PrefBlog

The latest report of nefarious skullduggery involves the possibility that banks have under-reported the yields paid on interbank borrowing to avoid looking desperate, resulting in a quote for LIBOR that understates the true rate. Naked Capitalism republishes an extract from the WSJ article; the British Bankers’ Association has threatened to ban any bank caught misquoting rates.

Speaking of the BBA, they have recently released a response to proposals for increased/changed regulation … most of it is UK-specific, but they have strong views on the funding of a central deposit insurer:

We are strongly of the view that a pre-funded deposit protection scheme is inappropriate for UK market. We believe that there should be greater appreciation of the limited ability of deposit protection schemes to save a troubled bank and the impracticality of devising a scheme large enough to cope with the failure of a large UK institution.

We have significant concerns over the competitiveness impacts on the UK financial sector of moving to a pre-funded deposit protection scheme. The costs of moving to a pre-funded scheme would be significant and would have a harmful effect on banks’ competitiveness and their ability to lend to business and individuals alike. The industry has already sustained a significant cost increase from the removal of coinsurance and, subject to further consideration of the issues involved, would be prepared to take on the additional costs of a move to gross payments.

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We note that in the US scheme, operated by the FDIC, the pre-fund was created for the purposes of closure and/or failure of a large number of small entities operating in that market. It is not set up to resolve problems in a bank the size of Northern Rock nor does the US system necessarily need a pre-fund to operate. Consumer confidence is driven by expectations that money can be retrieved in a crisis. We believe it would be impractical to build up a UK fund of sufficient size to deliver his. The United States ex-ante scheme of $49bn, built up over many years and in relation to circa $4 trillion insured deposits, is approximately equivalent to Northern Rock’s retail deposit base prior to the run. So unless it is a small institution that is in distress there would not be enough in the fund to head off a run.Whilst a pre-funded scheme would provide a ready pool of liquidity in the event of a bank default there are other more efficient means of delivering liquidity for prompt payout.

FDIC insurance is backed by the “full faith and credit of the United States Government”. We believe that a similar arrangement whereby the UK government provides support for an FSCS deposit scheme which borrows funds only when required provides the most effective balance for achieving a credible scheme in the eyes of the consumer whilst minimising costs to the industry.

In an update to my post Is Crony Capitalism Really Returning to America, I confessed to some confusion regarding the rationale for brokerages having such enormous chunks of sub-prime on their books:

Taking the last point a little further, I will highlight my confusion as to why the brokerages are taking such enormous write-downs on sub-prime product. This has never made a lot of sense to me

. The WSJ (via Naked Capitalism) has provided a much more venal rationale than the one I suggested at the time:

In August 2006, one Merrill trader fought back when managers pushed to have the firm retain $975 million of a new $1.5 billion CDO named Octans….

The result was a heated phone conversation with Merrill’s CDO co-chief, Harin De Silva, who was out of the office. Mr. De Silva urged the trader to accept the securities….The alternative was to let the deal fall apart, which would leave Merrill holding the risk of all the securities that would have backed the CDO.

In the end, Mr. Roy’s group took the $975 million of securities on the firm’s books….a step that helped the firm hold its top rank in CDO underwriting and led to an estimated $15 million in fee revenue…

Pressures rose in early 2007 as the housing bubble lost air. Merrill set out to reduce its exposure, in an effort referred to innocuously as “de-risking.”

It could have sold off billions of dollars’ worth of mortgage-backed bonds that it had stockpiled with the intention of packaging them into more CDOs. But with the market for such bonds slipping, Merrill would have had to record losses of $1.5 billion to $3 billion on the bonds, says a person familiar with the matter.

Instead, Merrill tried a different strategy: quickly turn the bonds into more CDOs.

Doing so was no longer a profitable enterprise….Still, executives believed that so long as all they retained on their books were super-senior tranches, they would be shielded from falls in the prices of mortgage securities….

In the first seven months of 2007, Merrill created more than $30 billion in mortgage CDOs, according to Dealogic, keeping Merrill No. 1 in Wall Street underwriting for this type of security.

The call for comments, Financial stability and depositor protection: strengthening the framework. At issue are the following notes regarding UK deposit insurance:

1.48 On 1 October 2007, the FSA changed the FSCS compensation limit applying to deposits so that 100 per cent of an eligible depositor’s losses up to £35,000 are covered. The FSA proposes that this limit will continue to be applied per person per bank, and without any co-insurance below the limit. The FSA intends to consult on a review of the FSCS limits in all sectors and other changes to the compensation scheme. The Authorities will also work with the financial sector to explore alternative ways for individuals to cover amounts above the threshold, as the Treasury Select Committee has recommended.

4.42 The Authorities have considered the possibility of making depositors a preferential class of creditor, (i.e. to introduce depositor preference), but the likely adverse consequences of this for other creditors in insolvency proceedings and for banks generally, in terms of increased costs of credit, shorter loan periods and increased demand for collateral, appear to make this undesirable in the UK context. It is therefore proposed that the claims of the FSCS and depositors (whose claims are not settled by the FSCS) will continue to rank alongside the claims of other ordinary unsecured creditors. While a bank liquidator will have a duty to assist the FSCS to effect a repaid payout (i.e. to process depositor information at an early stage), the funding for any payout to depositors would be provided by the FSCS.

