Month: April 2008

The most interesting news today was a report that Scotiabank is interested in National City. National City has had some problems lately:

Our mortgage business came under considerable pressure starting in late July and early August 2007 with the near-total stoppage in the mortgage capital markets. While we ceased broker production of new national home equity originations immediately, we had a warehouse of loans held for sale for which there were no buyers, as well as a pipeline of approved applications awaiting funding. The retention of these loans increased the size of our balance sheet above where we had planned it to be, and also drove losses in the third and fourth quarters as we marked loans down to their current value. Other than conforming, agency-eligible mortgages, the market for virtually all other types of mortgage loans continues to be illiquid to non-existent. Therefore, we have further downsized and restructured our mortgage business, exiting all wholesale production channels and narrowing our mortgage product set to agency-eligible mortgages and a small amount of high-quality “jumbo” mortgages.
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The combination of a larger balance sheet, further disruption in the capital markets, mortgage-driven losses, and other developments in the last two months of the year has taken the company’s year-end capital position below its target range. For that reason, we announced in early January plans to raise non-dilutive Tier 1 capital, as well as our Board’s decision to reduce the dividend by 49 percent. We did add $650 million of Tier 1 capital in January, exceeding our objective for that transaction. I can assure you that the decision to reduce the dividend was not taken lightly. However, it was and is an important step, in conjunction with the aforementioned capital issuance, to increase capital to the higher end of our announced target ranges: 5 to 6 percent for tangible common equity and 7 to 8 percent for Tier 1 risk-based capital. We have also embarked on an aggressive program to manage the size of the balance sheet to further accelerate the increase of these ratios to desired levels. A strong balance sheet is the foundation which will see us through difficult times.

National City’s year end ratios were appalling … Tangible common equity / Tangible assets of 5.28% (down from 7.77% at year end 2006); Tier 1 Capital of 6.53% (from 8.93%); Total Capital of 10.27% (from 12.16%). We shall see! I’ve been wondering for a long time when one or more of the Canadian banks would use its strong balance sheet to make a play in the States … but I think it was Ed Clark of TD Bank who said the problem with the idea was that after you bought it, you then had to recapitalize it.

On similar lines, Accrued Interest has a thoughtful piece on what appears to be a change in the Private Equity business model:

Private equity is one area where there is clearly plenty of capital. Its not just the WaMu transaction. Citi is apparently going to sell $12 billion in loans to private equity. Private equity is creating “PennyMac” to buy distressed mortgage loans. Etc. Etc.

So here is the question. Is private equity adroitly putting their excess capital to work in these distressed assets? Is this a case where PE is the only player with adequate capital to take on these risks, and therefore set to reap big profits?

Or is it a case where they have too much cash and not enough good ideas? Two years ago, PE was all about using their business acumen to acquire whole companies, usually by using huge leverage. Now, as Deal Journal’s Dennis Berman wrote, it isn’t PE’s smarts but their capital that’s in demand.

Time will tell. It would be my view that there are very good values in corporate loans. Some good values in residential mortgages, especially if there is some kind of government bailout. But for WaMu, I’m very skeptical. If I were a betting man, I’d bet on Washington Mutual eventually accepting a buyout offer from another bank, probably Wells Fargo or J.P. Morgan. Given that J.P. Morgan supposedly offered $8/share, TPG may wind up disappointed in their results.

I’ll suggest that what’s happening to Private Equity is the same thing that happened to Hedge Funds about ten years ago … time was, they were called “Hedge” funds because they … er … hedged. Market neutrality was the name of the game.

Then the market started getting a little more crowded and the salesmen needed a new gimmick. ‘A hedge’, they remembered, ‘is a position that wipes out the value of your good idea’. So the typical hedge fund model moved from “market neutral” to “highly levered”.

The private equity model is getting similarly crowded. There have been lots of complaints over the past couple of years that deals are getting harder to come by, it’s hard to find those 20% p.a. returns any more. So private equity is morphing too … the name is just a label. You can’t be sure it means anything until you look under the hood.

ABCP? I’m sorry … I just can’t seem to get interested in the whimpering over this fiasco, despite the discussion in the comments to April 9. Flaherty is claiming a federal regulator would have made everything better, but doesn’t say how. The Globe & Mail, of course, is doing its best to whip up hysteria, talking of “loopholes” and such. I’m sorry. It’s all meaningless and boring.

