PrefBlog

Headline inflation in the US came in a 4.3% yoy today, powered by Food (+4.8%) and Energy (+21.4%). The core rate, which excludes these two items, was +2.3% yoy. Not a good report, according to economists surveyed by the WSJ – the Fed is now caught between a rock and a hard place on rates. Stagflation, anyone?

On what might possibly be a related note, William C. Dudley, EVP of the Fed, gave a speech on TIPS (hat tip: WSJ Blogs and Economist’s View):

Put simply, I come here to praise TIPS… In my opinion, the benefits of the TIPS program significantly exceed the costs of the program.
…
we might start by comparing the difference in funding costs to the Treasury of TIPS versus a program of comparable duration nominal Treasuries.

But we should also be careful not to ignore other potential benefits of the TIPS program. As I see it, these potential benefits include:

• Greater diversification of the Treasury’s funding sources, which presumably has favorable implications for the Treasury’s funding costs.
• The potential for TIPS issuance to reduce the variability of the U.S. government’s net financial position.
• Access to a market-determined measure of inflation expectations that can help inform the conduct of monetary policy.
• The provision of a virtually risk-free investment that provides value to risk-averse investors.

One point that was discussed during Canada’s introduction of RRBs (Real Return Bonds) was that this indexing makes it at least a little bit more difficult for the government to deliberately inflate away the debt – which is also, explicitly, an argument in favour of borrowing in foreign currencies.

Continuing with the inflationary theme, Tommaso Monacelli of the Università Bocconi, Milan has written a very hawkish piece regarding the recent ECB decision to leave policy rates unchanged:

Can the ECB publish inflation forecasts between 2 and 3 percent and decide not to raise interest rates? Given that its explicit mandate is to keep inflation below but close to 2 percent, what type of signal is the Bank sending to the markets, especially as regards its own credibility?
…

In this mounting inflation context, more than ever, the lack of transparency in the ECB policy points to the need of a more rigorous (arguably “scientific”) framework in which its policy decisions can be rationalized. Much of the recent literature describes the optimal conduct of monetary policy in terms of ‘inflation forecast targeting’. Two are the basic ingredients. First, a numerical target for inflation (as it is well-known from the experience of many countries in the world that have adopted inflation targeting, including emerging-market economies). Second, and more importantly, a management of the path of interest rates such that in each period the inflation forecast at some horizon, and conditional on that same instrument path, are in line with the inflation target.

He also criticizes what he sees as a somewhat circular reasoning process:

Reading carefully through the technical notes in small print (not really an example of transparency), one observes that the staff projections are based on the markets’ expectations of future interest rates. Hence they are conditional not on the future interest rate path that the Bank itself foresees as most likely, but on the interest rate path that the markets foresee as most likely.

The projection for 2008 inflation does indeed note:

The technical assumptions about interest rates and both oil and non-energy commodity prices are based on market expectations, with a cut-off date of 14 November 2007. With regard to short-term interest rates, as measured by the three-month EURIBOR, market expectations are derived from forward rates, reflecting a snapshot of the yield curve at the cut-off date. They imply an average level of 4.9% in the fourth quarter of 2007, falling to 4.5% in 2008 and 4.3% in 2009. The market expectations for euro area ten-year nominal government bond yields imply a flat profile at their mid-November level of 4.3%. The baseline projection also includes the assumption that bank lending spreads will rise slightly over the projection horizon, reflecting the current episode of heightened risk consciousness in financial markets.

… but saying that this is in small print seems to me to be overstating the case a little! The iterative process that leads to the final Euroland forecast has led to the forecast:

On the basis of the information available up to 23 November 2007, Eurosystem staff have prepared projections for macroeconomic developments in the euro area.1 Average annual real GDP growth is projected to be between 2.4% and 2.8% in 2007, between 1.5% and 2.5% in 2008, and between 1.6% and 2.6% in 2009. The average rate of increase in the overall HICP is projected to be between 2.0% and 2.2% in 2007, between 2.0% and 3.0% in 2008, and between 1.2% and 2.4% in 2009.

