as an issue. Anyway, in the grand tradition of American politics, we’re going to hear a lot of disingenuous statements, unfounded assertions and outright lies over the next year. Jagdish Bhagwati has written a short essay on current economic thought.

Eric Rosengren of the Boston Fed has spoken in favour of the concept of sub-prime mortgages and noted that important regional benefits resulted from their existence. His speech, published on the Boston Fed’s website, conveys some fascinating detail:

A  first finding is that recent foreclosures have been disproportionately related to multi-family dwellings.  In Middlesex County, Massachusetts, multi-family properties accounted for approximately 10 percent of all homes, but 27 percent of foreclosures in 2007.  This highlights a potentially serious problem for tenants, who may not have known that the owner might be in a precarious financial position.

Second, the Bank’s research shows that the duration of a subprime mortgages is on average quite short – for a sample of subprime mortgages used to purchase a home between 1999 and 2004,  two-thirds have prepaid within two years and almost 90 percent have prepaid within three years.  Prepayment will occur if the home is refinanced or if it is sold.  While some of those sales may have been under difficult circumstances, it is plausible that many borrowers who purchased homes with subprime products did benefit from the appreciation of home prices in New England that occurred over the last decade.
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First, many subprime borrowers have respectable credit histories.  LoanPerformance data from Middlesex County show that almost two-thirds (64 cent) of borrowers who received subprime loans had FICO scores greater than 620, and 18 percent had scores over 700.  They may have been in subprime products because they chose to make a highly leveraged home purchase, or they may have been steered to a more costly mortgage for which they might have otherwise qualified.  Either way, it is encouraging to note that these borrowers could be in a position to refinance to another product.

Third, many borrowers of so-called “teaser” 2/28 mortgages were actually paying a much higher rate than is found on prime loans.  The average “teaser” rate was 7.3 percent in 2005 and 8.35 percent in 2006 for loans located in Middlesex County in Massachusetts.  This suggests that if these borrowers could qualify for a prime product, they would likely see a significant reduction in their interest rate.

Second, many subprime borrowers have held their house long enough for it to appreciate, so they may now have sufficient equity in their house to facilitate refinancing into a prime product.

Sorry to include such a long quote – but seeing some actual data on subPrime, as opposed to reporters’ drivel, is very exciting!

He even included a rather puzzling note, that may be an elliptic reference to Canadian ABCP:

Much of the asset-backed commercial paper had liquidity and often credit enhancements provided by banks, to insure that investors would receive their money should they decide they no longer wanted to hold the commercial paper.  The success of the asset-backed commercial paper in financing assets has encouraged some organizations to choose structures that were less reliant on liquidity provisions by banks.

But … that’s it for me. I have better things to do this evening; I will be updating HIMIPref™ data later and may have time for some comments (and perhaps some snarky comments about the election) but no guarantees!

Update: So … the Ontario election results are in and it looks like John Tory will have to run for Prime Minister next time. It’s a bit of a shame, in many ways, because he ran an absolutely masterful campaign. The faith-based-school thing (which was only charter-school-lite, anyway) was a beautiful distraction from the completely ludicrous budgetary plan and he managed to escape with a reputation as an earnestly mistaken zealot, rather than a dangerous bozo.

What has happened to the (Progressive) Conservative party to which I used to belong in pre-Harper, pre-Eves days? It used to be the party of fiscal responsibility and competent management; it has become the party of moronic tax cuts and vindictive politics of resentment.

Ontario voters have also shown good sense in rejecting proportional representation; a number of supporters are showing all the intellectual honesty of unrepentent Stalinists: ‘It’s a great system! It just wasn’t done right!’. Still rejection of the changes as written provides Ontario with an opportunity to increase revenues at some point in the future … instead of presenting the party leaders with a batch of seats to sell, the province might in the future sell them directly, at so much per year. This makes a lot more fiscal sense in these troubled times.

It was another bad day for prefs, with the PerpetualDiscount index down just over a third of a percentage point. PerpetualPremiums were down marginally.

I received some more fascinating correspondence tonight and will post about it tomorrow.

Update 2007-10-11

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

Worry over the fate of the USD continues to be a theme in the markets, and Menzie Chinn of Econbrowser has posted a review of the issues. I will admit, this post is notable mainly for its links to definitions and prior reviews of the issue, but these are good links. The 2005 post includes a link to a paper showing the futility of forecasting: it’s always gratifying to get some agreement with one’s prejudices! The examination of the interest-rate parity predictions are interesting, if only because I have seen it claimed – by a sophisticated retail investor – that carry trades are intrinsically unsound because interest-rate parity is guaranteed. Well … not in this world!