Very quiet day for preferreds today, but the market was up smartly, led by CM.

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

Not much today!

Prof. Stephen Cecchetti (regularly quoted on PrefBlog) has written a review of the Fed’s actions in fighting the credit crunch, in both full and ultra-condensed versions. It’s nice to have all the actions and numbers in one place, but there’s nothing particularly new or startling in the piece. He concludes:

In the heat of a financial crisis, the central bank is the only official body that can act quickly enough to make a difference. Politicians are not well-equipped to take actions literally from one day to the next. So, while we might want to reassess the role of the central bank once the crisis is over, for now it is difficult to fault the Federal Reserve’s creative responses to the crisis that began in August 2007. Let’s just hope that they work.

A complicating factor is that only five of the seven governor’s seats are filled; all in all, the crunch will be fodder for learned papers and theses for many, many years to come.

California was able to refinance some auction debt:

California is offering general obligation bonds to institutions such as mutual funds and insurers today after collecting $898 million of orders from individuals, according to Tom Dresslar, spokesman for state Treasurer Bill Lockyer. Denver International Airport also plans to refinance auction-rate securities by selling $445 million of fixed-rate bonds.
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Long-term municipal bonds have risen four of the past five days as investors buy tax-exempt securities whose yields have exceeded those on benchmark Treasuries.
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The gains drove yields on top-rated, 30-year municipal debt to 4.80 percent, the lowest in six weeks, according to Municipal Market Advisors. That still exceeds the 4.35 yield on the 30- year U.S. Treasury bond.
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Municipal bonds dropped in late February after hedge funds liquidated some of their holdings in the tax-exempt market, as asset values fell and funding costs rose.
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Such leveraged investors typically buy fixed bonds, fund their purchases by issuing lower-yielding variable-rate notes to money-market mutual funds, and then hedge their investments with interest-rate contracts.

Such a strategy by hedge funds will involve basis risk – if they buy a long-term bond and sell an interest-rate swap against it, they will be receiving LIBOR plus a spread. If this spread exceeds the spread they’re being paid on their own commercial paper, they’re happy … otherwise, not so much. It’s all part of the arbitrage that exists because borrowers want long-term funding and lenders want short term risk … and it works … usually.

Bernanke gave a speech today reviewing the situation. There will be more rules!

the Federal Reserve has used its authority under the Home Ownership and Equity Protection Act to propose and seek comment on new rules that, for higher-cost loans, would strengthen consumer protections. The rules would restrict the use of prepayment penalties and low-documentation lending, require the use of escrow accounts for property taxes and homeowner’s insurance, and ensure that lenders give sufficient consideration to borrowers’ ability to repay. In addition, for all mortgage loans, we have proposed rules regarding broker compensation methods and the ability of appraisers to provide judgments free of undue influence, as well as rules regarding the accuracy of advertisements and solicitations for mortgage loans and the timeliness of required disclosures. We also plan to propose a revised set of required mortgage disclosures based on the results of a program of consumer testing already under way.

… and pension boards might have to do something at their meetings …

Some investors, such as public pension funds, are subject to government oversight, and in these instances, the PWG will look to their government overseers to reinforce implementation of stronger due diligence practices. When investors employ advisers, the mandates and incentives given to these advisers should be structured so as to induce a more careful and nuanced evaluation of the risks and returns of alternative products.

Another “key priority” is:

analytical weaknesses and inadequate data underlay many of the problems in the ratings of structured finance products. Beyond improving their methods, however, the credit rating agencies would serve investors better by providing greater transparency. Credit rating agencies should, for example, publish sufficient information about the assumptions underlying their rating methodologies and models so that users can understand how a particular rating was determined. It is also important for the credit rating agencies to clarify that a given rating applied to a structured credit product may have a different meaning than the same rating applied to a corporate bond or a municipal security.

Different rating scales is a cosmetic change … but publishing assumptions is a little fishy. What if the assumptions relate to regulation FD? The only real problem with the credit rating agencies is that investors cannot reproduce their work without access to the material non-public information to which the agencies have access.