“HICP” is the “Harmonised Index of Consumer Prices”. I don’t see anything wrong with the system myself … it seems to me that basing projections on market expectations is as good as any other method and better than most. After having prepared these projections, the output (HICP) may be examined and if it’s outside the desired range then the actual policy decision may be made taking the expectation as a guide.

The most interesting part of all this, however, is that the spectre of inflation is intruding more often into public debate. Should stagflation become a more credible threat than it is now, I suspect policy makers will favour the stag- over the -flation and tighten even faster than they are currently easing … which could have major implications for long-bonds and therefore preferreds.

Mind you, though, the market as represented by LIBOR is ignoring the policy makers … at least for now:

The rates banks charge each other for three-month loans held at seven-year highs for a second day after policy makers in the U.S., U.K., Canada, Switzerland and the euro region agreed to ease the logjam in short-term credit markets. The cost of borrowing in euros stayed at 4.95 percent, the British Bankers’ Association said today, up from last month’s low of 4.57 percent and 3.68 percent a year ago.

“The market clearly doesn’t believe central banks can do anything about this crisis,” said Nathalie Fillet, senior interest-rate strategist at BNP Paribas SA in London. “This is not going to be a magical solution to the problem.”

There has been a certain amount of sensationalism regarding the deal – Accrued Interest doesn’t buy it:

Waldman says it’s a bailout because the Fed is offering loans that other banks wouldn’t be willing to offer. Here again, any bank who went to the discount window would borrow under the same terms. Does the continued existence of the discount window constitute a bailout? Put another way, banks would never use the discount window if financing was available elsewhere at similar costs elsewhere. So any time a bank uses the discount window, it’s a bailout by Waldman’s definition. This is why I am loathe to use that term.

Which brings us to the highly interesting topic of dissing the banks. Moody’s dissed Citibank today:

Moody’s Investors Service downgraded the long-term ratings of Citigroup Inc. (Citigroup) (senior to Aa3 from Aa2) and lowered the Bank Financial Strength Rating (BFSR) of Citibank, N.A. (Citibank) to B from A-. The rating on Citibank for long-term deposits and senior debt was lowered to Aa1 from Aaa. The rating outlook is stable.

The downgrade was prompted by Moody’s view that Citigroup’s capital ratios will remain low. According to Senior Vice President Sean Jones, “this situation is likely because management will need to take sizable write-downs against its subprime RMBS and CDO portfolio.” The bank is also expected to make significant sustained provisions against its residential mortgage book, which is over $200 billion. These charges are likely to occur when Citigroup’s normal earnings power is depressed, particularly in the United States.

“During 2008,” the analyst said, “Citigroup’s weak earnings should prohibit the bank from rapidly restoring capital ratios, despite its recent issuance of $7.5 billion hybrid capital.”
…
For Citigroup’s ratings to be upgraded, the company would need to rebuild its capital ratios to levels maintained prior to 2007. As well, the firm’s pre-provision earnings power has to return to its previous strong level, while reducing its concentration risks.

The company’s failure to restore its capital ratios in the medium term would possibly lead to a further downgrade

Remember the BCE/Teachers deal? It is not, repeat: not, being renegotiated:

BCE Inc. (TSX, NYSE: BCE) is today issuing a statement in response to certain rumours in the market regarding the status of its definitive agreement to be acquired by an investor group led by Teachers’ Private Capital, the private investment arm of the Ontario Teachers’ Pension Plan, Providence Equity Partners Inc. and Madison Dearborn Partners, LLC (the Investor Group).

While it is BCE’s policy not to comment on market rumours or speculation, in the interest of its shareholders, the company is today confirming that neither BCE nor its Board of Directors is involved in any discussions regarding any renegotiation of any of the terms of the definitive agreement entered into on June 29, 2007.

Under the terms of the definitive agreement, the Investor Group has agreed to acquire all of BCE’s outstanding common shares for $42.75 per share in cash and all of BCE’s outstanding preferred shares at prices set out in the definitive agreement.

And you’ll have to parse the significance of that yourselves, because I’m not touching it!

There may be a certain amount of turmoil in the US markets Monday, as the Moody’s announcement on Monolines is digested:

Moody’s Investors Service has updated its evaluation of US mortgage market stress on the ratings of financial guaranty companies, and has considered those companies’ plans for strengthening capitalization, as well as their developing strategies. The following actions are the result of that evaluation. The Aaa ratings of Financial Guaranty Insurance Company and XL Capital Assurance Inc. were placed on review for possible downgrade. The Aaa ratings of MBIA Insurance Corporation and CIFG Guaranty were affirmed, but the rating outlooks changed to negative. The Aaa ratings of Ambac Assurance Corporation, Assured Guaranty Corp, and Financial Security Assurance Inc. and the Aa3 rating of Radian Asset Assurance were all affirmed with a stable outlook.
…
As a result of these reviews, the Moody’s-rated securities that are “wrapped” or guaranteed by FGIC and XL Capital Assurance are also placed under review for possible downgrade. A full list of these securities will be made available later this evening under “Ratings Lists” on the company’s website at http://www.moodys.com/guarantors
…
Moody’s will also be hosting a teleconference on Monday, December 17 at 11:00 EST/16:00 GMT/17:00 CET to discuss these actions in further detail. To register for this teleconference, go to www.moodys.com/events.

There was supposed to be an announcement about the Montreal Accord and Canadian ABCP today … after the close … later, but I don’t see anything yet! Apparently, the banks are getting sticky about liquidity guarantees:

Bank of Canada Governor David Dodge and governor designate Mark Carney pushed the bank chief executives on a conference call Thursday night to make commitments for liquidity backup that could be as much as $1-billion for some of the big five banks, said people familiar with the situation.

The liquidity issue is one of the final hurdles in the hoped for re-jig of the frozen short-term debt, which if successful, would help to avoid a meltdown that could have massive ripple effects in financial markets.

I confess, I don’t understand why a liquidity guaranty is important – the entire purpose of the plan is to avoid the necessity for refinancing prior to the new notes’ maturity.

Another very active day in the preferred share market, with weak prices. Tax-loss selling? Sheer boneheadism? You tell me. The BAM issues continue to get hurt badly, which seems to me somewhat mysterious.

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

Well … it looks like yesterday’s shock-and-awe effort to provide liquidity has failed – assuming the point of the exercise was to lower EURIBOR:

The cost to borrow for three months remained at 4.95 percent, the British Bankers’ Association said today. That’s 95 basis points, or 0.95 percentage point, more than the European Central Bank’s benchmark interest rate, compared with 57 basis points a month ago. The difference averaged 25 basis points in the first half of the year, before losses on securities linked to U.S. subprime mortgages contaminated credit markets.

The TED Spread also ignored the theatricals:

Banks remain reluctant to lend to each other. The so-called “TED” spread, the difference between three-month Treasury bill yields and the London interbank offered rate for the same maturity, was 2.21 percentage points, near the highest since August. The increase indicates banks are charging more to lend to each other.

Mind you, Naked Capitalism focusses on the collateral that will be accepted for these loans and concludes:

Most of the CDO and subprime paper held by banks is AAA. Now I have no idea where this stuff is trading, and the fact is that a lot of it is not trading. However, lot of people are using the ABX as a proxy for subprime and other risky mortgage credit risk. So it may not be a price, but it’s a reference point for pricing. And it has AAA credits at 70 cents on the dollar.

So the Fed’s temporary facility could be used, quite legitimately, to mark anything that the Fed would accept as a repo at its collateral value for accounting purposes (you could theoretically have made the same argument for the discount window, but that’s an emergency facility, while this is intended for all comers). That places a very big floor under a lot of now-questionable credit. That move would reduce writedowns, the accompanying loss of confidence, and the need for additional equity well out of proportion to the paltry $40 billion the Fed is throwing into the mix.

