PrefBlog

Today’s phrase is “Minsky Moment” and today’s question is “Have we arrived at one?”.

Prof. Charles W. Calomiris of Columbia explains a “Minsky Moment” with:

The late Hyman Minsky developed theories of financial crises as macroeconomic events. The economic logic he focused on starts with unrealistically high asset prices and buildups of leverage based on momentum effects, myopic expectations and widespread overleveraging of consumers and firms. When asset prices collapse, the negative wealth effect on aggregate demand is amplified by a “financial accelerator”; that is, collapsing credit feeds and feeds on falling aggregate demand credit. A severe economic decline is the outcome. Many bloggers refer to this as a “Minsky moment” (see Minsky 1975 for the real thing.)

… in other words, a self-feeding collapse of the economy.

In an paper posted at VoxEU which summarizes his Not (yet) a Minsky Moment paper published by the American Enterprise Institute, he says (as one may surmise by the title) that we’re not there yet and provides eight reasons. Naked Capitalism takes violent exception to this view … so, let’s have a look at the reasons.

Calomiris: Housing prices may not be falling by as much as some economists say they are.

Smith: Real estate industry participants who have an incentive to say things are fine are instead saying they are terrible.

This is simply the old story: forecasts vs. experience. Neither player is particularly convincing.

Calomiris:Although the inventory of homes for sale has risen, housing construction activity has fallen substantially.

Smith: Per these charts, overhang is much worse than in 1988-1989, and rental vacancies are considerably higher as well. So you can’t take too much comfort from the fall off in housing starts.

I’ll award that point to Smith. Calomiris (both in the summary and the full paper) simply states that the trend in housing starts is in the proper direction; he performs no analysis of how long it will take to work of the excess inventory he acknowledges exists.

However, I would like to see more work done to relate the overhang to affordability. The latest NAHB Housing Affordability Index (MS-Excel File) shows a nationwide value of 43.1%. According to the NAHB:

“The latest HOI indicates that 43.1 percent of new and existing homes that were sold in the United States during this year’s second quarter were affordable to families earning the national median income,” said NAHB President Brian Catalde, a home builder from El Segundo, Calif.

… which is good enough, but I’m looking for something more like RBC’s Affordability Analysis, which indicates the percentage of household income taken up by ownership costs. Even this isn’t really good enough because what we are really interested in is the potential take-up of housing by those who don’t currently own houses. There must be somebody, somewhere, who’s devoted his life to the analysis of the work-out of housing inventory overhangs! Let’s find out who he is and talk to him … but I bet he’s a pretty popular guy at the moment.

Calomiris: The shock to the availability of credit has been concentrated primarily in securitisations rather than in credit markets defined more broadly (for example, in asset-backed commercial paper but not generally in the commercial paper market).

Smith Securitization has been taking market share from traditional credit intermediation (bank lending) for the last 30 years. Corporate lending, commercial and residential real estate loans, auto and credit card receivables and LBO loans are all securitized to a considerble degree. Residential real estate now depends on securitization; if there is no rebound in securitization, we will see a heap of trouble. That’s why policymakers are so keen to revive it.

Point to Calomiris. He is arguing that there is still credit around – albeit at a higher price – and (with the exception of Northern Rock) there are plenty of buyers around for commercial paper, provided the seller is willing to discount the price. Smith does not address the point raised.

Calomiris: Aggregate financial market indicators improved substantially in September and subsequently.

Smith: Events subsequent to the writing of his paper prove make this view inaccurate. The S&P 500 is on the verge of giving up its gains for the year. Bloomberg today reports that Treasuries are enjoying their longest rally in 5 years as investors seek safety.

Point to Calomiris. The fact that the S&P 500 “is on the verge of giving up its gains for the year” isn’t the most terrible thing that could happen, and hardly supports the idea that we have entered a self-feeding collapse. The point about Treasuries is stronger, but while spreads have widened, yields on mid-term bank & finance paper have more or less stayed the same.

Calomiris: nonfinancial firms are highly liquid and not overleveraged. Thus, many firms have the capacity to invest using their own resources, even if bank credit supply were to contract.

Smith: I’m not sure what his sample is. Average ratings of corporate issuers have declined, with nearly half the bonds now junk rated.

Point to Calomiris. He disclosed his sample, Federal Reserve Statistical Release Z.1, Table B.102, and Smith’s other points are irrelevant. They may be a cause for concern about the stability of the financial system, but they do not indicate that we are now in the midst of a collapse.

