PrefBlog

Another implosion in the US today, as CIT Group drew on bank credit to pay short-term debt:

“Protracted disruption” in capital markets and downgrades of its credit ratings prompted the company to borrow from backup lines, Chief Executive Officer Jeffrey Peek said in a statement today. Proceeds will be used to repay debt maturing this year, including commercial paper, New York-based CIT said.

Moody’s Investors Service and Standard & Poor’s cut the company’s credit ratings this week, restricting its ability to finance itself in the commercial paper market, where it has $2.8 billion in debt outstanding, John Guarnera, an analyst at Bank of America Corp., said. CIT, which leases airplanes and trains and provides financing to companies, follows Countrywide Financial Corp. in seeking bank financing after struggling to access traditional means of funding.

Quite frankly, I don’t understand this at all. I’ve been looking at CIT, and agree – they have problems! But their book value of $34 looks entirely reasonable, financing requirements don’t (didn’t!) seem to be horribly lumpy, lots of cash on the balance sheet. The worry is their 10:1 debt:equity ratio … but it’s a leasing company! That’s what they do! It seemed to me that while the common share holders were probably not going to be happy campers for the duration of crunch (higher financing costs grinding away at profit) and sometime thereafter (while the financing runs off the books), it seems to me the credit was fine. And now…

Credit-default swaps tied to CIT’s bonds traded at 27 percent upfront and 5 percent a year today, according to broker Phoenix Partners Group in New York, meaning it cost $2.7 million initially and $500,000 a year to protect the company’s bonds from default for five years. That’s up from 23 percent upfront and 5 percent a year yesterday.

Wow. At any rate, I suspect CIT is ripe for a take-over … market cap of $1.4-billion makes it a nice little tuck-in for a bank that wants a leasing business. But we shall see! My macro-calls are no better than any other idiot’s. One thing that may be affecting matters is extraordinary volatility in the stock markets:

The U.S. stock market is the most volatile in 70 years, according to a Standard & Poor’s study of daily price swings in the S&P 500.

The benchmark for American equities has advanced or declined 1 percent or more on 28 days this year. That’s 52 percent of the trading sessions so far, which is the highest proportion since 1938, said Howard Silverblatt, S&P’s senior index analyst. The S&P 500 lost 12 percent in 2008 through yesterday following $195 billion in bank losses related to subprime mortgages.

Increased stock volatility can lead to increased CDS spreads via variants of the Merton structural model.

And according to Citigroup’s analysis:

While Citigroup apparently does not invoke the underlying theory, they see a massive deleveraging in process and tell investors to get out of the way. Via Marketwatch:

The Great Unwind has begun, Citigroup Inc. strategists warned on Wednesday.

As markets and economies de-leverage across the globe, investors should avoid companies and countries that have grown to rely too much on borrowed money, they said.

That means favoring public-equity markets over hedge funds, private-equity and real estate, while leaning toward emerging market countries and away from developed nations like the U.S., the bank’s global equity strategy team advised.

Within equity markets, the financial-services should be avoided because it’s still over-leveraged, while other companies have stronger balance sheets, the strategists said….

For example, there are reports and speculation that Bear Stearns’ problems are feeding into commodities:

When confidence in the brokerage firm was waning last week, many hedge fund clients working with the firm’s prime brokerage division pulled back and tried to quickly move accounts to rival brokers, according to hedge fund investors, prime brokers and other experts in the business.

One executive at a smaller prime brokerage firm said he was bombarded by calls on Friday from hedge funds wanting to move from Bear. His firm has gained about 10 new clients from Bear during the past 10 days, he added. Another executive at one of the largest prime brokers said his firm has also been picking up new clients as a result of Bear’s problems. They both spoke on condition of anonymity.
…
“Leverage is being closely watched,” said Josh Galper, managing principal of Vodia Group, which advises hedge funds on borrowing strategies. “That does not mean that hedge funds from Bear are being told specifically that they may not put on as much leverage as Bear had let them, but rather that the amount of leverage being utilized is being reviewed much more carefully than it has been in the past, for obvious reasons.”
…
The price of commodities including energy, metals and grains slumped for a second day on Thursday amid speculation that some hedge funds are selling leveraged positions to either meet margin calls or lock in profits and shift to other assets.

Two articles today brought into sharp relief the issue of individuals’ compensation within the financial services industry. Naked Capitalism republishes an article from the Financial Times which brings up the old chestnut about an investment strategy that returns 10% in nine of ten years and -100% one time in ten:

We can identify two huge problems to be solved. First, many investment strategies have the characteristics of a “Taleb distribution”, after Nicholas Taleb, author of Fooled by Randomness. At its simplest, a Taleb distribution has a high probability of a modest gain and a low probability of huge losses in any period.