With respect to bank supervision:

Prudential supervisors in the affected financial markets began joint work late last summer to identify common deficiencies on which they and the firms should focus. The supervisors concluded that the firms that suffered the most significant losses tended to exhibit common problems, including insufficiently close monitoring of off-balance-sheet exposures, inadequate attention to the implications for the firm as a whole of risks taken in individual business lines, dependence on a narrow range of risk measures, deficiencies in liquidity planning, and inadequate attention to valuation issues.
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The PWG also will be asking U.S. regulators, working together and through international groups such as the Basel Committee on Banking Supervision, to enhance their guidance in a variety of areas in which weaknesses were identified. I expect, for example, to see work forthcoming on liquidity risk management, concentration risk management, stress testing, governance of the risk-control framework, and management information systems.

It will be most interesting to see what they come up with respect to liquidity risk management. The banks don’t like the idea … liquidity is a chancy thing!

On the regulatory front RS has a contested hearing about some allegations that are remarkable for their triviality. I truly hope that there’s a lot of back-story to the case that isn’t specified … the potential fine of $3-million seems far out of proportion to the wrongdoing. For heaven’s sake, shouldn’t these trade cancellations have resulted in an automatic penalty of $1,000, end of story? The stenographer at the hearing will cost more than the clients were harmed – even if you agree that the clients were harmed.

A quiet day today. A number of issues traded over 100,000 shares, but volume was highly, highly concentrated in these issues.

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

Update: Late update here from the PrefBlog Looking Gift Horses in the Mouth Department. Remember PIMCO’s Bill Gross’ comment yesterday?:

For Pimco’s Gross that’s not enough. “If Washington gets off its high `moral hazard’ horse and moves to support housing prices, investors will return in a rush,” he wrote in a note to investors published Feb. 26. Gross, who runs the $122 billion Total Return Fund from Newport Beach, California, didn’t return calls seeking additional comment.

Apparently, Pimco’s Gross Holds Most Mortgage Debt Since 2000:

Pacific Investment Management Co.’s Bill Gross lifted holdings of mortgage debt in the world’s largest bond fund to the highest since 2000, while putting on the biggest bet against government debt since at least the same year.

The $125.1 billion Pimco Total Return Fund had 59 percent of assets in mortgage debt in March, up from 52 percent the prior month and 23 percent in March 2007, according to data on the Newport Beach, California-based firm’s Web site. The fund’s cash position dropped to 32 percent, the lowest since July 2006, from 34 percent in February.

The hills are alive with speculation that the Fed might buy mortgage paper:

The Federal Reserve is considering contingency plans for expanding its lending power in the event its recent steps to unfreeze credit markets fail.
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The Fed, like any central bank, could print unlimited amounts of money, but that would push short-term interest rates lower than it believes would be wise. The contingency planning seeks ways to relieve strains in credit markets and restore liquidity without pushing down rates.

The Fed is reluctant to heed calls from some Wall Street participants and foreign officials for the Fed to directly purchase mortgage-backed securities to help a market that still is not functioning normally.

Such speculation has even reached Canada (hat tip: Assiduous Reader madequota):

Canadian Finance Minister Jim Flaherty said on Wednesday he expects Group of Seven finance ministers to adopt the Financial Stability Forum report with “perhaps some amendments.”
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One of the many options is a plan to recapitalize banks and repurchase mortgages, with the possible use of taxpayer money.

… but US participation in such a plan seems a little dubious:

“The use of public balance sheets may be needed to help financial and housing markets,” Simon Johnson, the IMF’s chief economist, said at a news conference on the fund’s report today in Washington. Fund economists anticipate a 14 percent to 22 percent slide in U.S. house prices.

The Bush administration has opposed using government funds to purchase mortgages or mortgage-backed securities, as proposed by some U.S. lawmakers.

… although some big players favour the idea:

A March 13 proposal by Senator Christopher Dodd and Congressman Barney Frank that the Federal Housing Administration insure refinanced mortgages after lenders reduce the loan principal to make payments more affordable to homeowners “is the next step,” Senator Charles Schumer, a New York Democrat, said in a Bloomberg Television interview on March 19. It’s a “broader step, but not as broad as [Resolution Trust Corp. (RTC)],” he said.

For Pimco’s Gross that’s not enough. “If Washington gets off its high `moral hazard’ horse and moves to support housing prices, investors will return in a rush,” he wrote in a note to investors published Feb. 26. Gross, who runs the $122 billion Total Return Fund from Newport Beach, California, didn’t return calls seeking additional comment.

