PrefBlog

The bond insurance business gets more interesting every day! Naked Capitalism has two pieces on it today, the first attempting to quantify the problem:

Bill Ackman of hedge fund Pershing Square has gotten a considerable amount of flack for his outspoken, negative views of the bond insurers, particularly MBIA and Ambac, which his firm has shorted. Ackman has been circulating a detailed analysis that estimates that the additional equity needed to maintain an AAA rating at the two biggest firms is roughly $15 billion.

This calculation is sharply contested by new rating agency Egan Jones (which also downgraded MBIA to a B+, a junk rating) which says the industry needs more than an order of magnitude more capital, namely $200 billion.

Egan-Jones was mentioned in PrefBlog on November 7. As a subscription-based credit advisor, they have an interest in saying exciting things … which is not to say they’re wrong, of course, but it is something to keep in mind. They received NRSRO status in December.

Naked Capitalism also takes a rather gloomy view of the New York Insurance Regulator’s bail-out facilitation – even gloomier than the one I remarked on yesterday. Until shown otherwise, I’m just going to assume the whole NY bail-out thing is plain-and-simple grandstanding … Mr. Dinallo, the head of the NY regulator, learned all about grandstanding in his last regulatory job:

Superintendent Dinallo served at the Office of Attorney General Eliot Spitzer from 1999 to 2003. As Chief of the Securities Bureau, he was charged with combining that bureau with the Real Estate Finance Bureau. The resulting Bureau was named the Investment Protection Bureau to reflect its focus, and Mr. Dinallo was named its first Chief. In that capacity, he led the reinvigorated Bureau’s investigations into the Wall Street Cases – conflicts of interest in the financial services industry, including research analyst cases and the spinning of hot initial public offerings. He produced more than 40 major civil and criminal matters, and led the Bureau through the beginning of the mutual fund industry investigations.

However, Barclays Capital has opined that there may be very serious knock-on effects should the insurers fail:

Banks that raised $72 billion to shore up capital depleted by subprime-related losses may require another $143 billion should credit rating firms downgrade bond insurers, according to analysts at Barclays Capital.

Banks will need at least $22 billion if bonds covered by insurers led by MBIA Inc. and Ambac Assurance Corp. are cut one level from AAA, and six times more for downgrades by four steps to A, Paul Fenner-Leitao wrote in a report published today. Barclays’ estimates are based on banks holding as much as 75 percent of the $820 billion of structured securities guaranteed by bond insurers.

I will have to do some more research into the bank capital regulations … it seems to me that having such levels of exposure to single names should attract a concentration charge on capital … I’m honestly not sure whether or not it does.

And Naked Capitalism draws to my attention (very good crop today, Yves!) an opinion piece by Willem Buiter, who is something of a regular on this blog:

Even with a few days worth of hindsight, the Fed’s out-of-sequence, out-of-hours 75 basis points cut in the target for the Federal Funds rate continues to look extraordinary and deeply misguided. Indeed, it looks less and less like a decisive pre-emptive move in response to unexpected bad news designed to meet the Fed’s triple mandate of maximum employment, stable prices and moderate long-term interest rates, than a knee-jerk panic reaction to a global stock market collapse.

Did the sharp global decline in stock values at the beginning of this week reflect a rational re-assessment of fundamentals? The only two candidate explanations I have heard are (a) that the collapse was probably triggered by concerns about the financial viability of the monolines and (b) that it was intensified by the unwinding by SocGen of the long equity positions taken by its employee of the year (not!). I find neither explanation convincing. If the collapse was a spurious, non-fundamental event, there is no reason for the Fed to react to it. The ability of the Fed to meet its fundamental objectives is seriously undermined if it is perceived as the poodle of the equity markets.

So sign up another member of the “But what about inflation?” camp.

Assiduous Readers will be familiar with my grumpiness about US Fiscal policy – the last six years have been permanent stimulation – but I’m in good company:

[Harvard Professor Jeffrey Frankel] explains:

“In 2001, very aggressive monetary and fiscal expansion reduced the severity and length of the recession. It is true that this time as well the Fed has been busy cutting interest rates and the government is working on a fiscal stimulus. But this time, before long, our policy makers will run into constraints. The government can’t keep cutting taxes, because the national debt is too high, the path of future deficits too steep, and the costs of the baby boomers’ retirement too imminent. The federal government needs to retain the confidence of the bond markets.