Calomiris: households’ wealth is at an all-time high and continues to grow. So long as employment remains strong, consumption may continue to grow despite housing sector problems.

Smith:  It won’t be for very long if housing continues on the trajectory that most anticipate, and will decline even more if the stock market follows.

Easy point to Calomiris (I should even consider giving him a bonus point). Smith is mistaking the existence of gloomy forecasts for evidence of horrible current conditions.

Calomiris: Of central importance is the healthy condition of banks.

Smith: Many are believed to be otherwise. Financial stocks hare dropped sharply this year, and large banks are now paying as much as 6% in dividends when Treasuries yield a mere 4%.

Point to Calomiris. Market prices – Smith’s idol – are down, but Tier 1 capital ratios are not showing evidence of disaster. Tough times are not a disaster. Citigroup is getting hammered – the stock is down 40% over the past year – but what’s really going on?

Deutsche Bank AG analyst Michael Mayo wrote in a report yesterday that Citigroup shares may fall to $29. He reiterated his “sell” rating and said the company may be prevented by regulators from making acquisitions because “recent risk management mishaps seem to violate” terms of an earlier agreement.

“It looks to us that recent problems with CDOs and their lack of disclosure reflect a serious risk management breakdown,” Mayo said. At $29, Citigroup would trade at eight times estimated earnings for 2008, he said.

‘Sell the stock!’ cries Mayo, ‘The earnings yield’s less than 12%!’ There may be no growth, and there may be more risks than were previously deemed to be the case, but Citigroup is still making lots of money. Dividends won’t grow much over the next few years as they rebuild their balance sheet … but this is not the end of the world. It’s a pause.

Calomiris: Banks hold much more diversified portfolios today than they used to. They are less exposed to real estate risk than in the 1980s, and much less exposed to local real estate risk, although US banks’ exposure to residential real estate has been rising since 2000

Smith: Not directly addressed.

Full point by default to Calomiris.

So I score the match 6-1 to Calomiris, with one point considered lost by both. And what’s more, I agree with him – which may, of course, have influenced my scoring. Times are tough. There’s a big indigestible mass of dubious debt on the books all over the place, but – as far as I can see – the financial system is not melting down and we are not in a depression. I’ll simply repeat what I’ve been saying for the past several months: Times are tough. Firms that have been living on the edge may find they fall off. There may even be a spectacular blow-up or two, if a financial institution finds out its risk controls aren’t what they might have wished them to be. And I most certainly would not want to be earning my living as a casual labourer in the US housing industry. But it’s a pause, nothing more.

There has been some news of interest to the carrion feeders: remember CPDOs? One of them is liquidating after a mark-to-market breached the terms of the deal. That’s the trouble with these things – it’s a great strategy, as long as there aren’t any margin calls or mark-to-markets. Moody’s assigned them a Aaa long term rating on July 6, 2007, put them under review for possible downgrade on August 21, and now they’ve defaulted. I hope UBS took its management fee in advance!

Highly leveraged muck – but, of course, when they work, they really work well. The problem with the market is, as always, stockbrokers: they’ll buy anything so long as somebody with a deep voice tells them it’s good. I cannot begin to tell you how much stuff I’ve been offered over the years that (so the salesmen say) may certainly be placed in a fixed income portfolio, but has a payoff based on something that won’t behave like a bond in the slightest. Somehow it sells. 

It’s a lot like buying an GIC from a bank with the return linked to the stock market and pretending to yourself that, because it’s a GIC, it’s really a fixed income instrument. It may be good, it may be bad – but it sure as hell ain’t a bond!

And another CDO is liquidating as the senior note-holders have decided they want their money back. I’ve had a look at the prospectus … I would like to say I can’t understand why anybody would invest in such a thing, but unfortunately, I know only too well. You can offer nice interest if you lever up to hell and gone.

The saga of Canadian ABCP continues, with Alberta Treasury Branches disclosing their write-down. They have assets of $22.5-billion, of which $1.2-billion is in ABCP and they’re taking a hit of 6.6%.

“ATB Financial has year-to-date earnings of $73 million despite absorbing a $79.6-million ABCP provision,” CEO Dave Mowat said in a release.

In more cheery news, there is a school of thought that predicts a takeover of E-Trade:

Ameritrade has an advantage as a potential buyer because it’s 40 percent owned by Toronto-Dominion Bank, Canada’s third- largest bank, Repetto said. “The bank has deep pockets and it has the ability to deal with some of the issues at E*Trade,” he said.

