PrefBlog

A good article on VoxEU today by Xavier Vives of the CEPR. He looks at policy responses to the credit crunch:

An old-fashioned bank run happened if enough people tried to withdraw their funds from a bank; even if the bank was solvent, it might not be able to meet all the withdrawals and thus the fear of bank failure could become a self-fulfilling prophecy. In the current crisis, participants in the interbank market take the place of long queues of withdrawers. They have stopped extending credit to other banks that they suspect to have been contaminated by the subprime loans and which therefore may face solvency problems. The commercial bond market and structured investment vehicles are facing similar trouble.

Both the old and new forms of crisis have at their heart a coordination problem. In the current one, participants in the interbank market and in the commercial bond market do not renew their credit because of fear others will not either.
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Bagehot advocated in 1873 that a Lender of Last Resort in a crisis should lend at a penalty rate to solvent but illiquid banks that have adequate collateral.
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Central banks, because of information limitations, are bound to make mistakes, losing face and money in the process. This doesn’t mean they should not try.

The collateral should be valued under “normal circumstances”, that is, in a situation where the coordination failure of investors does not occur. This involves a judgment call in which the central bank values the illiquid assets. A central bank that only takes high quality collateral will be safe, but will have to inject much more liquidity and/or set lower interest rates to stabilise the market. This may fuel future speculative behavior.
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The problem is that central banks are extending the lender of last resort facility outside the realm of traditional banks to entities, like Bear Stearns, that they do not supervise and, therefore, over which they do not have first hand information. How does the Fed know whether Bear Stearns or other similar institutions are solvent? It seems that the Fed is not following Bagehot’s doctrine here.

Finally, if banks and investors are bailed out now, why should they be careful next time? This is the moral hazard problem: help to the market that is optimal once the crisis starts has perverse effects in the incentives of market players at the investment stage. The issue is that only when the moral hazard problem is moderate does it pay to eliminate completely the coordination failure of investors with central bank help. When the moral hazard problem is severe, a certain degree of coordination failure of investors – that is, allowing some crises – is optimal to maintain discipline when investing and, amending Bagehot, some barely solvent institutions should not be helped.

I will take a certain amount of issue with the idea that there is a major problem with central banks lending to institutions they don’t supervise … most central banks, including the Canadian and UK institutions, have no supervisory powers. While I feel it is preferrable for them to supervise the banks, I am not prepared to agree that this is a necessary condition for lending.

The Fed / JPM / BSC situation is clearly a special case, with Bernanke using his discretion to address a problem that he felt had the potential for contagion – with the agreement of the other Fed governors. That’s fine with me. Why hire a smart guy and pay him well if you’re not going to allow him to exercise discretion? As far as solvency goes … JPM is prepared to take on risk and he’s got (surely!) reports from the SEC on BSC’s capital adequacy, as well as some collateral. The internuts are screaming that the collateral is all worthless, but I continue to believe that regulation – via the SEC – is good enough that prices have been marked down to some plausible estimate based on ultimate recovery and influenced by market value.

There is a danger in throwing out the baby with the bathwater here. I believe that Investment Banks should be regulated, but not in the same way and not by the same people as regular banks.

Of most interest, however, is Dr. Vive’s assertion that targetting the “bad collateral” that is the source of the problem, the Fed is acting to minimize the amount of more general liquidity injection that will be necessary to surmount the crunch. That seems eminently sensible to me.

There was some more capital-raising today, with a National Bank preferred issue and a Lehman preferred issue in the States. The reporting of the latter is illuminating:

Lehman Brothers Holdings Inc., which has dropped 42 percent this year in New York trading, is selling at least $3 billion of new shares to U.S. institutions to reassure investors it has ample access to capital.
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“We still maintain that we don’t need capital, but we’ve realized that perception is the dominant issue in today’s markets,” Chief Financial Officer Erin Callan said in an interview. “This is an endorsement of our balance sheet by investors.”
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Merrill Lynch raised $6.6 billion in January by selling preferred shares to a group including the Kuwaiti Investment Authority and Japan’s Mizuho Financial Group Inc.

Today’s motto is “Strong Balance Sheets Are Good”. I’ve just read a history of the Overend & Gurney collapse which drives this home – I’ll be reviewing the book here shortly, to add to the PrefBlog Museum of Catastrophe.