“This is different from 2001, which we entered with a record budget surplus, allowing room for stimulus. Similarly, the Fed can’t keep cutting interest rates because the dollar has been falling steeply, and America needs to retain confidence of foreign investors who are financing our deficits. This is different from 2001, when the dollar was strong, inflation was all but dead, and the Fed could cut interest rates by [5.5 percentage points].”

A few more details – and a bit more rational commentary – is emerging regarding the SocGen stock futures fiasco:

But a top French presidential advisor revealed that Kerviel had positions of more than 50 billion euros (73 billion dollars) — more than the bank’s current market capitalisation of 35.9 billion euros.
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Many experts said it was difficult to believe a lone trader could have successfully hid such colossal losses.”

“The feeling in the dealing rooms is that it is not possible for an individual to do all that. They think Societe Generale has overdone the fraud to cover up some bad market operations,” said Elie Cohen, an economy professor and research director for the National Centre for Scientific Research (CNRS).

One example of such feelings as were noted by Elie Cohen is:

Let’s get this straight: the MainSwamp media (who are such profoundly ignorant whip-kissers that they think that the wankfest at Davos is worth reporting on) would have you believe that a single trader whose entire remuneration package (including bonuses) was 100k euro, had such free rein that he could rack up positions with aggregate losses of A$9 bill, with nobody noticing. (To get to an aggregate loss of A$9 bill, you need an actual position larger than that, no?)

A bank with owners equity of about $20 billion, and its processes are so poor that such a thing could happen? The Banque de France – who audits every bank every year, and knows if an individual Frenchman passes a bad cheque – knew nothing of it?

Sorry lads – no sale.

What has happened here, I bet, is that SocGen has found an internal culprit, and is hanging as large an amount on him as they think they can get away with. So this geezer might have sent $100 mill to Money Heaven – that amount could possibly be hidden for a week or so – and the Bank has used him as a scapegoat and has attributed half its subprime-related losses to him rather than the subprime book.

… and a bit more delicately:

“That’s when he made his first mistake,” said Jean-Pierre Mustier, head of investment banking at Societe Generale. “He no longer knew the type and calendar of the controls.”

The trading loss raises questions about the bank’s risk management procedures.

“I find it really improbable that this trader was not abetted by at the very least incompetence, if not assistance from others,” said Joseph Mason, a risk-management researcher and professor of finance at Drexel University in Philadelphia. “Ultimately, we’re talking about a breakdown of fundamental operational controls.”

“Calendar of the controls”? No wonder SocGen’s lost so much. And finally (hat tip: Financial Webring Forum), Jim Sinclair reviews the data and offers the opinion:

The USD $7,000 million loss reported as an action of a junior trader hiding a losing position for a considerable amount of time as stated is total bull.

You would have to be totally IGNORANT of market mechanics to buy that plausible denial.

The public and much of the media are.

The reported loss was a buyout of a failed to or chosen not to perform derivative.

One theory regarding the mechanics of the scheme that has been suggested to me is that the trader was writing single puts on multiple futures/forward contracts rather than multiple puts on single futures/forward contracts, then fiddling with the documentation to make it look like one put = one contract, rather than the actual one put = multiple contracts.

Well, that may be. I responded that most cases like this aren’t very complicated, really. It’s usually just a matter of dumb stealing from dumber. Or, perhaps, dumber turning a blind eye, as long as dumb was making money.

I’ll admit, one thing that makes me a little nervous about the whole episode is the continued emphasis on his background in operations:

Kerviel drew on knowledge he acquired during six years in Societe Generale’s back office, where he went to work in 2000 after completing a degree in market operations at the University of Lyon II, according to an alumni Web page. He had to breach five levels of controls to get away with his trades, Bank of France Governor Christian Noyer said at a press conference yesterday.

His “intimate and perverse” knowledge of the bank’s controls let him avoid detection, co-Chief Executive Officer Philippe Citerne told reporters.