It could well be. I argued in the comments to JDH’s Econbrowser post that the problem with credit markets is funding. People have the equity needed to put a floor under the markets – even a position levered up 10:1 has 10% equity in the position – but can’t reliably borrow the funds required to make the effort worthwhile. It may be that the Central Banks are trying to encourage the banks to lend against collateral of, shall we say, non-traditional quality by assuring them that the collateral may be rehypothecated in time of need.

Greg Ip supports this view – that the point of the exercise is to expand the definition of acceptable collateral – in a WSJ post:

Ironically, the Fed for a long time has been unhappy with the fact that it can even accept agencies, seeing it as an implicit subsidy to Fannie and Freddie.
…
If Fed officials had the same freedom these central banks did, they may not have created the new “term auction facility.” As it is, the facility is a form of legal arbitrage — a way for the Fed to get around the artificial constraints imposed by the Federal Reserve Act. It “gives us a tool that lies somewhere between our open market operations” and the discount window, Mr. Geithner said. “It provides a mechanism for expanding the range of collateral against which we provide funds to the market — in effect to change the composition of our balance sheet — in ways we cannot do through traditional open market operations.”
…
The Fed, nonetheless, is hopeful (confident would be too strong) its facility will do some good. The 3-month Libor, a key gauge of stress in the bank funding market, was fixed at 4.99% today, down from 5.06% Wednesday. The New York Fed announced today it would redeem all $15.2 billion of the Treasury bills it holds that mature on Thursday. That will cause its balance sheet to shrink, contracting the money supply. To offset the effect, it expects to lend up to $20 billion through the new facility on Monday.

The redemption of T-Bills is significant: it means there is (basically) no net improvement in systemic liquidity. What there is is simply a smearing of the extant Fed-provided liquidity over a broader section of the market. For a while.

In monoline news, Ambac is trying to stay afloat by reinsuring some of its portfolio:

Ambac Financial Group Inc., the world’s second-largest bond insurer, will pass off the risk of $29 billion in securities it guarantees in an effort to convince ratings companies that it still deserves a AAA credit rating.

Assured Guaranty Ltd. will reinsure the securities, New York-based Ambac said today in a statement.

Ambac, whose credit rating stands behind $556 billion of securities, is among seven AAA rated bond insurers under the scrutiny of Moody’s Investors Service, Fitch Ratings and Standard & Poor’s. Moody’s and Fitch said last month that Ambac was “moderately likely” to breach capital requirements because of a deterioration in the credit quality of the securities it guarantees.

“Reinsurance is a valuable, capital-efficient and shareholder-friendly tool for managing risk and capital,” Ambac Chief Executive Officer, Robert Genader said in the statement.

Assured Guaranty has just been affirmed AAA by Fitch:

The affirmation of AGL’s ratings is based on the company’s disciplined underwriting strategy exemplified by minimal exposure to higher-risk structured finance collateralized debt obligations (SF CDOs), improving financial results and sufficient excess capital for its given rating. AGL’s capital position has been further supplemented by today’s announced $300 million equity issuance, with the proceeds to be down-streamed to its reinsurance affiliate, Assured Guaranty Re (AG Re), to provide capital to help fund increasing opportunities to support other ‘AAA’ financial guarantors’ reinsurance needs.
…
AGL’s capital position remains satisfactory for an ‘AAA’ company, and the additional $300 million capital issuance should help support rapid growth which is taking place in the fourth quarter of 2007. After analyzing AGL’s SF CDO and second lien exposures, Fitch believes that the impact on AGL’s capital cushion is minimal, between $125 and $150 million, which corresponds to a Core Capital Adequacy Ratio of about 1.07x our minimum AAA standard of 1.00x.

In other words, they kept their powder dry, raised capital for expansion rather than to repair damage, and I’ll bet they’re really sticking it to poor old Ambac! Guaranteed, most assuredly.

CIBC made the big-time today, with a Bloomberg story that was picked up by Calculated Risk:

CIBC’s lightly guarded secret is the name of a “U.S. financial guarantor” that faces a possible downgrade on its A credit rating and is “not necessarily rated by both Moody’s & S&P.” That’s how CIBC last week described the company that is insuring $3.47 billion, or about a third, of the collateralized- debt obligations it holds that are tied to U.S. subprime mortgages.