Second, the systems of reward fail to align the interests of managers with those of investors. As a result, the former have an incentive to exploit such distributions for their own benefit.

Further, it is claimed that:

Professors Foster and Young argue that it is extremely hard to resolve these difficulties. It is particularly difficult to know whether a manager is skilful rather than lucky.

Well, says I, no more difficult than with anything else. You have to actually look at an investment; looking at returns – whether actual or backtested – is only half the story. If we look, for instance, at the just-reported blow-up of Endeavor Capital, we see:

Endeavour Capital LLP, the London- based hedge-fund firm founded by former Salomon Smith Barney Inc. traders, has fallen about 28 percent this month because of “extreme volatility and vast moves” in Japanese bonds, according to two investors.

The $2.88 billion Endeavour Fund sold “substantially all” of its Japanese government debt this week, Chief Executive Officer Paul Matthews said today in an interview. He declined to comment on the March decline.

Endeavour seeks to profit from discrepancies in the prices of various fixed-income securities and currencies, a strategy known as relative-value trading. The fund lost money as the spread, or difference, between yields on Japanese 7- and 20-year bonds widened to 1.44 percentage points on March 17, the most in almost nine years. Investors bought shorter-term debt as the benchmark Nikkei 225 stock index fell 13 percent in March.

Let’s think about this. They lost money because the spread between 7s and 20s widened … so presumably they were long 20s and short 7s. Since they are calling themselves “relative value” investors, we will assume (assume!) that the position was duration neutral and in that case their position was most likely long cash, short 7s, long 20s in such a way that parallel shifts in the yield curve would not – to a first approximation anyway, for smaller small parallel moves – harm them. Note that the assumptions leading to this conclusion are entirely reasonable, but are still assumptions. Anybody who knows better – feel free to tell me. Anyway .. long cash / short 7s / long 20s is a coherent strategy, at the very least.

But “relative value”? Well – I don’t know what the proponents themselves called it when pitching clients for money. And, at a stretch, “relative value” can cover a lot of ground … if you feel that the value on stocks is cheap relative to cash, you can justify levering 20:1 on a stock portfolio and call it a “relative value” play.

I certainly wouldn’t call it a “relative value” play. The position I’ve described – long cash, short 7s, long 20s – is a “flattener”. It will make all kinds of money if the overall yield curve flattens, and lose all kinds of money if the overall yield curve steepens … and it appears that the Japanese government curve has just done that latter. It’s not a “relative value” play at all – it’s a macro-market call, subject to all the chaos and market risk of any other macro market call.

If they want to go long 5s, short 7s, long 10s … then maybe they can talk to me a little bit more about their “relative value” plays. Maybe. But that’s the outside limit, and too much leverage takes it out of consideration.

In a similar vein, Guido Tabellini of Bocconi University asks in VoxEU Why did bank supervision fail?:

On the other hand, there were systematic incentive distortions. First, the “originate and distribute” model entails obvious moral hazard problems. Second, credit rating agencies face a conflict of interest. Third, management compensation schemes reward myopic risk taking behaviour; it is rational for me to under-insure against the occurrence of rare disruptive events, if my bonus only depends on short-term performance indicators.

These are bare assertions – Prof. Tabellini may well have good reason to believe they are true, but they are incidental to the main point of his article, which I will not discuss.

What I find interesting is the renewed focus on short-term compensation; it’s reminiscent of the handwringing of the 1980’s – remember? When the ceaseless pressure on American corporations to post quarterly returns was blamed for all that was wrong with the world and predictions that the long-term oriented Japanese would end up owning the world? This was before the Japanese property bubble collapsed and sent them into a 15-year recession, of course.

I’ve said it before, but I never get tired of seeing my own words on screen: there are problems, sure, but most of these will be self-correcting. It’s going to be awfully difficult to sell originate-and-distribute product any more without better disclosure and accountability … the pendulum has, if anything, swung over too far on that one, at least for now. And bank supervision – via the Basel accords – needs to provide a brighter line between the (protected and regulated) banking system and the (unprotected and unregulated) shadow-banking system.

Compensation structures for individuals can always be improved – but there is always a lot competition for talent:

As more than 14,000 Bear Stearns Cos. employees watch the value of their stock sink and brace for firings, some of the company’s 550 brokers who handle individual investors’ accounts are receiving job offers from competitors promising windfalls of $2 million or more.