Exactly the kind of thing the bank should be doing … as long as they’re willing to walk away without a deal after starting negotiations.

Bond insurers, which I have discussed yesterday, took heart from the recent French bail-out and were up a lot on the day.

Still, on the lighter side, remember Flaherty and his Big Plans to Help Canadian Consumers? He was told about one of the problems at the time:

Diane Brisebois, of the Retail Council of Canada, said Flaherty should help retailers by cutting duties collected at the border.

“If you bring in sneakers from China, for example, retailers in Canada pay 18 per cent taxes. Retailers in the U.S. pay absolutely nothing,” she said.

So I thought of him today when I read this amusing snippet:

So how did the Buffalo-area mall prepare for the post-Thanksgiving shopping madness?

For one thing, Goodwill collection bins were situated at three entrances for all the clothes and shoes the crowds from the north have been ditching in restrooms and parking lots. Many shoppers have been wearing their new clothes home to avoid paying hefty taxes and duty at the border.

Good volume again in the pref market; Floaters got beat up again. It could be simply a credit thing on BAM; it could be that people are selling other BAM names to buy the perpetuals (and the derivative split share!); it could be that people are just getting out of floaters and picking on BAM to sell for other reasons. Who knows?

I continue to be utterly amazed by the yield on BNA.PR.C, which had yet another rough ride today, down 0.9444% to close at 17.83 bid, yield 8.39% to maturity. 8.39%! Basically, 11.75% interest equivalent!

I confess, I thought for a fleeting moment today that it might be inventory overhang from a barely successful underwriting … but that doesn’t seem to fit the data. They started trading January 10 and hung around at the $25.00 level until early May, when they – quite reasonably – got caught up in the downdraft. Markets were strong in the first part of the year – if the dealers had been left holding the baby, surely they would have, and could have, blown it out the door at $24.00 in, say, March.

The fund has a position in this issue and I’m getting killed on it. But how can it possibly be fairly valued at 160bp over the similar-and-parri-passu BNA.PR.B? On the bright side, looking at the price chart is highly entertaining … I’ve found a new illustration for the word “parabola”.

Such is the life of a preferred share investor …

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

The travails of Fannie & Freddie continued to attract attention, with James Hamilton of Econbrowser reviewing their purpose, capital structure and capital adequacy and concluding:

Perhaps you think we’ll probably muddle through OK, unless the sale of Freddie’s assets would so depress the market as to hinder extensions of new loans to creditworthy borrowers, thereby reducing home sales further, thereby depressing house prices further, thereby inducing more borrowers to default, so that we go from the good equilibrium to the bad equilibrium. But figuring out exactly where we stand currently on that slippery slope between A and B is not an easy matter.

Here’s my bottom line: if Freddie cuts its dividend, that’s a good thing. All the rest is worrisome.

The disagreement at issue is expressed by Felix Salmon:

According to the WSJ, Freddie Mac has serious capital-adequacy problems, and they’re basically the fault of the Office of Federal Housing Enterprise Oversight
…
because OFHEO is being strict with Freddie, it’s being forced to sell tens of billions of dollars’ worth of mortgages.
…
Instead, they’re dumping mortgages onto the secondary market in order to comply with OFHEO’s capital-adequacy requirements. There’s a time and a place for those kind of requirements, and it is emphatically not now.

My position remains that the GSEs walk like banks, talk like bank, make profits like banks and should be regulated like banks – as James Hamilton implied at Jackson Hole. I have been unable to determine what the Tier 1 and Total Capital ratios of the GSEs would be were this to be put into effect, but OFHEO head James B. Lockhart’s March speech to America’s Community Bankers is telling:

Presently, Fannie Mae and Freddie Mac have low regulatory minimum capital requirements compared with other financial institutions. The 1992 Act that created OFHEO requires them to maintain stockholder’s equity equal to 2.5 percent of assets. The FHLBanks hold 4 percent, albeit with a much different capital structure, and major banks hold over 6 percent. Given Fannie Mae’s and Freddie Mac’s present condition, I am certainly more comfortable with today’s extra 30 percent add-on for operational risk.

OFHEO’s risk-based capital test is also prescribed by that 15-year-old statute and needs to be modernized. Risk-based capital should be based on the full array of Enterprise risks — market, credit, and operational risk, as well as the risks they present to the overall financial markets. A new, stronger regulator needs the flexibility and authority to change both the risk-based and minimum capital requirements through a regulatory process supplemented by the ability to respond quickly to changing conditions.