It looks like CPD managed to arrest its fall and remain very slightly above its historical low point (in terms of total return) to close the month. This won’t be much consolation for holders, though, as their total return will have been minimal over the past four months since November 30. It’s close enough to the trough that I will not speculate on whether the BMOCM-50 was also able to eke out a gain. MAPF did not do well on the month, ending its streak of three superb months with a rather poor one – but will have outperformed CPD handsomely on the quarter.

Perpetuals got smacked today by the new National Bank issue; volume was good.

There were nineteen other index-included $25-pv-equivalent issues trading over 10,000 shares today.
Update, 2008-4-1:

No commentary today, I’m afraid! Month-end calls, with a shrill, unpleasant, voice!

Besides, I’m sulking. All those comments for March 27 and nobody explained to me why, given prices for all the other instruments, CIT CDSs have to be so expensive. Feh.

Apolcalyptionists will be thrilled to learn that we are within a whisker of deepening the peak-to-trough poor performance that I noted had set a record, March-November 2007. From November 30 to February 29, CPD returned +3.33% … month to date it has returned -2.96%. Mind you, the peak-to-trough referred to the BMOCM-50 Index, which is not the same as the S&P/TSX index referenced by CPD … but a bad day on Monday could make the Official Pain a year-long event.

Overall, a down day on the market, but with lots of outliers. Volume was low.

There were twelve other index-included $25-pv-equivalent issues trading over 10,000 shares today.

In a post remarkable for its vitriol, Naked Capitalism has attacked a rather innocuous article by Robert Shiller that mounted a defense of financial innovation. So today I’ll comment on the commentary and try to get past the slogans du jour.

Shiller: The entire sub-prime market is largely a decade-old innovation – the word “sub-prime” did not exist in any language before 1994 – built on such things as option adjustable-rate mortgages (option-ARM’s), new kinds of collateralized debt obligations, and structured investment vehicles. Previously, private investors in the US simply did not lend to mortgage seekers whose credit history was below prime.
Naked CapitalismFirst, option ARMs are not a subprime product; they were targeted to prime borrowers (see here and here from the esteemed Tanta). This is a striking error from a supposed expert on housing markets. Second, financial innovation does not equal “securitization of subprimes” which is what his second paragraph implies. CDOs frequently contain heterogeneous assets; many CDOs contain only corporate bond exposures.

Naked Capitalism is factually correct – option-ARMS (these are adjustable rate mortgages in which the borrower has an option regarding how much principal to repay … this can be a negative amount, giving rise to negative amortization) are not a sub-prime product.

As Table 9 in Ashcraft’s paper (reviewed on PrefBlog) shows, Option-ARMs have next-to-no representation in subprime MBS pools. However, the proportion of option-ARMs in Alt-A pools increased rapidly in recent times: from 1.7% in 2003 to 42.3% in 2006. Given that the second Calculated Risk post referenced by Naked Capitalism notes a 15% delinquency rate in Yuba City (north of Sacremento) I don’t quite see that this slight inaccuracy detracts from the credibility of the piece as a whole.

I am completely mystified regarding NC‘s second point: Shiller does not mention “securitization of subprimes” at all, despite NC‘s quotation marks. And while tranching and CDOs have been seen before, the widespread adoption of tranching in creating AAA securities from junk via subordination, which has confused so many commentators, is indeed a new thing.

Naked Capitalism then goes into a long rant, taking issue with Shiller’s statement that:

A study published in 2005 by economists Geert Bekaert, Campbell Harvey, and Christian Lundblad found that when countries liberalize their stock markets, allowing them to operate freely without government intervention, economic growth rises by an average of one percentage point annually.

NC claims a strong belief that this is in reference to a paper titled Growth Volatility and Financial Liberalization, going in to great detail to show why the paper does not show this. Unfortunately, a thirty second search of the SSRN site turns up a paper by the same three authors titled Does Financial Liberalization Spur Growth?, with the abstract:

We show that equity market liberalizations, on average, lead to a one percent increase in annual real economic growth. The effect is robust to alternative definitions of liberalization and does not reflect variation in the world business cycle. The effect also remains intact when an exogenous measure of growth opportunities is included in the regression. We find that capital account liberalization also plays a role in future economic growth, but, importantly, it does not subsume the contribution of equity market liberalizations. Other simultaneous reforms only partially account for the equity market liberalization effect. Finally, the largest growth response occurs in countries with high quality institutions.