This is the type of thing that might make a particularly overbearing, paternalistic and incompetent regulator (please don’t cry, Assiduous Readers, some such do exist) forbid such transitions.

I came up through operations. It was while working in operations on starvation wages that I got interested in finance. The background has served me well … back-office bullshitters find I’m asking them questions they’d rather not answer, on occasion. I’m hardly alone in this; the traditional manner of becoming a trader is by first becoming a traders’ clerk – something I wish I’d know when I got my first full-time operations job and spent several years kicking myself for asking for the higher-paying dead-end choice.

But we’ll see.

There’s a new inhabitant of litigation-land!

this move by New York City and State to sue lead manager Goldman, 25 other underwriters and accounting firms over a Countrwide stock offering is routine securities fraud, in this case making misrepresentations about the company’s prospects. No one has yet to develop a legal theory to go after Goldman for the move that has many offended, being net short subprime related debt while continuing to sell them to investors. And the latter is unlikely to go anywhere (saver perhaps serving as fodder for Congressional investigations) because that action didn’t violate any securities laws.

There is no indication as yet as to whether the New York City and State portfolio managers have even been asked as to whether they did a due diligence.

Well folks …. sorry! Prices are not yet available from the TSX and I’m going out for dinner. I’ve been keeping the HIMIPref™ indices up to date, by the way, after cramming in the prices at odd hours, just not reporting them. But I’ll see what I can do over the weekend to – at least – get today’s index levels up.

A so-called rogue trader socked it to SocGen … 4.9-billion Euros’ worth. So called? I haven’t seen any proof yet and won’t ever see it. Assiduous Readers might not believe this – but there are still some people in the world who believe that the honchos at Barings Bank were shocked – shocked! – to hear that Nick Leeson was speculating rather than arbitraging in order to make 10% of the bank’s profits. Fitch Ratings announced it:

has today downgraded Societe Generale’s (SG) Long-term (LT) Issuer Default Rating (IDR) to ‘AA-‘ (AA minus) from ‘AA’ and the Individual Rating to ‘B’ from ‘A/B’. SG’s Short-term (ST) IDR and Support Ratings are affirmed respectively at ‘F1+’ and ‘1’. The Outlook for the LT IDR is Stable and the Support Floor is affirmed at ‘A-‘ (A minus).

This action follows the profit warning announcement made by the bank today. The EUR4.9bn fraud-related trading loss uncovered at the bank is very substantial and has arisen within the bank’s equity trading division, core to SG’s business. While Fitch understands that SG has been the victim of fraud undertaken by one single trader under very specific circumstances, the extent to which the fraudulent positions taken were concealed raises questions about the effectiveness of the bank’s processing systems and creates reputational risk for the group.

Not much news today, frankly. I felt very hopeful about a VoxEU piece titled Ratings Agency Reform, but there’s no substance to it – it’s just a list of options with no accompanying argument, discussion or opinion.

The Congressional Budget Office does not believe the US is, or will be, in a recession – a slowdown, sure, but not an actual recession. Of far more interest than inane hairsplitting over definitions is their view on the US Federal deficit:

Our baseline – which assumes no change in current law — suggests that among other factors, the slowing economy will boost the deficit to $219 billion, or 1.5 percent of GDP, this year. If Congress provides the additional funding for operations in Iraq and Afghanistan requested by the Administration, the deficit would rise to $250 billion. And if a fiscal stimulus package is enacted, the 2008 deficit could be substantially higher – and at least from a short-term stimulus perspective, that could be desirable. The fiscal 2007 deficit was $163 billion, or 1.2% of GDP.

A mere $250-billion for fiscal 2008, without counting the stimulus package? Not a problem – just sell foreign investors a few more banks. It will be a lot easier than selling them LBO debt!

This is going to end in tears, you know. In Canada, we hit the wall in 1994 and since then politicians have found religion – even the NDP appears to be sincere when calling for balanced budgets. Mind you, the exercise is farcical … the federal deficit in Canada was what? $31-billion-odd in 1991, on top of huge provincial deficits? And there wasn’t anything extraordinarily stupid going on, most of that was just automatic stabilizers (welfare, unemployment insurance, reduced tax collections) acting as they should. And now we’re sitting with a massive national debt, huge health costs and reduced government revenues as the boomers retire while being told that $2-billion annually is a prudent and rational amount to pay on the national debt. It’s silly, really.

But anyway, my point is that the political climate regarding fiscal policy in Canada, for all its faults, is a lot healthier than in the States – and that’s going to get ugly when the chickens come home to roost. It’s not hard to imagine a scenario whereby nominal US allies – the ones with money – are politely asked to help defray the costs of US bases … and in the schoolyards in my neighborhood, that’s called “tribute”, “protection money” or “extortion” according to taste.

Naked Capitalism takes a gloomy view of the proposed monoline bailout – which I haven’t mentioned before because it’s not very interesting. Mr. Smith is greatly irritated by:

Sean Dilweg, the commissioner of insurance in Wisconsin, which regulates Ambac, sat in on the meeting but said he would be working with Ambac directly. Mr. Dilweg said he met separately on Tuesday with executives at Ambac, which is based in New York but chartered in Wisconsin.

“Eric is looking at the overall issue, but I am pretty confident that we will work through Ambac’s specific issues,” Mr. Dilweg said in a telephone interview. “They are a stable and well-capitalized company but they have some choices to make.”

and Mr. Smith responds:

the moron of a regulator from Wisconsin is not only not on the same page, but is dumb enough to undermine Dinallo by saying to the press that all is well in the land of cheeseheads. The odds of Ambac pulling through look even more remote.

This seems like very strong language. The potential monoline demise was mentioned in PrefBlog on January 18 when Fitch downgraded the insurer from AAA to AA. I’d say the regulator from Wisconsin is right – or, at least, he has not yet been proven wrong. What’s wrong with an AA rating from Fitch? Lots of companies would LOVE to have a AA rating from Fitch. They won’t be able to write much new business with that rating and a negative outlook, but why should the regulator care? An AA rating implies a very high probability of meeting the current obligations.

I guess I just don’t understand why this is considered a regulatory matter. I can see that the regulators should be interested, sure, and maybe send over a SWAT (Special Warning Accountancy Team), but public involvement does not yet appear to be warranted.

Again, there will be no tables for indices, performance and volume. Sorry about that!  

Those who are feeling unusually cheerful may find a cure their unfortunate condition by reading through Naked Capitalism‘s latest round-up of gloom and doom … for example, George Soros says:

Until recently, investors were hoping that the US Federal Reserve would do whatever it takes to avoid a recession, because that is what it did on previous occasions. Now they will have to realise that the Fed may no longer be in a position to do so. With oil, food and other commodities firm, and the renminbi appreciating somewhat faster, the Fed also has to worry about inflation. If federal funds were lowered beyond a certain point, the dollar would come under renewed pressure and long-term bonds would actually go up in yield. Where that point is, is impossible to determine. When it is reached, the ability of the Fed to stimulate the economy comes to an end.

Assiduous Readers will remember that I’m already amazed that long-term bonds haven’t already gone up in yield. What’s the 30-year Treasury doing, yielding 4.25% at yesterday’s close? It’s even lower today. I consider this to be proof that today’s archetypal bond manager is under 40 years old. Punk kids. Think inflation is one of their grandfather’s pointless old stories. They should all read Steven Cecchetti’s latest VoxEU piece:

Starting with the data, since the beginning of the month we have seen a very poor employment report (released on the 4 January), evidence of a fall in real retail sales (15 January), information that industrial production was unchanged in December (16 January), and confirmation of a continued precipitous decline in residential construction (17 January). Taken together, this all suggests that the US economy may already be in a recession. My own guess is that the peak in the business cycle was November 2007 and that the economy is currently shrinking, albeit modestly for now.
…
should not sign off without making some comment about inflation. As discussed in my most recent inflation update, recent readings suggest that inflation is on its way up. Most forecasts that I have seen suggest the inflation trend (as measured by the Consumer Price Index) will be not be lower a year from now than it is today. That means that we are likely to enter 2009 with a CPI inflation trend of at least 2¾ percent; surely above the 2 percent most of us would like to see. Clearly, today’s actions are not directed at combating this gathering menace. Instead, for now the FOMC is forsaking its inflation objective in an attempt to keep the recession from getting worse.

But Dean Croushore of the University of Richmond points out another nuance:

Fed Chairman Ben Bernanke’s first published economics article begins “This paper examines the possibility that the economy-wide level of bankruptcy risk plays a structural role in the propagation of recessions.” Published in the American Economic Review in 1981, Bernanke’s analysis showed how a recession causes lenders to reduce their lending so that they can remain solvent, which in turn causes the recession to become worse.
…
How ironic it is that Bernanke should be Fed chairman during the first financial crisis in a decade and the first credit crunch in almost two decades. But also how fortunate that he understands, far better than most economists, why it is crucial that the Fed ensure that credit flows smoothly in the economy, despite the clear breakdown of mortgage markets and substantial losses by financial firms.

The danger, I suppose, is that if you’re an expert on hammers, all problems look like nails!

Sean Silcoff of the Financial Post writes a very good article urging restraint with respect to the BCE / Teachers deal (link courtesy of Financial Webring Forum):

A sure thing? A lot of smart money doesn’t think so, fearing the deal could fall apart. After all, it requires about $33-billion in new debt, and the banks that committed the funds last summer are in worse shape than they were then, amid the bleakest credit crisis in 20 years. The lead backer, Citigroup, is one of the worst basket cases; it can hardly afford to take on more LBO debt. The LCDX, an index of high-yield loans, is trading at $90, implying a 10% discount for holders of high-yield debt.

There are $21-billion in such loans in the BCE deal. So they are worth $2-billion less to the financiers. There is another $11-billion in high-yield bonds to be sold. You can assume a 15% discount there. So anxious lenders are already US$3.5-billion in the hole, on capital they can hardly afford. The prospect of killing the deal and paying the $1-billion break fee to BCE must seem like a good trade.

The court case, in which BCE bondholders are attempting to quash the deal, continues:

In final arguments in court, BCE lawyers said the bondholder suits rely on a series of misrepresentations and incorrect or misleading evidence.

BCE says the bondholders are sophisticated creditors who know the potential risks and shouldn’t have been surprised by news of the sale.

So I guess all the widows and orphans bought the stock, leaving the bonds for the sophisticated creditors to buy.

Remember SIVs? Geez, it’s been a long time since I’ve written about SIVs. There was some more bail-out news today:

American International Group Inc., the world’s biggest insurer, will bail out its Nightingale Finance structured investment vehicle, according to Moody’s Investors Service.

AIG Financial Products Corp., a unit of the New York-based insurer, will either buy the SIV’s $2.2 billion of senior debt or replace it with loans, Moody’s said in an e-mailed statement today. Moody’s affirmed its top Aaa ratings for the U.K. Channel Islands-based SIV’s senior debt.
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“Any realisation of current or future mark-to-market losses will be avoided given the support of AIG Financial Products, provided that AIG FP remains a going concern,” the New York-based ratings company said in the statement.
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Bank of Montreal has shrunk its Links Finance Corp. SIV from $23.4 billion in July last year to $15.1 billion in mid- January, the Toronto-based bank said earlier this month.

Well … it’s after 9:30 and I still can’t download prices from the TSX. I can only suppose that the staff is so busy writing thank-you notes to Bernanke that they’ve run out of time to update the historical databases. I’ll update once I have something to update with.

Shock and awe in the markets today as the Fed cut 75bp to 3.5% and the Bank of Canada cut 25bp to 4.0%. James Hamilton at Econbrowser labels the Fed move an attempt to mitigate damage:

a 75-basis-point cut can not prevent a recession, if one is indeed already under way, any more than the 50-basis-point cut in April 2001 prevented that downturn. But, while many members of the public may believe in the Fed’s omnipotence, I doubt that members of the FOMC share that illusion. I expect that Bernanke instead simply intends to do what he can to mitigate the damage.My bottom line? I believe the FOMC cast its vote today with those who declare that a recession has already begun.