So … my bottom line is that the GSEs are grossly undercapitalized. If they want to grow, let them issue more equity. If it is deemed to be a social good that they grow, enough of a social good that the US Government is explicitly willing to bear some losses if things get really bad (right now the guarantee is only implicit) then fine! Make that decision! Have the US Government buy and pay for a big fat whack of common and preferred stock! 

In other news, it looks as if the MLEC / Super-Conduit is getting under way slowly, though not without carping from Naked Capitalism:

am now wondering who, exactly, will purchase the commercial paper that will fund this new entity. While this is anecdotal, I have heard a fair number of people, including financially savvy ones, say they would take money out of a money market fund that invested in this entity. So retail money market funds are somewhere between a hard sell and a non-starter. Enhanced cash management fund would have been the perfect target, but a number have broken the buck recently. Some mangers are contributing cash to the fund to make investors whole; others are letting investors take losses. As a result, that type of fund is operating under a cloud right now. Expect there to be near-term net withdrawals and greater conservatism in investment, which works against the SIV rescue program.

Hey – show me that the assets are fairly valued, show me that I’m senior to a good whack of mezzanine and capital notes, and show me that there’s a solid liquidity guarantee and I’ll invest! To be fair, Naked Capitalism has been dubious from the beginning as to whether my first condition would be met!

Naked Capitalism also provides a round-up of recent news concerning the bond insurance industry. ACA Capital and its woes – and subsequent vulnerability to a deep-pocketted strategic acquirer – was briefly mentioned yesterday. A ratings downgrade of the firm could have significant effects:

ACA Capital Holdings Inc., the bond insurer under scrutiny by Standard & Poor’s, may have its credit rating cut, forcing banks to take on $60 billion of collateralized debt obligations, JPMorgan Chase & Co. analyst Andrew Wessel said.

After all, there has just been a bail-out of a French insurer by those with a deep interest in its continuing health!

Natixis SA’s bond-insurance unit, CIFG Guaranty, will be taken over by the French bank’s controlling shareholders in a $1.5 billion rescue to preserve its top credit rating.

Natixis, France’s fourth-largest bank by market value, rose 16 percent in Paris trading after Groupe Banque Populaire and Groupe Caisse d’Epargne, French mutual banks that jointly control Natixis, said today they will provide the capital and assume full ownership of CIFG. They said the purchase will be completed “as quickly as possible.”

And continuing on the bond insurance theme, Accrued Interest has taken a look at AMBAC and doesn’t like what he sees:

I have completed a deep dive of AMBAC’s insured portfolio. The conclusion: I don’t see how they maintain a AAA rating without raising new capital.
…
So how much in capital would they need to retain their rating? Probably at least $2 billion.
…
Whether they can raise this kind of capital or not is difficult to see. It will be a question of whether a well-capitalized partner sees long-term value in their lucrative municipal insurance franchise in excess of the losses expected in ABS. I don’t doubt that many potential partners would be interested in the municipal business.

We’ll see how it goes … speaking for myself, and without having done any analysis or understanding the culture … I say this is a Canadian banking opportunity. Come on, guys! You’ve got great balance sheets and a strong currency behind you! Put them to work!

The links under “US Fixed Income Data” in the right-hand panel of this blog now includes a link to the US Yield-to-Maturity Convention, continuing my struggle to remind the world that YTM is not annualized-IRR.

It was a thoroughly horrific day for preferred shares, although the nature of the market showed itself by having normal volume even though the US was closed. The Floater total return index fell below its 2006-6-30 value – negative total return for floaters over a 16+ month period – on what appears to be a combination of BAM-bashing and a conviction that Canada Prime is going to zero. Split-shares only just barely managed to hang on to positive 16+ month returns, as bids just evaporated.

P.S.: I almost forgot. The PerpetualDiscount index hit a new post-June-30-2006 low today. JH

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

Update 2007-11-22: HardMaturity price of WFS.PR.A noted in table of price changes has been corrected. Sorry!

Menzie Chinn of Econbrowser wrote a good piece yesterday reviewing the dollar’s decline, noting:

So while there is a tremendous amount of inertia in a currency’s reserve role, what we might be seeing now is the interaction of cyclical factors (low U.S. interest rates and dollar depreciation) and structural factors (the strains on dollar pegs and consequent erosion of demand for dollar assets) which could lead to a substantial drop in the dollar’s value.

It’s always the way. Any kind of accident – whether in the financial markets or in everyday life – generally results from a confluence of factors … the one percent chance that you don’t look when crossing the street will sometime coincide with somebody else’s one percent chance of not checking carefully when making a turn. The comments to the post are quite good, but I confess I’m not looking forward to the next year … an economics discussion on the Internet about the US during an election year? The mind boggles.

In a related essay, Richard Baldwin writes an excellent review of a paper by Martin Feldstein that provides an intellectual framework for thinking about currency values:

Feldstein makes a bold simplification that helps him to think clearly about the messy world. He takes US savings and investment as primitives and views the value of the dollar as the variable that adjusts to make things fit. As he writes it: “This line of reasoning leads us to the low level of the U.S. saving rate as the primary cause of the high level of the dollar.”
…
If the US saving rate rises without a dollar drop, there is no narrowing of the trade gap to offset the closing saving/investment gap. Aggregate demand falls and we get a US recession or at least growth deceleration. More to the point facing us today, Feldstein notes that since a falling dollar stimulates net exports only with a lag, avoiding a slowdown in US aggregate demand growth would have required the dollar to fall before the saving rate rises, maybe a couple of quarters earlier. Or, as he puts it: “the domestic weakness will occur unless the dollar decline precedes the rise in saving.”

There was another insight into A Day in the Life of a Bond Guy on Accrued Interest; a discussion of an investment in Washington Mutual that the author is not prepared to support any more. After all the analysis, all the securities filings, all the worry … it all comes down to trust. In the comments section, AI floats the possibility of a takeover of WM … now that’s something that looks interesting. Every morning I rush to the newspaper, looking for the news that I am convinced will come in the near future: Major Canadian Bank Makes Massive Purchase in States.

The Canadian banks have balance sheets that are very strong by world standards – never mind just by comparison to US banks – AND we’re sitting on a hot currency AND the US financial sector is getting beat up beyond the bounds of rationality. If there was ever time to do something like this, it’s now. It doesn’t have to be another bank, or a big-name company like WaMu … it could be something like ACA Capital Holdings, which is not having a very nice time.

In more news of interest, yet another “enhanced yield” product was found to be in danger of breaking the buck and is getting a cash transfusion from Federated Investors. Note that Bear Stearns Cos.’ Enhanced Income Fund and General Electric Co.’s GEAM Trust Enhanced Cash Trust both broke the buck without support from their sponsors.

Readers will remember the concept of covered bonds and some will be aware that BMO is planning an issue. However, in addition to deterorating market conditions …

Abbey National Plc, the U.K. home lender owned by Banco Santander SA, became the third financial company to cancel an offering of covered bonds within a week today as investors demanded banks pay the highest interest premiums to sell bonds in the 12 years since Merrill Lynch & Co. began collecting the data.

“We are in a deteriorating situation,” Patrick Amat, chairman of the Brussels-based ECBC, said in a telephone interview. “A single sale can be like a hot potato. If repeated, this can lead to an unacceptable spread widening and you end up with an absurd situation.”

… there is now a recommendation from the trade association that:

“In light of the current market situation and in order to avoid undue over-acceleration in the widening of spreads, the 8-to-8 Market-Makers & Issuers Committee recommends that inter-bank marketmaking be suspended, temporarily, until Monday the 26th of November 2007. As this recommendation relates only to inter-bank trading, market-maker obligations to investors will remain unaffected.”

Fascinating. I have been advised that this recommendation only applies to extant market making agreements that commit the banks to calling a market in good size and is not a flat (unenforceable) prohibition of trades between two banks that want to trade. The Covered Bond Fact Book states:

Market Makers’ commitments define bid/offer spreads for sizes up to 15 million EUR for different maturities as follows:
> up to 4 years maturity – 5 cents;
> from 4 to 6 years – 6 cents;
> from 6 to 8 years – 8 cents;
> from 8 to 15 years – 10 cents;
> from 15 to 20 years – 15 cents; and
> from 20 years upwards – 20 cents.

I wrote about Fannie Mae and its accounting on November 16 … Accrued Interest has fleshed that out a little more (with the benefit of an American market background!) in a post about Freddie Mac.

Good volume for prefs today, and some of the more egregious silliness was smoothed away, but all in all performance was poor.

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