Merrill Lynch & Co., Morgan Stanley, UBS AG and Citigroup Inc.’s Smith Barney unit are offering Bear Stearns brokers packages that include signing bonuses of two times the revenue they bring in annually, said Mindy Diamond, president of Diamond Consultants LLC, a Chester, New Jersey-based executive search company. Someone generating $1 million in commissions and fees could receive $1.5 million up front and the rest over three years, she said.

Note that in highlighting this example, I am using the word “talent” to denote “ability to bring money in the door”.

Back to economics, Econbrowser‘s James Hamilton opines on yesterdays massive Fed easing:

suppose you believe that oil over $100 a barrel is a destabilizing influence– and I do— and that the Fed’s recent decisions on the fed funds rate are the primary reason that oil is over $100– and I do— and that further reductions in the Tbill rate have limited capacity to stimulate demand– and I do. Suppose you also saw a risk that the inflation, financial uncertainty, and slide of the dollar could precipitate a run from the dollar, introducing an international currency crisis dimension to our current headaches.
…
I think the Fed missed an opportunity here. A 25 or a 50 basis point cut would have sent commodity prices crashing. Even the mildly hawkish surprise of “only” a 75 basis point cut may have some effects in that direction. If the Fed did convince the commodity speculators that their path leads only to ruin– and I believe the Fed could easily have done just that– that would leave Bernanke with a lot more maneuvering room to cope with what comes next.

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.

In other words, I’m worried about the collateral damage from such an unfocused tool as the Fed Funds rate. I will note that Accrued Interest is of the view that the (assumed) objective of deleveraging is being (somewhat) achieved by the spanking given to Bear Stearns:

Deleveraging continues. All the big brokers know that the surest way to avoid a Bear Stearns problem is to make sure they aren’t over exposed to hedge funds. Supposedly there have been several commodities-oriented funds which are selling today. Gold getting crushed. Haven’t heard anything about equity-oriented funds but that might be part of what’s going on today as well.

Speaking of Bear Stearns, the SEC has released some FAQs, one of which supports Bear Stearns’ story of sudden and unforseeable liquidity collapse:

Why was Bear Stearns’ loss of credit so critical to its ongoing viability?

In accordance with customary industry practice, Bear Stearns relied day-to-day on its ability to obtain short-term financing through borrowing on a secured basis. Although Bear Stearns continued to have high quality collateral to provide as security for borrowings, as concerns grew late in the week, market counterparties became less willing to enter into collateralized funding arrangements with Bear Stearns.

Late Monday, March 10, rumors spread about liquidity problems at Bear Stearns, which eroded investor confidence in the firm. Bear Stearns’ counterparties became concerned, and a crisis of confidence occurred late in the week. In particular, counterparties to Bear Stearns were unwilling to make secured funding available to Bear Stearns on customary terms.

This unwillingness to fund on a secured basis placed stress on the liquidity of the firm. On Tuesday, March 11, the holding company liquidity pool declined from $18.1 billion to $11.5 billion. On Wednesday, March 12, Bear Stearns’ liquidity pool actually increased by $900 million to a total of $12.4 billion. On Thursday, March 13, however, Bear Stearns’ liquidity pool fell sharply, and continued to fall on Friday.

Joe Lewis is opposing the JPM / BSC deal:

Lewis, a former currencies trader born in an apartment above a pub in London’s East End, will take “whatever action” he deems necessary to protect his $1.26 billion investment in New York-based Bear Stearns, he said in a filing today with the U.S. Securities and Exchange Commission. He said he may “encourage” the firm and “third parties to consider other strategic transactions.
…
“If he gets others to vote with him he may be able to get some token increase in the price,” said John Coffee, a securities law professor at Columbia University in New York, referring to Lewis. “He’s not going to get a significantly higher bid because no one else can get the Fed’s support and the Fed’s financing.”

Lewis paid an average of $103.89 apiece for his 12.14 million Bear Stearns shares, according to today’s filing. He started accumulating most of his shares last July and has lost about $1.19 billion on the investment, or almost half his wealth, which Forbes magazine estimated at $2.5 billion in its 2007 survey.
…
The SEC filing today showed that Lewis purchased 1.04 million Bear Stearns shares during February and March, raising his total stake 8.35 percent of common shares outstanding. His price per share ranged from $55.13 to $86.31. He said he may dispose of his holdings entirely or bet that the stock will drop further.

Naked Capitalism highlights some rumours about European banks, which brings to mind Accrued Interest‘s prescient emphasis on the effect of rumours in a bear (Bear?) market reported here March 12. 