But even after this massive move, many market players are calling for more, e.g.:

The Fed will cut rates again at next week’s meeting by either [a quarter of half percentage point]. The Fed has been unwilling to disappoint the market and fed funds futures are leaning very strongly toward a half-point cut next week. However, we disagree with the Fed over the longer-term outlook for inflation — to us, events have a strong stagflationary feel about them. –Bear Stearns

Bloomberg has some interesting colour regarding the Bond Insurer Implosion:

The first to fall was ACA Capital Holdings Inc., whose ACA Financial Guaranty Corp. unit guaranteed $26.6 billion of CDOs backed by subprime mortgages, according to S&P. The New York- based firm was founded in 1997 by H. Russell Fraser, a one-time chairman of Fitch, to insure municipal bonds that triple-A rated insurers wouldn’t cover.
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“I knew that if they played with fire long enough, they were going to get burned,” says Fraser, 66.

He left the company in 2001 over a dispute with the board about insuring CDOs, he says. Back then, it was debt of Enron Corp. and WorldCom Inc. — companies that later filed the two largest bankruptcies in U.S. history — that was being shoveled into CDOs.

‘But’ roars the crowd, ‘We’re not interested in ancient history! Can we go back to sleep yet?’ Not according to Moody’s!:

Moody’s placed under review for possible downgrade BAC’s senior debt, rated Aa1, and Bank of America N.A.’s financial strength, rated A, on January 11, 2008, when the company announced its planned Countrywide acquisition. The bank’s Aaa deposit ratings and all Prime-1 short-term ratings are not under review.

“The rating review is focused on BAC’s capital position, which is further stressed by a barely profitable fourth quarter and the payment of substantial dividends”, said Rosemarie Conforte, Moody’s Senior Vice President. Moody’s said continued CDO write-downs and increased credit provisions severely affected BAC’s earnings performance during the fourth quarter 2007. Ms. Conforte added, “Bank and holding company liquidity are soundly managed and any capital-raising initiatives would be evaluated during the rating process.”

All in all, it was a pretty interesting day in the financial markets. James Hamilton at Econbrowser took a look after the close and pointed out that 10-year Treasuries yield less than 3.50% and:

All of which invites the question, What’s left for the Fed to do at their regular meeting still scheduled for next week? Futures market participants, whom we left on Friday in the belief that a 75-basis-point cut by the end of January was more likely than a 50-basis-point cut, roared out of the box today, bidding the February fed funds futures contract up to 96.95, implying an expected fed funds rate of 3.05%. That sounds like an additional 50-basis-point cut at the meeting coming up next week, or, if not, a good chance of another intermeeting move in February.

I’m appalled, frankly. If the Fed is trying to inflate its way out of the credit crunch, the yield curve should be WAY steeper than it is now … let’s say inflation becomes a large-but-not-disastrous 3% … and we want 2% real-yield on 10-years (at least! 2% is skimpy) … my calculator must be broken, I get an answer that’s nowhere near 3.5%. Where are the bond vigilantes when you need them?

Somebody, somewhere, is saying that US real-estate is a major deflationary force. Let’s hope they’re right … but until I see some convincing analysis, I’m gonna agree with Bear Stearns, quoted above.

Those who have read my most recently publicized article When Will Preferreds Recover will remember that March-November 2007 marked the greatest peak-to-trough decline in the BMOCM-50 Preferred Share Index going back to at least 1993-12-31. Such readers will doubtless be interested to note that, as of today, the calculated NAV for CPD now shows a decline of 1.06% for January to date, vs. a gain of 1.14% in December. In other words, we are now within a whisker of deepening the trough. Have a nice day!

Mind you, though, the PerpetualDiscount index now has a weighted average bid-yield-to-worst of 5.63% … with interest-equivalency of 1.4x, that’s the equivalent of 7.88% interest, compared to the Long Corporate Yield of about 5.75% … so the spread to bonds still looks pretty good! The Bank of Canada has the long Canada benchmark at 4.06% (!!), so spread-to-long-Canadas is a whopping 3.82%, a noticable increase from the high point shown in Chart 4 of my latest masterpiece.

By and large, preferreds ignored the excitement of the wider financial markets and just did their own thing … with a certain amount of weakness! Volume picked up a bit, to the low side of normal

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