Accrued Interest reviewed the jobs numbers on the weekend, with a view to discussing the investment difference between “lawyers” and “detectives” – the former seeking evidence to support a particular view; the latter (greatly favoured) seeking to examine evidence to form a view.

What’s a good name for those, such as myself, who feel that the process is pointless because natural chaos will destroy any prediction as soon as it’s made? Weatherman, perhaps? I’m not going to predict a hurricane, but I will say that if there is a hurricane, you should have a good solid house; but if it’s sunny and pleasant, you’ll want nice windows; so build your house with the objective of surviving hurricanes with not too much damage while being able to enjoy the sunny times.

Perhaps this is stretching a metaphor too far! The markets can be outperformed, but you have to get your hands dirty and examine a wide variety of scenarios. And – assuming you are a rational investor and avoid the One Big Bet school of thought – you’re not going to double your money while everyone else goes broke, either! Ideally, you’ll outperform by a constant, small-but-worthwhile amount, irregardless of economic conditions.

The Northern Rock Saga continues:

Northern Rock, based in Newcastle, England, said in a statement today that money deposited after Sept. 19 will now be covered by the Bank of England, the U.K. Treasury and Financial Services Authority. The authorities previously only protected deposits made before then.

“This may make Northern Rock easier to sell,” said Philip Shaw, chief European economist at Investec Bank in London.
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The case has been “damaging” for the reputation of the U.K., Financial Services Authority Chairman Callum McCarthy told the Treasury Select Committee of lawmakers today. Still, it was “impossible” to predict closure of the markets both for securitization and for short-term repurchase agreements, he said.

“We didn’t identify the probability of that happening,” McCarthy said. “No regulator anywhere around the world succeeded in predicting that.”

Sion Simon, a Labour Party member of the committee, said he had heard that relations between the FSA and the Bank of England were “poisonous” and compared McCarthy to a boxer.

“You are the Sugar Ray Leonard of the financial-services sector. You are a world-class ducker and diver.” Simon told McCarthy. “There was a run on the bank, the nation was a global laughing stock, and you say the provisions worked?”

Instead of saying ‘We didn’t predict it and neither did anybody else’, McCarthy should have blamed the credit rating agencies. That technique is working beautifully in North America!

Speaking of credit rating agencies, I see in the Globe today that State Street (among other Money-Market-Fund sponsors) is seeing a big uptick in business:

Executives at many small to mid-sized companies across Canada woke up in mid-August to find a portion of their supposedly liquid cash holdings were frozen, as a $30-billion segment of the asset-backed commercial paper market (ABCP) collapsed. Airline Transat A.T. Inc., for example, has $154-million of its $340-million in cash reserves stuck in a holding pattern.

“Corporate treasurers suddenly became aware that they face risks in their cash holdings, and they’re rushing to deal with these risks,” said Gregory Chrispin, president of State Street’s Canadian arm and former treasurer of Export Development Canada.

It is nice to see that some companies are taking my advice to stick to what they’re good at and pay for portfolio management. Whether or not there will be a surge of CFO replacements to accompany the sudden discovery that treasury departments have been speculating with shareholder assets remains to be seen! 

Treasuries drifted downwards, attributed to a ‘no-recession’ indication by the Fed, though today’s retail sales number provided no indication of a huge economic boom. Canadas fell, as a strong housing number decreased chances for a rate cut. US equities rose (no recession!) while Canadian equities were pretty quiet.

The news in the preferred share market today was that the TD New Issue and the closing of the BMO new issue combined to drive the PerpetualDiscount index to a new low. The prior low (since the temporary index was started, as of 2006-6-30, that is) was set on June 12, 2007. The four main indices since then have returned:

If we look at returns for CPD …

So, speculating on price movements in prefs has not been a jolly time for the past four months! Fortunately, the investments are paying the same income as they have done in the past, so income – which is the entire reason for investing in prefs, right? – is unaffected. Market timers may wish to kick themselves for getting it wrong, but an honest market timer is always kicking himself anyway, so there’s not much difference there.

It was nice to see some good volume in the pref market today, with a few good-sized crosses courtesy of Scotia.

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

Remember last month’s US jobs number? Don’t. It’s been revised upwards with an entirely solid number reported for September, which has been enthusiastically greeted by most economists, ( including JDH of Econbrowser) although Noriel Roubini sees the devil in the details. There was much the same thing in Canada. So, basically, bad news for bonds.

But in a reminder that, yes, sub-prime is really still a concern, both Merrill Lynch and Washington Mutual took big housing-related write-downs amidst reports of fire-sale liquidations and horrifying lack of quality in 2007-vintage sub-prime loans. Concern, yes; end of the world, no. For sure, $150-billion in sub-prime losses ($50-billion? $100-billion?) sounds like a very big number, but I’ll just take a moment to remind readers of Nortel’s market cap in 2000: almost $400-billion. So by all means, worry. But don’t try to tell me that this is an unprecedented disaster requiring extensive regulation. Accrued Interest has taken a look at contagion in non-RMBS asset-backed paper.

There’s entirely too much speculation that the credit crunch is over. Accrued Interest is concerned that the pendulum, having swung too far one way, will promply over-correct in the other direction. Panic, ecstasy … just another day in the markets. Those who wish to profit from panic without having access to institutional markets might wish to take a look at DG.UN, which was mentioned here on August 28 when it suspended redemptions (ABCP financing dried up). According to their September 26 Press Release:

its net asset value (“NAV”) per unit as at August 31, 2007 was $7.92 based on an indicative price received from a large international bank (the “Bank”) as of August 28, 2007.
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The NAV on a particular date is equal to the aggregate value of the assets of the Trust, less the aggregate value of its liabilities (calculated in conformity with Generally Accepted Accounting Principles (GAAP)). The NAV does not reflect any eventual write-down resulting from the interruption of payments that MMAI is required to make to Global DIGIT under the swaps, nor does it reflect any potential impairment in the value of the assets of Global DIGIT from any eventual restructuring of MMAI debts, as it not possible at present to determine if, when and to what extent such payments to Global DIGIT under the swaps will resume or the effect of any eventual restructuring of any such MMAI debts.

So … there’s some warnings there and there could be legal problems and all sorts of things. But from what I could make out with a VERY brief look, the underlying credit was fine – it’s just liquidity that causes concern … and it’s quoted today on the TSX at 2.80-00, 8×23; so it seems to me it’s worth closer inspection by those willing to rip apart the books and make a few ‘phone calls prior to a decision.

The Economist has published a commentary on bank liquidity that echoes Dodge’s comments on the seemingly very high level of liquidity guarantees given by the banks. I suggest that one thing that be considered is a sliding scale of capital charges for liquidity guarantees: the charge is now a 10% CCF across the board; 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.

Brad Setser continues to worry about the USD, which has been a topic of some concern lately.

I added an ad to the recent reader inquiry; you don’t really need to do it all yourselves, you know! I’m willing to help!

The jobs numbers crushed bonds in both the US and Canada today.

It was an interesting day for prefs! The yield on PerpetualPremiums is finally back below PerpetualDiscounts, which is only sensible given the greater interest rate risk on the latter. Operating Retractibles and SplitShares have been virtually immune to the recent declines in perpetuals … this makes sense up to a point, but only up to that point.

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

There was a report today of another sub-prime winner:

Harbinger Capital Partners, the hedge fund firm run by former Barclays Capital trader Philip Falcone, generated returns of more than 65 percent this year, helped by bets against subprime-mortgage bonds and gains on commodities.Harbinger’s $2.5 billion Special Situations fund increased 9.9 percent last month and more than 100 percent in 2007, said two of the firm’s investors. The $11 billion Harbinger Capital Partners fund rose 5.4 percent last month and 65 percent this year.

Lucky or smart? Does it matter?

The Fed released Commercial Paper Outstandings today; it would appear the situation is normalizing rapidly. ABCP outstanding was down about $6-billion on the week, a nice chunk of change but relatively small in the context of the $906-billion total outstanding. Quality spreads, while still high compared to the last six years, are in decline.

The following posts were either written or updated today:

• Whoosh! Market Adjustment Affects Fair Value of New Issues
• Early Commentary on Canadian ABCP
• Fed Regulation of US ABCP Liquidity Guarantees
• Query from a Reader: Time to Buy?

… which should go a long way towards explaining the brevity of today’s round-up!

There are some very thoughtful essays regarding the Northern Rock bail-out in the WSG Economics Blog and the Economist. There’s another link to an Economist article about the funding gap in British banking … there is an increased reliance on commercial paper, as opposed to deposits, to fund bank loans:

Meanwhile, the preferred share market showed a little stability today. There were some rather violent individual moves, but most of these were reversals of previous silliness.

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