And in the regular trickle of news about LBOs in general and how the market is affecting the chances for Teachers / BCE, there is a snippet about current conditions on Bloomberg:

U.S. banks have whittled their holdings of leveraged buyout loans to $129 billion from $163 billion at the beginning of the year by offering the debt at discounts, according to Bank of America Corp. analysts led by Jeffrey Rosenberg.
…
Goldman reduced its backlog of loans by $20 billion in the past quarter from $43 billion, chief financial officer David Viniar said on an investor call yesterday. The New York-based firm, which booked a loss of $1 billion on the loans, also added $4 billion of new commitments during the period.

Lehman, the fourth-biggest U.S. securities firm, booked losses of $500 million on leveraged loans last quarter, CFO Erin Callan said on a conference call with investors yesterday.

Morgan Stanley, the second-biggest U.S. securities firm, reduced its leveraged finance pipeline to $16 billion from $20 billion during the first quarter, CFO Colm Kelleher said in an interview today after the company reported first-quarter profit fell 42 percent.

Make of it what you will!

In other jolly news, DBRS has announced that it:

has today withdrawn the ratings of the below-listed Affected Trusts under the Montréal Accord. This action has been taken at the request of the Affected Trusts.

Well, I guess the court appointed monitor didn’t want to pay rating bills for trusts that were under CCCA protection anyway! Speaking of ratings, by the way, I am participating in an exchange with Naked Capitalism in the comments to an almost unrelated post.

The pref market eased downward today on modest volume, enlivened by some sharp declines among financial-based splitShare corporations.

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

Price & Value! They’re not always the same thing – which is wonderful for those of us who achieve outperformance by exploiting the difference – but sometimes they get so far out of whack that real pain is experienced. We’re going to be hearing a lot about the two over the next few years, as the regulators wrestle with what they can do to avoid future procyclical margin calls on banks.

AIG, for instance, took an $11.1-billion hit in its fourth quarter, compared to its internal “worst case” stress test of $0.9-billion because its CDS positions (short) were marked-to-disfunctional-market. Bear Stearns investors are looking at book value $84, accepted bid $2. And, of course, it has become fashionable to make fun of mark to make believe accounting, enjoyment being inversely proportional to understanding.

Brace yourselves! There’s going to be a lot of discussion over the next year! Nouriel Roubini claims that the Bear Stearns price is, in and of itself, clear proof of insolvency:

As JPMorgan paid only about $200 million for Bear Stearns – and only after the Fed promised a $30 billlion loan – this was a clear case where this non bank financial institution was insolvent.

I think Prof. Roubini goes too far in his statements:

The Fed has no idea of which other primary dealers may be insolvent as it does not supervise and regulate those primary dealers that are not banks. But it is treating this crisis – the most severe financial crisis in the US since the Great Depression – as if it was purely a liquidity crisis.

While it is indeed true that the Fed does not regulate the brokers, the SEC does, and had examiners on the scene at Bear as the crisis evolved:

Cox said on March 11 the SEC was monitoring firms’ capital levels on a “constant” basis and sometimes daily in response to the subprime-loan meltdown that triggered the crisis.

Now, I will agree that it is better, in general, for the Lender of Last Resort to also wear the Regulators’ hat … this has been discussed before on PrefBlog, but now I find that the damn “search” function isn’t working and I can’t find it … but if the functions are separate (as they are in Canada and the UK, to name but two) it’s not the end of the world. Any bureaucracy is much more dependent upon esteem, morale and independence from politicians than it is on formal structure. If Bernanke calls Cox and asks (in J. P. Morgan’s famous 1907 phrase) “Are they solvent?” I’m sure he gets the best answer available.

Back to Roubini:

Here you have highly leveraged non bank financial institutions that made reckless investments and lending, had extremely poor risk management and altogether disregarded liquidity risks; some may be insolvent but now the Fed is providing them with a blank check for unlimited amounts.

All I can say is … it’s easy to second-guess. BSC management has come a cropper and it’s easy to say ‘I told you so’ … especially when, as in Prof. Roubini’s case, he DID say ‘I told you so’! And share-holders are looking at a wipe-out scenario as a result. The Fed moves involve a risk of moral hazard, but somehow I feel a little doubtful that BSC executives are currently exchanging high-fives at being bailed out so generously; if moral hazard exists in this matter, it is with respect to the bond-holders who, it would seem, have a good expectation of seeing their credit quality improve with a takeover.