5.53 The Treasury Select Committee has identified two disadvantages of a ‘pay as you go’ approach to financing the FSCS:

There are reports that Citigroup’s sale of LBO debt is not going as planned, with investors picking off debt from the deals they know best, rather than buying the complete package holus-bolus.

And the SIV-unwinding proceeds apace. Bloomberg reports that State Street bought $850-million in assets from its sponsored conduits; Assiduous Readers will remember that PrefBlog reported on August 28 that State Street had the highest exposure to conduits of its American and European peers. However, they’ve experienced a strong first quarter:

“During the first quarter, we strengthened our regulatory capital position with strong net income of more than $500 million and the issuance of $500 million of tier-1 qualified regulatory capital.”

Their 8-K filed today discloses (page 32 of the PDF) that their Tier 1 Capital Ratio of 12.35% would decline to 10.15% if all their ABCP conduits were to be consolidated. They have a considerable investment portfolio devoted to AAA tranches of sub-prime – fortunately, mostly well seasoned, with a high degree of credit enhancement.

Credit enhancement is a good thing, with bank repossessions of houses doubling over 2007 levels! Meanwhile, Naked Capitalism highlights a story about increased corporate bankruptcies … some firms were dancing pretty close to the edge even in those halcyon days of easy money and have now been pushed off, as I suggested September 20.

Derivative indices have come in for some heavy criticism:

“The indices are just trading on their own account with no relationship whatsoever to an underlying cash market that’s ceased to exist,” Jacques Aigrain, chief executive officer of Zurich-based Swiss Reinsurance Co., said at a March 18 insurance conference in Dubai.
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“The last thing the securitization market needs is another no-cash-upfront instrument that people can use to knock the markets about with,” said Andrew Dennis, the London-based head of the asset-backed debt syndication group for UBS AG of Zurich.
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The latest version for AAA rated subprime mortgage bonds slumped by 43 percent since it began trading in August, according to Markit, as rising U.S. home loan delinquencies triggered a surge in the cost of credit-default swaps. That implies a 53 percent loss on the underlying mortgages, according to Schultz, almost four times the 13.75 percent rate predicted by Wachovia.

The cost to protect $10 million of AAA commercial mortgage securities jumped 10-fold during one six-month period to $100,000 a year, based on the first CMBX index from Markit. That implies about 13 percent losses on the underlying loans, more than four times the 2.8 percent forecast in the event of a recession by JPMorgan Chase & Co. analyst Alan Todd in New York.

“ABX, CMBX, any kind of X you like, are totally uncorrelated to any kind of underlying market,” Swiss Re’s Aigrain said at the Dubai conference.

Indices without an option of forcing delivery (of something! anything!) are evil. Assiduous Readers will remember that I pointed out the discrepency between the cash market and the index-marked market in my review of the IMF report as well as the earlier Goldman Sachs paper.

There was finally a day of decent volume for preferreds, but price moves were pretty insignificant.

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

On March 31 I indicated my approval of the idea that the Fed should have discretion over the conduct of monetary policy; in Econbrowser, Prof. James Hamilton has pointed out that discretion should have boundaries:

And this is where I feel that Robert Reich raises an excellent point:

the Fed can expose taxpayers to hundreds of billions of dollars of potential losses without a single appropriation hearing, as it did recently when it allowed Wall Street’s major investment banks to exchange tainted mortgage-backed securities for nice clean loans from the Treasury. And the Fed can do amazing things– like decide one big bank, JP Morgan, is going to take over another, Bear Stearns, backed by $29 billion of taxpayer money.

Reich is exactly correct– the Fed’s recent behavior does expose U.S. taxpayers to a risk of default on these assets. While some may argue that the Treasury is exposed to risks in the current situation no matter what the Fed does, it seems to me that this decision is ultimately a matter for fiscal policy. And just as I don’t want Congress deciding how much money to print, I don’t want the Fed deciding how much taxpayer money is appropriate to pledge for purposes of promoting financial stability.
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I agree very much that Congress has a quite proper role in determining the magnitude of the fiscal risk that the Fed opts to assume. Congress’s statutory limit on the quantity of debt that the Treasury can issue is something I have previously derided as political circus. But a statutory limit on the non-Treasury assets that the Fed is allowed to hold might make sense. Perhaps the outcome of a public debate on this issue would be a decision that the Fed needs the power to lend to private borrowers even more than the $800 billion or so limit that it would run into from completely swapping out its entire portfolio. Indeed, Greg Ip speculates on the possibility that the Fed could “ask Treasury to issue more debt than it needs to fund government operations.” Surely that would be something that should require congressional approval. Or perhaps after deliberations, Congress would decide that the business of swapping Treasury debt for private sector loans is one that is better run by the Treasury rather than the Federal Reserve.

Another bank, Wachovia, is cutting its dividend and raising capital, while Deutsche is flogging its LBO debt in an effort to delever … in competition with Citigroup’s efforts, mentioned April 11 to unload $12-billion worth.

A very quiet day for preferreds.

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