It would seem that NC is very eager to confound financial liberalization with depredations of investors! There are other problems with his post; mainly attempts to portray innovation as the antithesis of regulation, but I’ll leave those as an exercise for the student.

Fascinating disclosure about Bear Stearns’ ownership today:

Bear Stearns Cos. Chairman James “Jimmy” Cayne sold his shares in the firm prior to a shareholder vote on the company’s pending takeover by JPMorgan Chase & Co.

Cayne sold 5.6 million shares at $10.84 a piece on March 25 on the New York Stock Exchange, according to a regulatory filing today. Bear Stearns spokesman Russell Sherman had no comment on why or to whom Cayne sold his shares.

I think I’ve mentioned my interest in CIT Group before; a number of interesting things have happened recently. They announced they were tapping their bank lines to build up cash and pay off their un-rollable commercial paper; short interest skyrocketted; Option volatility went way up; the price of CDSs soared (it’s a member of the investment grade high volatility index); and bonds tanked.

So … I’m trying to figure out investment strategies that would relate all thes data (bonds / CDSs is too easy. No marks for that one). I do recognize that all this could be happening completely independently … but I have real trouble believing that CDSs at +1300 is a rational response … even at +1000, that was being quoted at 25 points up front and 5 points a year. That’s not default risk – that’s “how much recovery will there be from the carcass?” What I’m saying is, I suspect that there’s some kind of amplification/transmission mechanism that’s operative and I’m trying to figure out how such a thing might work.

I’m not expecting to find a perfect arbitrage, I’m just trying to find a transmission mechanism. How about … short the stock at $10. Buy a call option with a $15 strike to cover. Sell 5-year Credit protection at 1000bp (net. get some points up front!). Do all this for $10-million notional on each position.

Scenario #1: CIT taken over. Stock goes way up, option exercised, loss $6-million. CDS comes in 700bp, gain about $3.5-million. Net -$2.5-million. Hmmm … maybe the hedge ratio on that one needs to be changed…

Scenario #2: CIT goes bust. Stock goes to zero, option expires worthless. Gain $9-million. CDS settles at 40% recovery. Loss $6-million. Net +$3-million Hedge ratio again … but this is beginning to look interesting.

Scenario #3: Nothing happens. Replace option, cost … Oh, call it $4 annually, or $4-million annually on the position. Receive credit protection payment of $1-million. Net loss $3-million annually

Scenario #4: Nothing happens, but you got 25 points up front. Wait one year, buy back the stock at $10, stop replacing options. Cost of options $4-million. Receive CDS payments of $2.5-million up front + $0.5-million for the year. Net loss $1-million; left with written CDS of 4-years at 500bp

So it doesn’t quite work (with these prices, which probably aren’t 100% executable), but I think there’s something there. And it’s the CDS prices I think are abnormal anyway, so that strategy’s in the wrong direction. How about … buy $10-million stock, buy $25-million notional credit protection?

Scenario 1: Company goes bust in one year. Lose $10-million on stock. Pay $6.25-million up front on CDS, pay $1.25-million annual charge. Make 60% (assumed) on notional CDS = $15-million. Net loss $2.5-million … $2.50/share

Scenario 2: Company taken over at $20. Make $10-million on stock. Pay $6.25-million up front on CDS, pay $6.25-million (total over 5 years) for four year’s credit protection on acquirer. Net = four year, $25-million CDS on acquirer for total cost $2.5-million = 25bp That’s very very cheap, could be sold for … um … 150bp? Then $25-million x 4 years x 125bp = $1.25-million profit. So the break-even takeover price is about $18.75, with full exposure up or down. You’re paying $8.75 for the chance at the other two scenarios.

Scenario 3: Nothing happens. Sell stock, no loss or gain. Have very expensive credit protection on CIT.

… Hmmmmm … still doesn’t quite work.