The most familiar example of moral hazard is in banking; I have previously discussed the state of deposit insurance in Europe … it’s really lousy because they are absolutely terrified of moral hazard. It may be necessary to regulate brokerages more strictly and come up with some refinement of the rules to ensure that liquidity is always abounding … but I’m not sure if, ultimately, such an effort will be worth-while. How often does a market turn from go-go-go! to zero inside of six months, as has happened with sub-prime? How often does an eighty-five year old securities firm with $11-billion book value and profitable operations find itself with dusty telephones?

I’ll listen to suggestions, but I suggest that this is probably one to be permanently filed in the “Why Regulators Need Discretion” category. A much greater source of moral hazard is deliberate moral hazard, as is now being encouraged by Congress:

At the beginning of this decade, derivative risk management geeks, interest rate swaps traders and central bank econometricians filled up entire server farms with what-ifs on the balance-sheet hedging activities of the GSEs. The essential problem was that the GSEs were balancing ever-larger portfolios of fixed-rate mortgages on tiny equity bases. Fortunately, as we all knew, the credit risks of those portfolios were limited because homeowners rarely default on their mortgages. But that still left very large interest rate risks.

The core problem for the housing GSEs is, and has been, the prepayment option embedded in US fixed-rate mortgages. That has meant that the term of the GSE assets extends or contracts depending on whether homeowners can refinance at an advantageous rate. However, most of the long-term debt on the liability side of the GSE balance sheets has a fixed term. So the GSEs must more or less continually offset this imbalance between the average maturity of their assets and liabilities through the derivatives market, specifically the interest rate swap market. Otherwise the mark-to-market losses would overwhelm their small equity bases.

I have said before: the terms on a perfectly normal, standard US mortgage are ridiculous:

Americans should also be taking a hard look at the ultimate consumer friendliness of their financial expectations. They take as a matter of course mortgages that are:

• 30 years in term
• refinancable at little or no charge (usually; this may apply only to GSE mortgages; I don’t know all the rules)
• non-recourse to borrower (there may be exceptions in some states)
• guaranteed by institutions that simply could not operate as a private enterprise without considerably more financing
• Added 2008-3-8: How could I forget? Tax Deductible 

First, the GSEs need to be regulated as the banks they are; second, implementation of this discipline must be allowed to make the terms of US mortgages less procyclical. 

Back to Bear Stearns for a moment, with a hat-tip to Financial Webring Forum. There are some very interesting theories regarding why BSC stock is going up:

what could account for the rise in shares? One of the most intriguing theories, as expressed by observers like ThePanelist.com’s David Neubert, Portfolio’s Felix Salmon and Fortune’s Roddy Boyd, is that bondholders are buying up Bear Stearns shares. Bankruptcy would almost surely have been Bear Stearns’ fate if it had not secured an 11th-hour deal, which would have defenestrated shareholders and thrust bondholders into a potentially bruising battle with other, more senior creditors.

But the JPMorgan deal offers bondholders a potential payout: Upon completion, Bear Stearns bonds currently trading at steep discounts would be made whole by the banking giant. Buying shares in Bear Stearns would help ensure that the deal goes through, and so it’s possible that bondholders are buying up the still-cheap shares in hopes of guiding the JPMorgan takeover to completion.

Buying shares in Bear Stearns could also be a hedge, Mr. Neubert and Mr. Salmon add. If the deal falls through, the bonds will fall in value, but the stock could rise.

Mr. Roddy also points out that hedge funds who sell credit default swaps, financial instruments that protect buyers against the default of a given company, have an incentive to see the deal go through as well. As Bear Stearns’ financial health improves by forging closer ties to the bigger, steadier JPMorgan, the cost of insuring the company through these swaps goes down.

I’ve mentioned the decoupling of de facto & de jure economic interest before, in the context of Credit Default Swaps. Now maybe the swaps boys are at it again! Fascinating. Incidentally, another story making the rounds is that JPM wanted to bid more, but the Fed insisted that management not only be wiped out, but publicly humiliated to boot. Makes sense, but I will not venture an opinion on its accuracy!

Update:In the absence of an endgame, it makes more sense for the bond shorts (that is, those who have bought CDS Protection) to buy shares, since there’s a bigger payoff if they get their way, forcing bankruptcy and then forcing a fire-sale. There is the danger, however, that the company would walk into bankruptcy court with a ready-made plan signed by the Fed giving full recovery to bondholders. The game-players would then lose on both sides of their hedge. Those long bonds have the Promised Land at their feet as soon as the merger succeeds.

Econbrowser‘s James Hamilton approves of the Fed action:

Bear is not going to be last, but it is the model I think for what we’d want to see– owners of the companies absorb as much of the loss as possible, while the Fed does its best to minimize collateral damage.

And I’d say he’s right.

A good strong day in the preferred market, with volume picking up substantially.

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