An RTC-like entity may not be “the best idea, but maybe it’s the idea that gets us through this,” said New York Life Investment Management’s Girard. “The likelihood of it happening has certainly increased.”

A certain amount of impetus for the idea comes, apparently, from the Bank of England. A recent speech by PMW Tucker of the BoE outlines the central banks’ conundrum:

The serious puzzle which that underlines is why there is a dearth of buyers for the supposedly undervalued paper. With the terms and availability of financing from banks and dealers having tightened, levered funds are hardly likely to be the US Cavalry. But it is interesting that there has not been more interest from investment institutions with ostensibly long holding periods, which are largely unlevered and are not exposed to liquidity risk from borrowing short and lending long. What we commonly hear from contacts is that investment managers do not want to be caught out if asset prices fall further before they recover. But no one can seriously believe that they can spot the bottom of the market, and short-term horizons should not weigh heavily in longer-term investment institutions. All of which suggests that there may be structural impediments. Those could include some combination of the reasonable difficulty that some asset managers experience in assessing the quality of securitised assets; and mandates and accounting policies that may have the effect of shortening asset managers’ time horizons.

… which, to a certain extent, underlines the difference between asset management and the selling of asset management capability that I whine about from time to time. According to Mr. Tucker, at any rate, there is undervalued paper out there that is known to be undervalued. Asset managers, however, are constrained from buying it because all their clients know that it’s all worthless garbage and will fire them if they do. Even if their clients – who are largely pension funds – are OK with the idea, the pension funds might expect difficulties from their clients, the beneficiaries, should this paper be bought and the prices move down a penny. So we have a coordination problem and overall conditions get worse.

Willem Buiter has no problems with the idea in principle:

If the central bank, or some other government agency, were to act as Market Maker of Last Resort and buy the impaired asset at a price no greater than its fair value but higher than what it would fetch in the free but unfair illiquid market, such a purchase would not be a bail-out. It would also be welfare-increasing.

The central bank is especially well placed to play this role because, as long as the distressed/impaired assets are denominated in domestic currency, the central bank will never become illiquid or insolvent by purchasing them.

Should, despite the fact that the impaired asset was purchased at a price below its fundamental value, the central bank eventually make a loss on the asset, recapitalisation of the central bank by the Treasury (that is, the tax payer) may well be necessary, or at least desirable, if the only alternative is self-recapitalisation by the central bank through monetary issuance.

This possibility of a capital loss and fiscalisation of this loss does not mean that the transaction ex-ante involved a subsidy by the central bank to the owner of the impaired asset, or a bail-out of the owner.

A subsidy is present only if the expected, risk-adjusted, rate of return for the central bank on the purchase of the impaired asset is less than the central bank’s opportunity cost of funds. There is no economic subsidy if the price paid to the seller exceeds what the seller would have received from a sale in the free but illiquid market, as long as the central bank expects to earn an appropriate risk-adjusted rate of return on the purchase.

… but he has not, as far as I know, actually advocated taking that step right now in this instance.

I don’t see a need, at this point, for the central banks to take that ultimate step. The success of regulation – yes, I used the word “success” and I have used it advisedly! – is shown by the fact that the system is still functioning at all. No major players have gone bankrupt (although some may wish to quibble about Bear Stearns) and capital ratios – while certainly lower than optimal and under strain – remain relatively strong.

At this moment, as I’ve said before, I think Bernanke’s got it right in acting as a lender of last resort. My only quibble is that I would like to see a penalty rate applied when lending to investment banks against mortgage collateral … say, maybe, discount rate + 25bp … or maybe a little bit more, just to ensure that the borrowers have a negative carry on the deal and feel some (well, OK, let’s make it “a lot of”) pain, without actually going bankrupt. Additionally, it should be made clear that the facility will be cancelled as soon as the situation has stabilized sufficiently that one or two of them can go bankrupt without causing systemic collapse.

Along these lines, there are reports that Citigroup is biting the bullet and selling $12-billion in loans at a big loss, just to get them off the books.

On a lighter note, the Fed has pointed out that a stunning proportion of the populace is financially illiterate. He feels that financial literacy should be a requirement for a high school diploma … well, first I want to know what will be thrown overboard to make room for such a thing. Make the information available and make it part of optional courses – sure, I have no problems with that.

The market moved up strongly today, with volume continuing fair.

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