PrefBlog

The Apocalyptionists will be upset! Not only did DTCC close out Lehman’s CDS book without loss:

it successfully closed out over $500 billion in market participants’ exposure from the Lehman Brothers, Inc. (Lehman) bankruptcy which occurred the week of Sept. 22. This was the largest close-out in DTCC’s history. DTCC reports it does not expect there to be any impact to its retained earnings or to market participants’ clearing fund deposits as a result of closing out these pending trade obligations.

“The liquidation of Lehman was complex, involved multiple asset classes, and required a methodical approach to mitigate potential losses from outstanding trading obligations,” said Donald F. Donahue, DTCC chairman and CEO. “Without question, our ability to manage risk and see exposure from a central vantage point was instrumental in helping us ensure that market risk – and systemic risk – was avoided.

… but settlement of CDS obligations on Lehman itself proceeded seamlessly …

On Oct. 21, DTCC also completed, without incident, the automated credit event processing of Lehman Brothers Holdings Inc. (LBHI) involving $72 billion of credit default swaps. DTCC calculated and bilaterally netted all amounts due on credit default swaps written on LBHI. This resulted in approximately US$5.2 billion owed from net sellers of protection on LBHI to net buyers of protection. The portion of this net funds settlement allocable to trades between major dealers was handled through the normal settlement procedures of CLS Bank International, DTCC’s settlement partner for the Warehouse and the world’s central settlement bank for foreign exchange.

DTCC also announced:

it will begin to publish aggregate market data from its Trade Information Warehouse (Warehouse), the worldwide central trade registry it maintains on credit derivatives. Starting Tuesday, November 4 and continuing weekly, DTCC will post on its website www.dtcc.com/derivserv the outstanding gross and net notional values (“stock” values) of credit default swap (CDS) contracts registered in the Warehouse for the top 1,000 underlying single-name reference entities and all indices, as well as certain aggregates of this data on a gross notional basis only. The data is intended to address market concerns about transparency.

According to their 2007 Annual Report:

While the total outstanding of credit default swaps (CDS) has grown to $45.5 trillion in 2007 from $3.7 trillion in 2003, our Deriv/SERV platform has been credited with significantly reducing the risk previously associated with unconfirmed trades. Today, over 90% of CDS trades are matched and confirmed through Deriv/SERV, compared with 15% late in 2003.

I have added the warehouse information address to the links, under “US Fixed Income Data”.

The Treasury guarantee of bank debt – reported on October 27 as seeming cheap – is mired in confusion:

Almost three weeks after the government threw its guarantee behind new bank bonds, no U.S. finance company has braved the market.

While Citigroup Inc., JPMorgan Chase & Co. and Bank of America Corp. were the three largest U.S. banks issuing debt last year, they haven’t sold dollar-denominated corporate bonds since August.
…
Banks are hamstrung because they’re waiting for the “fine print,” said Ira Jersey, an interest-rate strategist at Credit Suisse Group AG in New York. Because they don’t know if the debt will be guaranteed under all circumstances, bonds are difficult to price, he said.

Mind you, the Commercial Paper programme – that is busily grossing up the Fed’s balance sheet – is working great!

Interest rates on U.S. commercial paper fell to about the lowest in four years after the Federal Reserve said it absorbed more than 9 percent of the market.

Interest rates on the highest-ranked 30-day commercial paper dropped 39 basis points to 2.02 percent, about the lowest in four years, according to yields offered by companies and compiled by Bloomberg. Yields on overnight and seven-day paper fell to the lowest levels in at least 13 years, Bloomberg data show.

Naked Capitalism reprints a Financial Times article regarding the effect of changes in bankruptcy law on the recent investment bank collapses:

The 2005 changes made clear that certain derivatives and financial transactions were exempt from provisions in the bankruptcy code that freeze a failed company’s assets until a court decides how to apportion them among creditors.
…
Lawyers said under the old rules, creditors of companies facing financial difficulties were wary of settling trades or seeking extra collateral because they knew such demands could precipitate a bankruptcy filing and potentially freeze their claims.

