PrefBlog

Of most interest today (well … last night!) was the Abu-Dhabi SWF investment in Citigroup. As noted by Naked Capitalism, this deal was done, effectively, at a concession to the current market price, given that the preferreds are protected against a dividend cut on the common, have a dividend yield that is greatly in excess of the common yield, and convert to common at prices not all that much in excess of current prices in a few years’ time. The concession has not escaped notice:

The deal may dilute the value of Citigroup’s stock, reducing 2008 earnings by as much as 20 cents a share, Bank of America analyst John McDonald estimated.

Citigroup shareholders are “ultimately the ones who are paying,” said William Smith, chief executive officer of Smith Asset Management in New York, which oversees $80 million, including about 70,000 Citigroup shares. “If you look at 11 percent, that’s basically junk bond yields, and so it’s great for Abu Dhabi.”

However, the deal will reinforce Citigroup’s capital ratios and that’s what counts. A bad capital ratio could mean no profits to be diluted! Freddie Mac is also selling prefs at concessionary prices:

Freddie Mac, the second-biggest source of money for U.S. home loans, plans to sell $6 billion in preferred stock and cut its dividend in half to shore up capital depleted by record mortgage defaults and foreclosures.

The two-part sale will include non-convertible, non- cumulative preferred stock and a “substantially smaller” portion of convertible preferred shares, Freddie Mac said in a statement today.
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Freddie Mac sold $500 million of preferred shares in September with a fixed dividend rate of 6.55 percent. The shares, issued at $25 each, were trading at about $20 today.

Those who are familiar with the rules for Tier 1 bank capital will be most amused by the following bizarre attempt to create a controversy (hat tip: Financial Webring Forum):

When either Freddie or Fannie attempt to build capital, they are handicapped by a peculiarity that very few investors know about: They cannot sell the most popular kind of preferred stock, the “cumulative” variety, because their regulator will not let these securities count toward capital.

What “cumulative” signifies in this context is that if dividends are missed, they pile up to be paid on some brighter day, if that arrives. To the extent that Freddie and Fannie issue preferred shares, therefore, they are forced into selling the “non-cumulative” variety. That means if a dividend is missed, say, in the first quarter of 2008, the owners of the preferred will never get that dividend. It’s just gone, zip!

Naturally, prudent investors are not wild about owning non-cumulative preferred shares, which is why there are not many of these securities around. What smart investor unnecessarily wants to put himself in the position – no matter how remote – of missing a dividend and never thereafter being able to capture it?

Note that Quantum Online lists 144 non-cumulative US issues. Cumulative issues are very nice to have, but they don’t count as Tier 1 Capital for banks. OFHEO is to be applauded for disallowing the inclusion of such issues in capital.

These deals, I think, may be classed in the same category as GWO’s sale of its US healthcare business, in that what is going on – once all the frippery is tossed aside, is a conversion of debt into equity. Lord knows what Abu-Dhabi has had its money invested in until now – I mentioned the transparency issue briefly on September 24 – but there is no reason why it can’t have been a savings account at Citigroup, which is now, as far as they’re concerned, moving up the ladder to become equity; with no effect on Citigroup’s cash, but salutary effects on their ratios.

GWO  is using the proceeds of their sale to repay the bridge debt on their purchase of Putnam, instead of selling term debt to finance this. Even if the buyer, Cigna, finances through debt it will be term debt from a strategic buyer.

There is another very similar – in its essentials – situation occuring in the SIV area. MBIA and its problems in finding financing for its conduit, Hudson-Thames was mentioned here on October 25. Now we learn that:

MBIA Inc., the largest bond insurer, is winding down its structured investment vehicle after failing to find buyers for the SIV’s short-term debt since August, Chief Financial Officer Chuck Chaplin said.

MBIA has shrunk its Hudson Thames Capital SIV to about $400 million from $2 billion through asset sales to bondholders, Chaplin said. The Armonk, New York-based company has taken an “impairment” on its own $15.8 million equity stake, Chaplin told a conference hosted by Bank of America Corp. in New York today.
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MBIA asked holders of the lowest ranking bonds of Hudson Thames, known as capital notes, to buy a share of the SIV’s bank bonds, asset-backed securities and other holdings in proportion to the amount of debt they own.

The so-called “vertical slice” deals enable SIVs to raise cash while bondholders avoid the risk of their investment being wiped out in a fire sale, Fitch said in a report this month.

And this is how the credit crunch will be resolved. Equity holders will take their lumps; debt holders will move up the risk-return ladder at concessionary prices; and the indigestible debt will slowly, but as inexorably as the ticking of a clock, be run off the books.

I think.