The company’s identity matters because the bank said these hedged CDOs were worth just $1.76 billion at Oct. 31, down almost half from their face amount. If the guarantor goes poof, CIBC loses its hedge on these derivative contracts. And the Toronto-based bank would have to recognize the loss, which is growing.
…
Analysts watching CIBC, including Darko Mihelic of CIBC World Markets, quickly fingered what they believe is the unlucky backer: ACA Financial Guaranty Corp.

While we’re on the topic of enormous write-offs, how about that Washington Mutual, eh? This was discussed yesterday; they’ve now released a prospectus for a new preferred issue, with some interesting snippets:

As a result of the fundamental shift in the mortgage market and the actions we are taking to resize our Home Loans business, we will incur a fourth quarter after-tax charge of approximately $1.6 billion for the write-down of all the goodwill associated with the Home Loans business. This non-cash charge will not affect our tangible or regulatory capital or our liquidity.

Loan Loss Provision. Continued deterioration in the mortgage markets and declining housing prices have led to increasing fourth quarter charge-offs and delinquencies in our loan portfolio. As a result, we now expect our fourth quarter 2007 provision for loan losses to be between $1.5 and $1.6 billion, approximately twice the level of expected fourth quarter net charge-offs.

We currently expect our first quarter 2008 provision for loan losses to be in the range of $1.8 to $2.0 billion, reflecting an increase in provision which we expect to be well ahead of charge-offs, which are also expected to increase significantly during that quarter. The first quarter 2008 range reflects our current view that prevailing adverse conditions in the credit and housing markets will persist through 2008.

While difficult to predict, we also currently expect quarterly loan loss provisions through the end of 2008 to remain elevated, generally consistent with our expectation for the first quarter of 2008. We anticipate that there may be some additional variation depending on the level of credit card securitization activity during any quarter.

It’s a $3-billion issue, convertible into common, paying 7.75%; their shareholders’ equity is currently (September 30, 3rd Quarter) $23.9-billion. I found the discussion of taxes fairly entertaining:

Under current law, if a U.S. holder is an individual or other non-corporate holder, dividends received by such U.S. holder generally will be subject to a reduced maximum tax rate of 15% for taxable years beginning before January 1, 2011, after which the rate applicable to dividends is scheduled to return to the tax rate generally applicable to ordinary income. The rate reduction does not apply to dividends received to the extent that U.S. holders elect to treat the dividends as “investment income,” for purposes of the rules relating to the limitation on the deductibility of investment-related interest, which may be offset by investment expense. Furthermore, the rate reduction will also not apply to dividends that are paid to such holders with respect to the Series R Preferred Stock or our common stock that is held by the holder for less than 61 days during the 121-day period beginning on the date which is 60 days before the date on which the Series R Preferred Stock or our common stock become ex-dividend with respect to such dividend. (A 91-day minimum holding period applies to any dividends on the Series R Preferred Stock that are attributable to periods in excess of 366 days.)

Yeah, I could put some adjustments into HIMIPref™ to analyze it properly … but holy smokes, they’d be messy!

In what is probably the death-knell for MLEC/Super-Conduit, Citigroup is taking its SIVs onto its own balance sheet:

As assets continue to be sold, Citi’s risk exposure, and the capital ratio impact from consolidation, will be reduced accordingly.

Given the high credit quality of the SIV assets, Citi’s credit exposure under its commitment is substantially limited. Approximately 54% of the SIV assets are rated triple-A and 43% double-A by Moody’s, with no direct exposure to sub-prime assets and immaterial indirect sub-prime exposure of $51 million. In addition, the junior notes, which have a current market value of $2.5 billion, are in the first loss position.

…

The commitment is independent of the “Master Liquidity Enhancement Conduit” (“M-LEC”). Citi continues to support the formation of the M-LEC, which is an initiative that involves Citi and other financial institutions.

Another active day in the preferred share market, with a slight drift downwards.

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