However, when the financial health of Bear, Lehman and AIG took a sharp turn for the worse this year, their trading counterparties – mainly hedge funds and other banks – were not deterred from seeking to settle their trades or forcing the three companies to put up more collateral.

Such pressure exacerbated the liquidity squeeze that ultimately forced the three companies to hoist the white flag. Bear was sold to JPMorgan in a cut-price deal in March, while Lehman filed for bankruptcy last month and AIG was rescued by a $120bn government loan.

Calculated Risk provides a thoroughly fascinating graph (via Dealbreaker and Abnormal Returns) [click for big]:

And, just to make Hallowe’en a little scarier, the FDIC closed down another bank:

As of October 17, 2008, Freedom Bank had total assets of $287 million and total deposits of $254 million. Fifth Third agreed to assume all the deposits for a premium of 1.16 percent. In addition to assuming the failed bank’s deposits, Fifth Third will purchase approximately $36 million of assets. The FDIC will retain the remaining assets for later disposition.
…
The FDIC estimates that the cost to the Deposit Insurance Fund will be between $80 million and $104 million. Fifth Third’s acquisition of all deposits was the “least costly” resolution for the FDIC’s Deposit Insurance Fund compared to alternatives. The last failure in Florida was First Priority Bank, Bradenton, which was closed on August 1, 2008. Freedom Bank is the seventeenth FDIC-insured institution to be closed this year.

A small bank, but look at the proportions! They had $287-million in assets, and Fifth Third is buying $36-million of them. That leaves the FDIC with $251-million and they’re expecting a loss of between $80-million and $100-million. Now that’s a whacking!

And that’s the end of another month – and it was a pretty horrible one for prefs, believe me! I’ll be doing all the usual posts shortly, but a brief examination is sufficient to conclude that CPD lost 7.21% on the month … a huge number for such a thoroughly diversified fund. MAPF, on the other hand, traded like gangbusters – an absolutely massive trading month – and, while still having lost money, will have out-performed CPD substantially.

The key to portfolio management is to arrange your portfolio into various asset classes that will meet your long terms goals without subjecting the portfolio as a whole to extreme short term risk. Then – and this is where I come in – you attempt to outperform within each asset class.

What a day on the market! Hefty volume, some very chunky crosses and a sharp move upwards! If only there had been more days like that this month!

PerpetualDiscounts were up 1.6586% to yield 6.90% (pre-tax price-weighted mean YTW). At the standard 1.4x equivalency factor, this is equivalent to 9.66% interest; long corporates ar at 7.5%, so the pre-tax interest-equivalent spread is 216bp … starting to narrow, but the bonds are wide!

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

There is news of a substantial drop in LIBOR:

The swap agreements with central banks, which also followed rate cuts from China to Norway, led to a drop in three-month rates in Asia. The London interbank offered rate, or Libor, for three- month loans in dollars slid 23 basis points to 3.19 percent today, its 14th consecutive drop, according to the British Bankers’ Association. The overnight dollar rate tumbled 41 basis points to 0.73 percent, the lowest level since at least January 2001.
…
The three-month Libor for dollars remains 219 basis points above the Fed’s rate, up from 82 basis points the day Lehman failed. It was 192 basis points yesterday before the rate cut.

The re-intermediation (novo-intermediation? It hasn’t really been done before) by the Fed in the US commercial paper markets (discussed last weekend) has continued big-time with the Fed’s latest H.4.1 release showing an increase of nearly $200-billion in deposits from banks, offset by a decline of $36-billion in Treasury balances, an increase of $145-billion in commercial paper holdings and an increase of $22-billion in foreign currency assets.

I expressed concern yesterday that the Excess Reserves / Discount Window spread, at 60bp, was too small to encourage reintermediation by the the banks – I’d like to see that bumped to 85bp just for starters. But I’m less concerned about the spread on the Commercial Paper Funding Facility – at 235bp for regular commercial paper, it’s high enough to encourage reintermediation by the banks as soon as they’re feeling a little braver.

Derek DeCloet has a column in today’s Globe cackling with glee over hedge funds that didn’t hedge; in this category comes a fund from Deephaven which is being deep-sixed:

Deephaven Capital Management LLC, the hedge-fund unit of stockbroker Knight Capital Group Inc., froze a $1.6 billion fund after investors asked to get back 30 percent of their money.

Withdrawals from the Deephaven Global Multistrategy Fund were suspended so managers wouldn’t be forced to sell assets in falling stock and debt markets, the Minnetonka, Minnesota-based firm said today in a letter to investors. Lenders and trading partners also imposed stricter financing requirements, according to the letter.

If it was an actual hedge fund, of course, they would be buying just as much as selling. But perhaps I quibble.

Treasury today released guidance on tax breaks for Fannie & Freddie preferred share investors (as long as they’re banks):

The Treasury Department and the Internal Revenue Service today issued Revenue Procedure 2008-64 (Rev. Proc. 2008-64), which provides that certain gains and losses from indirect ownership of Fannie Mae and Freddie Mac preferred stock can be treated as ordinary income and loss.

The Emergency Economic Stabilization Act of 2008 (EESA) provided banks and certain financial institutions ordinary treatment for gains and losses on direct investments in preferred stock of Fannie Mae and Freddie Mac. It also directed the Treasury Department to issue guidance with respect to the treatment of these gains or losses when realized indirectly through certain investment vehicles.

Rev. Proc. 2008-64 provides banks and certain other financial institutions the benefit of ordinary treatment on gains and losses that they are experiencing on certain indirect investments in this preferred stock.

And, just to ensure everybody is cheerful, there is news of a lock-up in the Japanese bond market:

Japanese yen corporate bond sales dried up in the second half of October as the seizure in global credit markets, plunging equity values and volatility in the Asian nation’s currency deterred investors.

Toyota Finance Corp. was the last company to sell yen bonds when it issued 42 billion yen ($428 million) of three- and five- year notes on Oct. 15, data compiled by Bloomberg show. The Tokyo-based lessor reduced that sale from a planned 50 billion yen after market turmoil pushed up borrowing costs, a company official said at the time.

“The credit market is dead,” said Kazuaki Oh’e, a debt salesman in Tokyo at CIBC World Markets Japan, part of Canada’s fifth-biggest bank. “Investors don’t want to buy anything because there’s so much credit risk right now.”

An active day for prefs – and there were many lower-quality issues trading in good volume that weren’t included in the tally.

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

Deflation? Econbrowser‘s James Hamilton doesn’t think so!

If the U.S. were ever to arrive at such a situation, here’s what I’d recommend. First, have the Federal Reserve buy up the entire outstanding debt of the U.S. Treasury, which it can do easily enough by just creating new dollars to pay for the Treasury securities. No need to worry about those burdens on future taxpayers now! Then buy up all the commercial paper anybody cares to issue. Bye-bye credit crunch! In fact, you might as well buy up all the equities on the Tokyo Stock Exchange. Fix that nasty trade deficit while we’re at it! Print an arbitrarily large quantity of money with which you’re allowed to buy whatever you like at fixed nominal prices, and the sky’s the limit on what you might set out to do.

Of course, the reason I don’t advocate such policies is that they would cause a wee bit of inflation. It’s ridiculous to think that people would continue to sell these claims against real assets at a fixed exchange rate against dollar bills when we’re flooding the market with a tsunami of newly created dollars. But if inflation is what you want, put me in charge of the Federal Reserve and believe me, I can give you some inflation.

The Fed announced:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 1 percent.
…
In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 1-1/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Cleveland, and San Francisco.

The cut to 1.00% Fed Funds was widely anticipated. Remember that interest on excess reserves is Fed Funds less 35bp … the Fed is earning a spread of only 60bp on excess reserves to Discount Window. I would have been much more comfortable had the discount rate been lowered only 25bp to 1.50%.