Any ideas for transmission between asset classes will be appreciated! I do appreciate that a drop in stock price accompanied by a rise in volatility will lead to a higher CDS price according to some models – I’ve mentioned the BoC study – but … but … I want something more direct.

Volume was light on the preferred market today, but there were some violent price moves amid a sharp decline. BCE issues did very well, but quite a few PerpetualDiscounts got hammered.

There were thirteen other index-included $25-pv-equivalent issues trading over 10,000 shares today.

There’s a bit more colour on the Clear Channel deal today, which will of intense interest to those watching the BCE / Teachers deal:

Banks financing the $19.5 billion buyout of Clear Channel Communications Inc. stand to lose about $3 billion on the transaction because loan prices have tumbled since they promised to fund the deal.

Banks led by Citigroup Inc. and Deutsche Bank AG agreed in April to provide $22.1 billion for the purchase by private- equity firms Thomas H. Lee Partners LP and Bain Capital Partners LLC. Since then, losses on subprime-mortgage securities spread throughout credit markets and loan prices for similar LBOs fell to as low as 85 cents on the dollar
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“It doesn’t appear to be a gentleman’s market anymore,” said Neal Schweitzer, who analyzes the bank loan market as senior vice president at Moody’s Investors Service in New York. “The larger the transaction, the greater the potential for bigger discounts” when selling the debt.

The BCE buying group has repeated the same old party line.

Econbrowser‘s James Hamilton voices his support for Jeff Frankel’s explanation of high commodity prices mentioned here yesterday and follows up with a warning:

I have long argued that the broad increase in commodity prices over the last five years has primarily been driven by strong global demand. But I am equally persuaded that the phenomenal increase ([1], [2]) in the price of virtually every storable commodity in January and February cannot be due to those same forces.
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Nor do I agree with those who attribute the recent commodity price increases primarily to the falling value of the dollar.
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Instead I believe that Harvard Professor Jeff Frankel has the correct explanation– commodity prices at the moment are being driven by interest rates, with a strongly negative real interest rate increasing the incentives for speculation in any storable commodity.
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Swings in relative prices of this magnitude are destabilizing. The Fed would like to stimulate more, but it also has to be realistic about what it is capable of accomplishing through manipulation of the fed funds target. Bernanke also needs to be mindful that one of his most valuable assets, if he hopes to be able to accomplish anything through adjustments of the fed funds rate, is the confidence on the part of the public in the Fed’s long-run inflation-fighting resolve.

I agree. As written here on March 19:

I agree with him, as I agreed with his recently expressed view on limits to monetary policy. It seems to me that as far as the overall economy is concerned, the Fed should be waiting to see what its cuts – now 300bp cumulative since August – do to the economy. At the moment, the problem is land-mines of illiquidity blowing up unexpectedly, and the TSLF, together with the occasional spectacular display of force are the best defense against that.

I will also note that a linking of commodities with short-term rates seems in large part to be an attempt to treat them as money market substitutes … we’ve had far too much problems with money-market substitutes in the last year to start inventing more! Well … it’s not my money, and I suspect that the speculators will – eventually – pay through the nose for their presumption.
Accrued Interest mourns the lot of fixed income analysts in this environment:

In the case of mortgage-related credit risk, for instance the ABX index, prices should obviously be drastically lower. This is the kind of risk pricing that capital markets can handle. In fact, that kind of risk pricing is exactly why capital markets are an important part of our free-market system.
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But the second major theme is interfering with the market’s ability to properly price risks. Potential buyers of risk, from hedge funds to banks to broker/dealers, became overextended during the credit bull market and now need to repair their their own balance sheets. No matter how attractive various pricing levels are, these buyers are are not a position to take advantage. Some of those that became overextended have been forced to unwind some or all of their positions.
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As a result, classic investment analysis, pouring over 10K’s and analyzing cash flows, has not been a winning strategy. Until very recently, investors who dabbled in anything that looked fundamentally “cheap” got burned. Sector after sector suffered historic spread widening amidst persistent forced selling.

A major (major! major!) problem this time ’round is that we are currently experiencing the very first credit crisis in which it has been possible to short credit on a large scale – via Credit Default Swaps and Index shorts, for instance. In every other crisis to date, anybody who wanted to speculate against corporate credit had to arrange to borrow physical bonds, preferrably for a long term … at the very least, this added to frictional costs, even assuming a counterparty could be found.