There is shock and horror all over the place with the release of the Case-Shiller US Housing Price Index for September:

“The declines in the national figure are notable for two reasons,” says Robert J. Shiller, Chief Economist at MacroMarkets LLC. “First, the 3rd quarter decline, at 1.7%, was the largest quarterly decline in the index’s 21-year history. And, second, the year-over-year decline posted its second consecutive record low at -4.5%. Consistent with prior 2007 reports, there is no real positive news in today’s data. Most of the metro areas continue to show declining or decelerating returns on both an annual and monthly basis. All 20 metro areas were in decline in September over August. Even the five metro areas that still have positive annual growth rates — Atlanta, Charlotte, Dallas, Portland and Seattle — show continued deceleration in returns.”

Appallingly, the annualized internal rate of return for the indices since their base-date of January 2000 is a mere 9.15%. There’s a great post at the Irvine Housing Blog (hat tip: WSJ) about the loan history of a Very Nice House:

The property was purchased in January 2005 for $1,157,000. The combined first and second mortgages totalled $1,156,730 leaving a downpayment of $270. Let’s just call it 100% financing.

By April, they owners were able to find refinancing through Countrywide with a $999,999 first mortgage. This mortgage was an Option ARM with a 1% teaser rate. The minimum payment would be $3,216 per month.

Also in April of 2005, they took out a simultaneous second mortgage for $215,000 pulling out their first $58,000.

So look at their situation: They are living in a million dollar plus home in Turtle Ridge making payments less than those renting, and they “made” $58,000 in their first 4 months of ownership.

Apparently, these owners liked how hard their house was working for them, so they opened a revolving line of credit (HELOC) in August 2005 for $293,000. Did they spend it all? I can’t be sure, but the following certainly suggests they did.

In December of 2005, they extended their HELOC to $397,990.

In June of 2006, they extended their HELOC to $485,000.

In April of 2007, the well ran dry as they did their final HELOC of $491,000. I bet they were pissed when they couldn’t get more money.

So by April 2007, they have a first mortgage (Option ARM with a 1% teaser rate) for $999,999, and a HELOC for $491,000. These owners pulled $333,000 in HELOC money to fuel consumer spending.

Assuming they spent the entire HELOC (does anyone think they didn’t?), and assuming the negative amortization on the first mortgage has increased the loan balance, the total debt on the property exceeds $1,500,000. The asking price of $1,249,000 does not look like a rollback, but if the property actually sells at this price, the lender on the HELOC (Washington Mutual) will lose over $300,000.

Speculation about the forthcoming Fed meeting is ramping up, with Goldman calling for 150bp easing by the second quarter, but … what are the implications for inflation?

So far, inflation expectations have remained stable. Yet I consider those expectations more fragile now than I did four to six months ago. The rise in oil prices and the simultaneous increases in a broader basket of commodity prices suggest that significant inflationary pressures exist in the economy and thus the Fed must be very vigilant. If inflationary expectations rise, it could prove very costly to put the genie back in the bottle.

Very good volume in the pref market today, but performance continued to be (i) Weird and (ii) Poor. Splitshares bounced back (despite their expulsion from the S&P/TSX index), but that was more of a dead cat kind of thing than anything else – although it is rather pleasant to say that WFS.PR.A closed at 9.70-79, 121x10.

The PerpetualDiscount index broke below the 900-mark, setting yet another new low. But with all this volume, things must rationalize soon … mustn’t they?

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

The big news today was Quebecor World’s suspension of preferred dividends; but that has its own post.

There was a fair bit of news on the MLEC/Super-conduit front. HSBC is bailing out its SIVs, taking $35-45-billion onto its balance sheet to avoid a fire-sale of the assets. It has been reported:

The SuperSIV is “is all good and well, but it’s not big enough,” said Tom Jenkins, a credit analyst at Royal Bank of Scotland Group Plc in London. “If you have a large SIV, you’re going to need to find another solution.”
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Cullinan’s net asset value, the amount left over after selling all its assets and repaying debt, fell to 69 percent of its capital, Moody’s Investors Service said Nov. 7. Asscher’s net asset value has declined to 71 percent, Moody’s said.
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HSBC plans to make a formal offer to investors in the SIVs’ lower-ranking mezzanine and income notes later this year or early 2008. It expects to complete the restructuring by August 2008.
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“HSBC believes there is not likely to be a near-term resolution of the funding problems faced by the SIV sector,” the bank said.

It will be most interesting to see what kind of bid the capital noteholders will see – I bet HSBC sticks it to them!

Meanwhile, there is a report that marketting of the Super-Conduit is about to commence in earnest … but one can detect a certain jeering tone in the commentary:

“Why should we put something on our balance sheet that is going to result in further writedowns?” is how most contributors will respond, [Punk Ziegel & Co. analyst Richard] Bove said in an interview. “The job of the Treasury isn’t to go out and defraud investors.”
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Bank of America “has far more to gain down the road” with regulators by backing SuperSIV, said Tony Plath, a financial professor at the University of North Carolina at Charlotte, who expects the plan to fail. “They are setting themselves up so they aren’t criticized when this thing falls apart.”
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The fund’s lack of disclosure makes it “a necessary failure,” Bill Gross, manager of the world’s biggest bond fund at Newport Beach, California-based Pacific Investment Management Co., said in an Oct. 31 interview. “Transparency is what the Treasury and Fed are supposedly all about.”
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Loomis Sayles & Co. declined to invest after receiving one of 16 invitations for a personal meeting last week with current Fed Chairman Ben Bernanke, said Daniel Fuss, who oversees $22 billion as chief investment officer at the Boston-based firm. The Securities Industries Financial Markets Association trade group extended the invitations, Fuss said.

“It’s so nice to get a personal invitation to go to Washington and have a one-hour visit with Ben Bernanke,” said Fuss, who decided participating wasn’t worth the risk to his firm. “Oh, boy, did I feel important for about 27 seconds, and then you smell a rat.”

Well … we shall see! But it is certain that a certain amount of forceful statements need to be made by the sponsors if there is to be any funding extended … but, on the other hand, if the idea is to stick it to the SIVs that are in trouble, how much sales will be needed? Given a choice between defaulting on their senior debt and getting a fistful of Super-Conduit term senior FRNs and capital notes, sponsors of troubled SIVs will find themselves between a rock and hard place. Naked Capitalism notes that Larry Summers writes in the Financial Times:

The priority now has to be maintaining the flow of credit. The current main policy thrust – the so-called “super conduit”, in which banks co-operate to take on the assets of troubled investment vehicles – has never been publicly explained in any detail by the US Treasury. On the information available, the “super conduit” has worrying similarities with Japanese banking practices of the 1990s that aroused criticism from American authorities for their lack of transparency, suppression of genuine market pricing of bad credits, and inhibiting effect on new lending. Perhaps there is a strong case for it, but that case has yet to be made.

Mr. Summers predicts a recession, but many disagree with him … for now:

Even bulls say that the biggest rally in government debt since 2002 has pushed yields on 10-year notes so low that they can only decline if the economy shrinks. None of the 68 economists surveyed by Bloomberg News from Nov. 1 to Nov. 8 expect the economy to contract before the end of 2008.

Prof. Stephen Cecchetti of Brandeis has been quoted here on August 27 (blaming rating agencies) and November 19 (wanting as much trading as possible on regulated exchanges) and has now commenced a four part series for VoxEU. In Part 1 he notes that:

Financial institutions have been allowed to reduce the capital that they hold by shifting assets to various legal entities that they did not own – what we now know refer to as “conduits” and “special investment vehicles” (SIV). (Every financial crisis seems to come with a new vocabulary.) Instead of owning the assets, which would have attracted a capital charge, the banks issued various guarantees to the SIVs; guarantees that did not require the banks to hold capital.

but does not suggest a solution, noting that:

under any system of rules, clever (and very highly paid) bankers will always develop strategies for holding the risks that they wanted as cheaply as they can, thereby minimizing their capital.

I have suggested that the 10% charge for a liquidity guarantee should (almost certainly) be increased; to avoid the next evasion, regulators should deem these guarantees to be in place if the bank is merely sponsoring the SIV without a guarantee; or if it has an economic interest in the survival of the SIV. Or maybe X% for an arm’s-length guarantee, double that if the bank has an economic interest.

Yes, it’s a bit like trying to plug a seive (hah!). But you do what you can.

He admits that another problem defies solution in this wicked world:

Think about the manager of a pension fund who is looking for a place to put some cash. Rules, both governmental and institutional, restrict the choices to high-rated fixed-income securities. The manager finds some AAA-rated bond that has a slightly higher yield than the rest. Because of differences in liquidity risk, for example, one bond might have a yield that is 20 or 30 basis points (0.30 or 0.30 percentage points) higher. Looking at this higher-yielding option, the pension-fund manager notices that there is a very slightly higher probability of a loss. But, on closer examination, he sees that this higher-yielding bond will only start experiencing difficulties if there is a system-wide catastrophe. Knowing that in the event of crisis, he will have bigger problems that just this one bond, the manager buys it; thereby beating the benchmark against which his performance is measured.I submit that there is no way to stop this. Managers of financial institutions will always search for the boundaries defined by the regulatory apparatus, and they will find them.

I don’t have much of a solution either! Enforcement of the Prudent Man Rule can only go so far … and if some paper defaults, it’s very difficult to show that the chance of this happening was underestimated at time of purchase. But … Prudent Man Rule will help, anyway!

Remember the Federal Home Loan Banks (FHLBs) mentioned here on October 30? It seems that FHLB Atlanta has credit policies that would be considered somewhat unusual in the private sector:

Countrywide Financial Corp. fell more than 10 percent in New York Stock Exchange trading after U.S. Senator Charles Schumer urged the regulator of the Federal Home Loan Bank system to probe cash advances to the largest U.S. mortgage lender.

Schumer said he was alarmed by the volume of advances the system’s Atlanta bank has made to Countrywide considering “the rapid deterioration” in the credit quality of some of the Calabasas, California-based company’s mortgages. Schumer expressed his concerns in a letter sent today to Federal Housing Finance Board Chairman Ronald Rosenfeld.

The Atlanta bank has made $51.1 billion in advances to Countrywide as of Sept. 30, representing 37 percent of the bank’s total outstanding advances, Schumer wrote, citing U.S. Securities and Exchange Commission filings.

In more cheerful news, Naked Capitalism reports on a hedge fund that’s hit a ten-bagger betting against sub-prime and Ed Yardeni, of Millennium Bug fame, offers up nine reasons to be thankful:

(1) The S&P 500 is up 53% since Thanksgiving 2002. The current bull market has been the third best since 1960.
(2) The 10-year Treasury yield was near 5.5% in early 2002. It is down to 4.0% this morning.
(3) The core CPI inflation rate in the US has been remarkably steady around 2%, and down from 2.6% to 1.8% on average among the 30 members of the OECD, despite the soaring price of crude oil, which is up from $27 a barrel to $99 a barrel since Thanksgiving 2002, based on West Texas Intermediate price.
(4) Notwithstanding all the nonsense about outsourcing, the unemployment rate was down to 4.7% in October vs. 5.7% five years ago as payroll employment rose 8.1 million to a record high of 138.4 million.
(5) Real disposable personal income was at a record high in September, up 16.0% since September 2002. Real per capita income is also at a record high and up 2.1% per year, on average, over the past five years.
(6) Real GDP is up 15.3% over the past five years.
(7) In the US, since the end of 2002, household net worth is up nearly 50% to a record $57.9 trillion.
(8) World exports have doubled since November 2002. The OECD world industrial production index is up 30% since then. Today, roughly three billion people around the world are aspiring and perspiring to improve their standards of living.
(9) Alan Greenspan’s book tour is over.

The New York Fed made headlines, pumping $8-billion into the term-repo market, stating:

In response to heightened pressures in money markets for funding through the year-end, the Federal Reserve Bank of New York’s Open Market Trading Desk plans to conduct a series of term repurchase agreements that will extend into the new year.

The first such operation will be arranged and settle on Wednesday, November 28, and mature on January 10, 2008, for an amount of about $8 billion. The timing and amounts of subsequent term operations spanning the year-end will be influenced by market and reserve developments.

In addition, the Desk plans to provide sufficient reserves to resist upward pressures on the federal funds rate above the FOMC’s target rate around year-end.

The Bloomberg story seems a bit peculiar – they claim that:

Fed officials acted after the average U.S. overnight lending rate between banks exceeded their target seven of the past eight days, suggesting a reluctance to lend amid mounting subprime mortgage losses. In most years, banks face year-end pressures as they adjust their books to show ample liquidity and at the same time meet a jump in demand for cash from consumers.

While there may well be pressures, Fed Funds Data show that, in terms of averages, we’re only talking about a basis point or so. However, the maintenance period ended November 21 was clearly tighter than the period ended November 4 – and we don’t know what they had to do to keep the actual rate so well aligned with target. They may well have been influenced by the fearsome size of the TED spread:

The cost of borrowing dollars for three months rose as banks hoarded cash to cover their commitments through the end of the year. The London interbank offered rate, or Libor, for dollars rose 1 basis point to 5.05 percent, for a four-week high and the ninth straight day of gains, the British Bankers’ Association said today.

That pushed the “TED” spread, or the difference between three-month Treasury bill yields and Libor, to 1.92 percentage points from 1.82 percentage points on Nov. 23. The yield on the three-month bill fell 9 basis points to 3.12 percent.

Preferreds saw heavy volume today and violent random (as far as I can tell!) price movements based on the latest headlines. PerpetualDiscounts hit a new post-2006-6-30 low, as did SplitShares, the latter now having provided negative return since the start of these temporary indices.

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