PrefBlog

I must say, my respect for Arthur Levitt continues to decline – his Credit Rating Agency recommendations did not impress and now he is quoted in a manner which makes it appear he doesn’t understand investing:

The Florida agency that manages about $50 billion of short-term investments for the state, school districts and local governments holds $2.2 billion of debt that was cut below investment grade.
…
“It’s really disgraceful,” Levitt said. “I think what’s really bad about this is that the state has called for investments to be prudent and careful but clearly the custodians of this fund were reaching, they were trying to get maximum yield.”

Four percent of a portfolio goes bad (and I’ll bet a nickel that recovery handsomely exceeds 90%) and that is sufficient for Levitt to use words like “disgraceful”? This does not do a service to anyone. Four percent does not sound reckless to me; it sounds diversified – especially since there are four different vehicles involved. If Mr. Levitt wishes all public pension funds to be invested in guaranteed-no-default T-bills exclusively, he should say so, instead of gleefully crying “I told you so! Or, at least, I could have told you so if you’d asked me!” after the events.

The Prudent Man Rule goes both ways, Mr. Levitt. A Prudent Man will take Prudent Risks to increase return. Sometimes, Mr. Levitt, taking a risk will lose money. That’s why they’re called Risks, Mr. Levitt. There is nothing in Mr. Levitt’s remarks to indicate that the managers of the portfolio violated their mandate.

In somewhat related news, Naked Capitalism informs us that a GE Cash Management Fund has Broken the Buck. This is not a Money Market Fund, as regulatorially defined, but an enhanced yield fund – in addition to bailing out its MMF, Bank of America also bailed out its “institutional cash fund, which isn’t technically a money fund.” I have written an article, which I hope will be published shortly, on this general topic.

I’m a much bigger fan of Dallas Fed President Richard Fisher. He sounds much more reasonable when discussing a Central Banker’s favourite topic:

But he says rising food and energy prices are the big concern, creating “a risk of a more pernicious pass-through effect than we saw in the recent price increases of underlying commodities.”

The spread between food price inflation and core inflation hasn’t been so large in a quarter century, Mr. Fisher says. And energy prices are rising due to strong demand and trading activity. “All this gives me a sense of discomfort on the headline inflation front, and it is a reminder that the balance of risks is not skewed unilaterally toward slower growth.”
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“You might say the credit markets have gone from the ridiculous to the subprime; the subprime and related derivatives market is the focus of angst, but the ridiculous practice of the suspension of reason in valuing all asset classes appears to be in remission, if not over,” he says.

While we’re on the topic of the Fed … explicit inflation targetting, the subject of some speculation November 12, has not been adopted. Meanwhile, Paul De Grauwe weighs in with an essay advocating:

• Asset-price targetting by Central Banks (a recurring theme discussed at the Jackson Hole conference and reported here August 31)
• Central Bank “regulation of all institutions that create credit and liquidity”.

His justification for the second point is:

During the last few years, a significant part of liquidity and credit creation has occurred outside the banking system. Hedge funds and special conduits have been borrowing short and lending long, and as a result, have created credit and liquidity on a massive scale, thereby circumventing the supervisory and regulatory framework. As long as this liquidity creation was not affecting banks, it was not a source of concern for the central bank. However, banks were heavily implicated. Thus, the central bank was implicitly extending its liquidity insurance to institutions outside the regulatory framework. It is unreasonable for a central bank to insure activities of agents over which it has no oversight, very much as it would be unreasonable for an insurance company selling fire insurance not to check whether the insured persons take sufficient precautions against the outbreak of fire.

I don’t buy it. Regular readers will remember that while I am all in favour of a very strong financial system, I am also a big fan of an unregulated “country bank” sector where innovation is king … a junior league where risks are taken and products are developed. While the existence of such a sector should not be allowed to endanger the core banking system, this policy objective does not require stringent regulation of the sector. What it requires is stringent regulation of the banking system’s exposure to this sector – readers with memories going back to October 15 will remember that I suspect that such exposure has not been stringent enough; the risk-weighted assets deemed to be on the banks’ balance sheets through such exposures should simply be weighted more highly.

Bear Stearns has ruthlessly prettied-up its balance sheet:

Bear Stearns Cos., after posting its biggest earnings decline in more than a decade, reduced subprime holdings by 50 percent in the past two months, limiting writedowns in the fourth quarter to $1.2 billion.
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Bear Stearns is regaining hedge fund customers that defected amid the credit rout in the third quarter, Molinaro said.

Hedge fund balances are “coming back” to the firm’s prime brokerage unit, and have steadied in the current quarter, he said. The business is “on pace for a record year.”

I say “prettied up” rather than “improved” because I have no way of knowing whether the sale of sub-prime assets actually improved their financial condition or not. However, if you have assets held at $100 on the balance sheet with a “fair value” (whatever that means) of $90 and a market price of $80 that are being valued by investors in your company (and your customers!) at $50 … well, taking one consideration with another, you’re better off gritting your teeth and selling them at the lousy $80 price, which is $10 cheap. It pretties up the balance sheet.

Remember BCE? Geez, it’s been a long time since I’ve discussed BCE. There was a rather interesting story today about Cerberus and United Rentals:

“This deal was expected to close sometime this week,” wrote Stephen Volkmann, an analyst with J.P. Morgan Securities Inc. in New York. “The banks were struggling with selling the associated debt offering.”

The takeover agreement includes a $100 million termination fee that Cerberus, founded by former Drexel Burnham Lambert Inc. trader Stephen Feinberg, would be required to pay unless it can show that there was “material adverse change” in United Rentals financial condition.

Cerberus told United Rentals there had been no such change, according to the statement. Cerberus has commitments from its banks to finance the transaction through bridge facilities, United Rentals said, adding it believes the banks stand ready to fulfill their contractual obligations.

“It’s a combination of the financing being more expensive and they must also think the business is not as attractive,” said Steven Kaplan, a professor at the University of Chicago Graduate School of Business who studies private equity. “Paying $100 million is a better outcome than doing a deal that’s not going to work.”

I continue to have no opinion regarding whether the BCE/Teachers deal will actually be consumated – there’s simply no information available on which to base an opinion and things may change a lot between now and the last minute. But if it comes to the point at which the consortium believes it has a choice between losing $1-billion quickly or $10-billion slowly … I’ll bet a nickel I can tell you which way they’ll jump.

OK, let’s step back a bit and discuss a funny thing on the Internet I’ve seen today!

Canada Newswire has very strict terms of use, but I can’t link to them. I can only link to “CNW Group Home Page” as per their terms of use:

Unless you have a written agreement in effect with CNW Group which states otherwise, you may only provide a hypertext link to the CNW Group Web site on another Web site, provided that (a) the link is a text-only link clearly marked “CNW Group Home Page”; (b) the link “points” to (i.e. links the user directly to) the URL www.newswire.ca/en and not to other pages within the CNW Group Web site; (c) the appearance, position and other aspects of the link is not such as to damage or dilute the goodwill associated with CNW Group’s name and trade-marks; (d) the appearance, position and other aspects of the link does not create the false appearance that an entity is associated with or sponsored by any of us; (e) the link, when activated by a user, displays CNW Group Web site full-screen and not within a “frame” on the linked Web site; and (f) CNW Group reserves the right to revoke its consent to the link at any time in its sole discretion. [Emphasis added – JH]

Now, turn to any random press release. They invite you to use four different web cross-referencing techniques to link to a particular press release.

Well … I thought it was funny!

Indices will be delayed. Prices have been updated, but I’m having some kind of strange server problem, probably related to database size … buy you don’t want to know about that! I will update in the near future.

Update, 2007-11-15

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

Menzie Chinn at Econbrowser has reviewed credit and term spreads: 

He notes:

It might appear that the two phenomena are unrelated. But the DB article argues that while banks pursued off-balance sheet activities such as “rating transformation” (transmuting assets of one credit default risk category to another category by financial engineering), they moved away from reliance on maturity transformation and taking on credit risk. With the end of the structured credit market, and reorienting of banks’ operations, credit spreads and term spreads will reappear.

Interestingly, as Chart 6 illustrates, term and credit spreads are not back to where they were pre-2005. However, in terms of the latter, they’re close. And, as time on goes on, one might very well expect further curve steepening.

It would certainly be a pleasure to see some actual curve steepening! Preferably a bull steepening (in which the steepening is effected by a decline in shorter-term rates), just to wipe the smug smile off the faces of those who claim to be avoiding risk by shortening term! Bloomberg notes, however, that steepness and fear of inflation are intertwined.

In somewhat related news:

JPMorgan Chase & Co. CEO Jamie Dimon said SIVs, whose assets have dwindled by at least $75 billion since July, will “go the way of the dinosaur.”

“SIVs don’t have a business purpose,” Dimon, 51, said at the Merrill Lynch conference today.

I consider this “somewhat related” because of the term spread; a SIV is nothing more nor less than an unregulated “country bank”, seeking to make money from the term spread (financing long-term assets with short paper) and the credit spread (enhancing the credit quality of its debt by subordination of its senior tranches with equity tranches). What we are seeing now is the unravelling of the business model due to:

• General loss of confidence (equivalent to a bank run)
• Bad quality on their asset side

… which are the same things that will do in any bank.

While I agree that SIVs qua SIVs are dead, I’m not so sure that they served no business purpose; and feel entirely confident that other vehicles – probably better capitalized and not so aggressive with their financing models – will arise to take their place. People want to lend short and borrow long. In the aggregate, short-term money is available for the long term. Banks, SIVs and ABCP conduits all serve the same business purpose in this respect … so I’m not sure what Dimon meant.

I mentioned possible downgrades of bond insurers on November 9. Accrued Interest has continued his educational campaign by analyzing some scenarios for ABS default, insurance and recovery that sheds quite a bit of light on the matter.

The CDOs are tricksy things! Fitch Ratings indulged in a mass downgrade yesterday:

Derivative Fitch–New York–12 November 2007: Derivative Fitch has downgraded $37.2 billion (U.S. dollar and U.S. dollar equivalent) and affirmed $6.9 billion of structured finance collateralized debt obligations (SF CDOs) across 84 transactions. Fitch’s rating actions follow the completion of a review of 55 U.S. and European SF CDOs executed on a synthetic basis, and 29 U.S. and Asian SF CDOs executed on a cash/hybrid basis. Ratings on 66 U.S. cash and hybrid SF CDOs remain on Rating Watch Negative pending resolution on or before Nov. 21, 2007.

A downgrade:affirm ratio in excess of 5:1 is big news, especially since many of the downgrades are multi-level:

more than $14 billion worth of transactions falling from the highest-rated AAA perch to speculative-grade, or junk, status.

The implications can be as scary as you want them to be. Naked Capitalism provides excellent links to some informed discussion. Just to make things even more interesting – for those of you who are bored by mere multi-billion writeoffs – Naked Capitalism also reports on a now somewhat dated (two weeks) judgement refusing foreclosure to Deutsche Bank:

Judge Christopher A. Boyko of the Eastern Ohio United States District Court, on October 31, 2007 dismissed 14 Deutsche Bank-filed foreclosures in a ruling based on lack of standing for not owning/holding the mortgage loan at the time the lawsuits were filed.

Whether this was an isolated SNAFU by Deutsche, or indicative of lack of paper trail maintenance by the various intermediaries, is something regarding which I do not care to speculate at this time.

Naked Capitalism also takes issue with Countrywide funding its operations with Certificates of Deposit, but I can’t see any problem with that … provided that FDIC and Fed is supervising the bank properly and it’s solvent. Otherwise, of course, it would be a Bad Thing. I’m much more concerned about the back-door guarantees via the Federal Home Loan Banks, as I noted on October 30.

I noted yesterday that Legg Mason was bailing one of its MMFs out of SIV paper – now it appears that Sun Trust is doing the same thing along with Bank of America and at least two others. This is a very worrisome development for the investment industry as a whole … I am currently trying to finish an article on the topic, but there’s a lot going on in the market just now! In an overdue development:

The 10 largest managers of U.S. money funds have about $50 billion in short term debt of SIVs, some issued by vehicles such as Cheyne Finance Plc that defaulted as investors shunned the funds on concerns about losses from securities linked to subprime mortgages, according to reports from the companies.
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BlackRock, the largest U.S. publicly traded asset manager, has been in contact with the Treasury, Fink said. BlackRock will raise “multibillion dollars” to invest in distressed securities that are resulting from the “chaos” in the market, Fink said, while declining to elaborate on fund details.

Well, whether Superconduit = Vulture or not, there’s at least one major player stepping up!

If today’s news has been too cheery for you: consider deadly bird flu!

Good volume, poor returns in the preferred share market today.

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

A quiet day, with bond markets closed for Rememberance Day.

There is speculation the Fed will move to explicit inflation targetting … but the WSJ can’t make up its mind. At a Bank of Canada conference in 2006, Alan Blinder, a former Fed Vice Chairman, commented on evolution of Bernanke’s thinking on the subject to that date.