No more. Just buy protection on a billion corporates and wait for the money to roll in.

The problem with this strategy is that shorting credit is ultimately a losing game. Issuers short their own credit because they can (or think they can) use the funds to invest in profitable ventures; ventures not available for the speculator, especially one who isn’t actually getting the funds but is just paying the spread. Shorting credit is a game for the short term only.

From a policy perspective, the ability to short credit is disturbing due to its procyclical nature – that is, speculation may be counted upon to exaggerate legitimate price swings.

Which is not to say I am in favour of banning the practice! However, I do think the margin requirements applicable to players in the core banking system and investment banking system should be reviewed to ensure that speculation is contained. This is similar to regulatory margin requirements on stocks: set partially in order to ensure that there are no destabilizing bankruptcies; and also to discourage ‘walk-away’ trades, in which a player just walks away from a losing bet. We’ve seen quite enough walk-away trades in the US housing market, thank you very much!

As an aside … I mentioned BMO’s new issue of sub-debt yesterday, as a note to the the 5.80% pref new issue announcement … that was a 10+5 year deal at 10s + 260. I have now been advised that TD is also issuing sub-debt, a 7+5 deal at 7s + 225.

In a speech that may be laying the groundwork for massive regulatory changes, Treasury Secretary Paulson has opined:

the Federal Reserve should broaden its oversight to include Wall Street investment firms that borrow from the central bank at the same interest rate as commercial lenders.
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“The Bear Stearns action was a sea change,” said Gilbert Schwartz, a former associate general counsel at the Fed, and now a partner at Schwartz & Ballen in Washington. “The Fed should be the umbrella agency for all these institutions. The SEC is not set up to handle this.”
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“We don’t think the SEC has the tenure and the expertise in a lot of these global capital adequacy, funding and derivative issues that the Fed would have,” said David Hendler, an analyst at CreditSights Inc. in New York. “If you’re going to extend the money you should have the right to look over the books.”
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“The Federal Reserve should have the information about these institutions it deems necessary for making informed lending decisions,” said Paulson, whose three decades on Wall Street culminated in seven years as chief executive officer of Goldman Sachs Group Inc. “Certainly, any regular access to the discount window should involve the same type of regulation and supervision.”

I’m not sure how much I agree with this. I am opposed to regulating investment banks on the same basis as regular banks, for reasons that I have stated until I have bored even myself: they represent part of the grey zone between banks – that should be ultra-regulated – and hedge funds – that should not be regulated at all. If the Fed extends only over-collateralized to brokerages, how necessary is it that they have supervisory responsibilities? Many countries – Canada included – separate central bank & bank supervision, a separation that I feel is sub-optimal, but not all that much sub-optimal.

Is there really anything wrong with the Fed simply seeking an opinion from the SEC regarding solvency of a brokerage prior to extending an over-collateralized loan in emergency circumstances? One thing’s for sure: we don’t want too many rules. Get good people at the Fed, pay them well and give them discretion; that’s the winning formula.

An increased field of operations for the Fed has been endorsed by Dallas Fed President Fisher.

Maybe they can lend money to the monolines next! FGIC dropped a bomb today:

Bond insurer FGIC Corp said on Wednesday that its exposure to mortgage losses exceeded legal risk limits and it may raise loss reserves due to litigation related to stricken German bank IKB.
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FGIC in a statement also said it has a substantially reduced capital and surplus position through December 31. As a result, insured exposures exceeded risk limits required by New York state insurance law, the New York-based company said.

Moody’s downgraded FGIC in mid-February … there’s no word yet on the implications of the new revelations. They recently downgraded Security Capital Assurance when:

elected not to declare the semi-annual dividend payment on its Series A perpetual non-cumulative preference shares.

In other monoline news, Fitch has published a monograph on their ratings model, which takes note of the special characteristics of municipals.

Not a very good day for the markets, but no disaster and volume held steady. I regret I don’t have time for the indices tonight … I’ll try to get to them tomorrow.

There were nineteen other index-included $25-pv-equivalent issues trading over 10,000 shares today.
Update, 2008-3-27: