PrefBlog

Finally, there is a good crop of links today!

James Hamilton of Econbrowser remarks on a WSJ article about prime no-doc loans, which arose through a Countrywide “Fast and Easy” programme which generated no-doc / low-doc loans which were then sold to Fannie Mae, which has classified them as “Prime”. He has been taken to task in the comments (there are claims that this is not only not news, but isn’t even interesting, since the borrowers were approved due to high credit scores and low loan-to-value). Regardless of whether the story is simply an example of media hysteria, I am as concerned as he is about the big issue:

From page 102 of Fannie’s 2007 Annual Report, as of the end of 2007, the enterprise had leveraged $44 B in stockholders’ equity with $796 B in short- and long-term debt to acquire $761 B in mortgages either held outright or intended for resale or trading. I read that as an equity cushion against a 5.8% loss on the mortgages held directly (44/761 = 0.058). But in addition (page 1), Fannie has guaranteed $2.1 trillion in separate mortgage-backed securities it has sold to outside investors, for a ratio of core capital to total book of business of 1.6%.

From the beginning, my conception of a really big financial meltdown would be one that pulls one of the GSEs into insolvency. Please tell me why it can’t happen.

The GSEs have to start being regulated like banks; there’s no question in my mind about that.

Congress pressured the Fed to rescue the moribund Student Loans securitization market:

A month after the Federal Reserve rescued Bear Stearns Cos. from bankruptcy, Chairman Ben S. Bernanke got an S.O.S. from Congress.

There is “a potential crisis in the student-loan market” requiring “similar bold action,” Chairman Christopher Dodd of Connecticut and six other Democrats wrote Bernanke. They want the Fed to swap Treasury notes for bonds backed by student loans. In a separate letter, Pennsylvania Democratic Representative Paul Kanjorski and 31 House members said they want Bernanke to channel money directly to education-finance firms.

… and, somewhat surprisingly, the Fed responded:

The Federal Reserve announced today an increase in the amounts auctioned to eligible depository institutions under its biweekly Term Auction Facility (TAF) from $50 billion to $75 billion, beginning with the auction on May 5. This increase will bring the amounts outstanding under the TAF to $150 billion.
…
In addition, the Federal Open Market Committee authorized an expansion of the collateral that can be pledged in the Federal Reserve’s Schedule 2 Term Securities Lending Facility (TSLF) auctions.
…
The wider pool of collateral should promote improved financing conditions in a broader range of financial markets.

Bloomberg points out that securitized Student Loans are now eligible:

Fed officials also expanded the collateral they accept under the Term Securities Lending Facility to include AAA rated asset-backed investments. About 95 percent of outstanding student-loan securities are AAA, according to the American Securitization Forum.

In other political news, there are rumblings of tweaking capital requirements for brokerages, which is being puffed up as a major change.

Meanwhile, in deeply upsetting news, I have been advised that the Hershey’s January price increase has percolated through the system to the point where “Mr. Big” chocolate bars are having their price yanked from $1.25 to $1.35. This implies that my total cost of living has increased by 4%; PrefBlog’s future quality may be adversely affected due to malnutrition.

The Globe reports that a decision on ABCP will be delayed:

The judge overseeing the $32-billion restructuring of the seized-up market for asset-backed commercial paper wants to put off a ruling on the plan’s fairness until mid-May, saying he needs more time to review the complex case.

Ontario Superior Court Justice Colin Campbell, who was originally scheduled to rule on the fairness on Friday, said he would like to hold the so-called “sanction” hearing on May 12 and May 13, but could do it sooner in a pinch.

To give more time, the judge asked that a key standstill agreement with banks that prevents a meltdown in the market be extended. The current standstill expires May 9.

“I can’t think possibly how I can get a decision out by May 9,” the judge said.
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The deal, however, includes a controversial clause that would give all the players in the market immunity from lawsuits, something that has angered many holders and led to challenges in court that the judge wants more time to consider.

The lawsuits, if allowed, could run into many hundreds of millions, according to court documents filed Thursday. Aeroports de Montreal, Air Transat A.T. Inc., Cinar Corp., Labopharm Inc. and dozens of other companies laid out the claims they believe they have, which total at least $700-million.

As indicated by Assiduous Reader madequota in the comments to May 1, today was a pretty good day for prefs … but volume was lacklustre. Banks still need to raise cash and we haven’t seen an insurer come to market for quite some time … so there is considerable room for carping regarding the market’s ability to absorb new issues and bad news. Long corporates now yield a hair less than 6.00% so the dividend of 5.72% on PerpetualDiscounts (= 8.01% Interest Equivalent) represents a spread of 200bp … within the range of the last six months.

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

Today’s Workers’ Day, so I’m not doing much. Geez, if I get any lazier, I’m gonna have to become an investor advocate!

But I can’t resist commenting on US Pension Bonds:

Pension bonds are making a comeback, as states and cities from Alaska to Philadelphia bet they can use the proceeds to help fill deficits in their retirement funds and still generate a higher return than what they pay in interest.

Officials may sell a record $35 billion of the securities this year after offerings declined since 2003, according to data compiled by Bloomberg. Connecticut issued $2.2 billion of pension debt last month, paying an average rate of 5.88 percent on money state officials project will earn 8.5 percent when invested.

Hmmm … leveraging up a pension account to hell-‘n’-gone … I have to agree with Jon Corzine:

“It’s the dumbest idea I ever heard,” said New Jersey Governor Jon Corzine, the Democrat and former chairman of investment bank Goldman, Sachs & Co.

Naked Capitalism republishes a Financial Times commentary on the CDS basis:

“In cash bonds, companies [that wish to borrow money] provide an offset to investors [who wish to lend]. This allows an equilibrium between supply and demand to form. In CDS, the lack of supply side creates a major imbalance, which increases volatility.”

The problem is that complex investments known as synthetic collateralised debt obligations previously acted as big buyers of credit risk. But these products have withered and left the CDS market dominated by people who want to sell credit risk (go short, or buy protection) when things look bad, or switch to buying back credit risk to cover their shorts when the outlook improves.

“Until the synthetic CDO market re-emerges, the CDS market might be doomed to heightened volatility, moving above cash levels in bear runs (everyone buying protection) and below in bull runs (everyone covering shorts), while volatility of cash spreads will be tamed by supply/demand forces.”

We need more people trading the basis, that’s what we need! Unfortunately, shorting cash bonds is fraught with peril and expense on the borrowing front, so straightforward arbitrage will not happen … what needs to happen is more real-money bond investors willing to write covered CDS as a synthetic bond. As has been noted, though, there are counterparty and convergence problems with such a process so, if it ever happens, it will be the province of big, big shops who can afford to set up a specialty unit.

Avinash Persaud writes in VoxEU on a topic close to my heart: The Inappropriateness of Financial Regulation. He argues that the root of the problem is:

A good bank is one that lends to a borrower that other banks would not lend to because of their superior knowledge of the borrower or one that would not lend to a borrower to which everyone lends because of their superior knowledge of the borrower. Modern regulators believe this is too quaint, and, to be fair, many banks were not any good at it. But instead of removing banking licenses from these banks, regulators decided to do away with relationship banking altogether and promoted a switch away from bank finance to market finance where loans are securitised, given public ratings, sold to many investors including other banks, and assessed using approved risk tools that are sensitive to publicly available prices. Now, bankers lend to borrowers that everyone else is lending to, the outcome of a process where the public price of risk is compared with its historic average and a control is applied based on public ratings.

… but cautions that …

Almost every economic model will tell you that if all the players have the same tastes (reduce capital adequacy requirements) and have the same information (public ratings, approved risk-models using market prices) that the system will sooner or later send the herd off the cliff edge (Persaud 2000). And no degree of greater sophistication in the modelling of the price of risk will get around this fact.

Instead he suggests that:

• Capital charges (when computing regulatory ratios of financial strength) should be contra-cyclical (rising when credit risk is cheap and vice versa)
• regulation should be based on asset-liability mismatches, not bank/non-bank.
• “requiring banks to pay an insurance premium to tax payers against the risk that the tax payer will be required to bail them out.”

The first item sounds great, but might be a little difficult to apply in practice. Who decides whether risk is cheap or expensive? The weakness of the current system is also its strength: it provides a rules-based framework.

I disagree with the second item. Shadow banks are wonderful and the sector should be encouraged, to ensure the banks don’t get too fat on the fruits of regulation: insurance, central bank access and cheap financing.

The third item sounds like an attempt to intervene in the current UK debate on deposit insurance. The principle is great … let deposit insurance premia vary according to financial strength, as measured by standard capital ratios. I believe – although I’m not sure, and frankly, today I’m too damn lazy to check – that CDIC premia in Canada do vary, at least to some extent.

“Gummy” has announced a new spreadsheet that allows intraday updating of home-made indices. But watch out for dividend ex-dates!

There’s some fairly unclear reporting about BoC Governor Carney’s Senate appearance today. Bloomberg says:

The central bank would be hard-pressed to rescue financial institutions as the U.S. Federal Reserve did with Bear Stearns Cos. earlier this year, Carney hinted.

“People bear the cost of their decisions,” he said. “In the case of financial institutions which would have taken excessive risk, the people who bear the consequences of that are the shareholders and the senior management. There should never have been any doubt about that.”

The Bloomberg story also says, by the way:

Carney said potential losses from the global credit crisis are hard to gauge, because financial institutions have used derivatives to estimate the value of some assets that are difficult to trade. The derivatives have “implied default probabilities” that are “substantially higher” than history would indicate and thus may be overstated, he said.

… which is just what I’ve said about the IMF report. The Bloomberg story was picked up essentially unchanged by the Financial Post. As far as I can tell, the Globe doesn’t mention the Bear Stearns speculation, even in the story about acceptable collateral. The Canadian Press story says:

Mark Carney says the central bank won’t be bailing out Canadian financial institutions like the U.S. government did when the Bear Stearns brokerage, one of the giants of Wall Street, ran afoul of the subprime mortgage mess.

“If you cannot make a judgment (on the value of an asset), you should not own the security,” Carney told a Senate committee Thursday.

“There is very high value if a situation came about to ensuring the shareholders and senior managers bear the full consequences of their actions,” Carney said.

“The Bank of Canada has a role to become lender of last resort, but we would do that on the advice of the Superintendent of Financial Institutions that the institution is solvent, not because the institution needed money.”

Carney said the central bank would come to the rescue of a chartered bank in the case of a temporary liquidity problem, if the institution had sufficient capital to be considered viable.

But he added if investors and managers thought there would always be a safety net, they would be encouraged to take inordinate risks in order to maximize profits.

What got me interested in this was the implied criticism of the Fed in the first quoted sentence, Mark Carney says the central bank won’t be bailing out Canadian financial institutions like the U.S. government did when the Bear Stearns brokerage, one of the giants of Wall Street, ran afoul of the subprime mortgage mess.

So … did he actually mention BSC or is this merely reporter’s interpretation? Further, he’s saying that they’ll be the lender of last resort to solvent institutions … but BSC was solvent at the time according to all the information I have (which is confirmed by the SEC, which serves the same role that OSFI would serve in such a case) … so there’s no real contradiction there, in the remarks which are directly quoted. The rest is all standard Central Banker Talk and doesn’t need further interpretation.

A good, solid, positive day for the preferred share market. Volume was a little unusual – there were six issues trading in excess of 100,000 shares, but volume breadth was down.

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