There are some heavy-weight predictions of a US slowdown floating around, linked by both Naked Capitalism and WSJ. Willem Buiter points out that the banks are feeling some strain:

At the end of October 2007, the net worth of commercial banks in the US (as reported by the Fed) stood at just under $ 1.1 trillion (against assets of $10.7 trillion). Tier 1 capital stood approximately at $964 bn. While quite a significant share of the mortgage-related losses will be born by financial institutions other than commercial banks, such as investment banks, commercial banks’ capital will take a significant hit.
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The combination of losses and unintended asset accumulation may depress the banks’ capital ratios to the point that dividends and share repurchases are threatened and even rights issues may have to be contemplated. All that does not do much for their willingness to engage in new lending, including to the real economy.
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The single best thing that could happen would be for the true magnitude of the losses suffered by banks and other exposed parties to be revealed and put in the P&L. Until what happens, fear of getting stuck with the hot potato makes banks unnaturally unwilling to extend credit against the kind of collateral that they would not have thought about twice accepting at the beginning of the year.

Noriel Roubini, while acknowledging the banks’ problems, considers the wealth effect and increased difficulty of Home Equity Withdrawal to be more important.

Naked Capitalism points out that there is mass confusion over Super-Conduit, what it is supposed to be doing and whether there is economic reason to expect it to work … but quite frankly, I can’t be bothered to discuss the situation much any more. There’s no information – merely rumours. I’ll talk about it when there’s something to talk about.

But there is some related news illustrating the problem. Readers with exceptional memories may remember Ottimo Funding, briefly mentioned here on August 21:

Mortgage companies without any sub-prime on their books, such as Ottimo Funding LLC, are experiencing financing difficulties.

Well, it’s gone bust:

Ottimo Funding Ltd., whose name is Italian for “excellent,” started selling its $2.8 billion of mortgage bonds this week after being unable to raise debt financing in the commercial paper market, according to three people with knowledge of the sale.

The securities being auctioned are rated AAA and backed by Alt-A mortgages, a credit class above subprime, according to Standard & Poor’s. The sale probably won’t generate enough cash to fully repay investors who bought short-term debt from the fund, the ratings firm said last week.

As far as I can make out from S&P ratings reports, Ottimo was one of several Extendible asset-backed commercial paper (ABCP) conduits with no or partial third-party liquidity support – in other words, it was like a Canadian ABCP issuer, relying on credit enhancement and extendability to avoid liquidity squeezes.

In a fascinating report, the Asset Management firm Legg Mason has disclosed it is bailing one of its MMFs out of ABCP trouble:

Legg Mason Inc. invested $100 million in one of its money-market funds and arranged $238 million in credit for two others as a cushion against potential losses on commercial paper linked to subprime mortgages.

In related problems, E-Trade is in trouble:

Chief Executive Officer Mitchell Caplan’s strategy of building E*Trade’s bank by tripling loans outstanding backfired as borrowers fell behind on payments and U.S. home prices declined.
…
Bhatia estimated that E*Trade will post a loss in the fourth quarter after setting aside $500 million in extra money for bad loans and writedowns. Clients in the company’s brokerage unit may shift their accounts to rivals, while deposits at the bank could erode, said Bhatia, who cut his rating on the stock to “sell” from “hold.”

Citigroup is downgrading E*Trade “based on the higher probability of a run on the bank,” Bhatia said.

But let’s keep things in perspective. While there is lots of pain, while some people are losing their jobs, others their houses and an overall slowdown in forecast by some … Wall Street is still on track for a great year. They take risks and when it works against them the numbers are huge … but when they work out – as, by and large, they did in the first half of the year – the numbers are even bigger.

At least one Wallaby Street player is doing pretty well too:

Macquarie Group Ltd., Australia’s biggest securities firm, said first-half profit climbed 45 percent to a record on higher trading income and increased fees from mergers and acquisitions.

Net income rose to a record A$1.06 billion ($931 million), or A$4.02 a share, in the six months to Sept. 30, from A$730 million, or A$3.01 a share, a year earlier, the Sydney-based bank said in statement today. That beat the $1.03 billion median estimate of four analysts surveyed by Bloomberg.

It was a quiet day for prefs with relatively light volume … not only were the bond markets closed, but all eyes were on stocks and currencies! It was good to see BAM.PR.N among the volume leaders … but a continuing puzzle to see it among the loss leaders as well!

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