There are indications that CDS rates are being used to price loans:

Nestle SA, the biggest food producer, Nokia Oyj, the largest mobile-phone maker, FirstEnergy Corp., the Ohio-based owner of electric utilities, and at least three other companies bowed to banks’ demands to link the interest rate on credit lines to the swaps, which are used to bet on borrowers’ likelihood of default.
…
[First Energy] would pay Libor plus 3 percentage points to draw on the line, according to company filings. Based on yesterday’s levels, FirstEnergy would be charged an additional 1.70 percentage points, reflecting the levels of its credit- default swaps, and another 1.35 percent to account for the bank’s own spread, according to [First Energy Assistant Treasurer Randy] Scilla.

This is a worrisome development. Events of the past year have shown that the ease of shorting corporate debt with CDSs has led to huge volatility, with some credits (e.g., CIT Group) trading at amazing levels … 2500bp or more, while maintaining an “A(low)” rating that seems entirely justified. While I in favour of market based pricing in a general way, we have seen (in the pricing of AAA sub-prime tranches) that total reliance on market pricing implies total reliance on infinite liquidity … and we ain’t there, by a long shot.

Simply put, there isn’t enough depth in the CDS market to ensure that there will be sufficient supply of protection writers when the cowboys take a run at these companies.

On the other hand, the facilities arranged – so far – with these CDS-linked rates are commercial paper back-up lines. Together with the Big Scare due to the recent lock-up of the the CP market, we may see a reduced corporate reliance on money market paper, with a massive term extension – at least to five year notes – to handle the funding instead. This part is a Good Thing, because it will decrease the term mismatch between assets and liabilities on corporate balance sheets.

So right now, it is unclear how this will play out, as is the case with so much of the structural change that taking place in financial markets right now.

Speaking of shorts how about that VW, eh?:

Porsche, a rival seeking to build one of Europe’s great car dynasties, revealed it had increased its holdings in VW, giving it an economic stake equal to about 75 percent of the company’s voting shares.

Volkswagen’s stock soared to as high as 1,005 euros a share, about $1,258, on Tuesday before closing at 918 euros. The shares ended last week at 210 euros.
…
On Sunday, Porsche said it raised its stake in Volkswagen to 42.6 percent from 35 percent, and that it had taken options for another 31.5 percent.

Porsche said it made the announcement to give investors who sold the stock short “the opportunity to close their positions unhurriedly and without bigger risk.”

The opposite happened. The risk soared, and the short sellers were forced to act quickly.
…
Volkswagen is one of the 30 companies in the DAX index, Germany’s most prominent stock index, and index funds own a significant number of shares.

Those funds, however, may sell shares Wednesday. On Tuesday night the German stock exchange said it would reduce from 27 percent to 10 percent the weighting of VW in the index. To rebalance, the funds will have to sell VW and buy the 29 other companies.

The re-weighting of VW in DAX is a disgrace:

“This adjustment is an extraordinary measure,” Deutsche Boerse said in a statement yesterday. The reduction will take place on Nov. 3, and the weightings of other DAX companies will also be adjusted at that time.

Changing the rules because some short-sellers are getting toasted? That’s not your job, guys! If you want to create a capped index – as the Toronto Exchange did after the Nortel fiasco – that’s fine … but the occasional gruesome loss is part of the risk of being short, and the occasional bonus profit is part of the reward of being long.

As Dealbreaker so eloquently states:

That’s the other shoe dropping right there. Shares drop 50%, it’s a regulatory failure. Shares spike 400%, its a regulatory failure.
…
When are we going to let risk be risk? These are all big boys playing with Volkswagen. Had it gone right, they would have made big profits.

BCE has announced its 3Q08 Operating Results, and it doesn’t seem – to me – to help the chances for a successful conclusion of the takeover much.

BCE’s cash from operating activities was $1,649 million this quarter, up 2.7% from last year. BCE’s free cash flow [footnote 3] of $89 million this quarter was lower than $425 million in Q3 2007 due to the expenditure of $741 million for AWS spectrum licences partly offset by a reduction of $293 million in common dividends paid.
…
[Footnote 3 – extract] We define free cash flow as cash from operating activities after capital expenditures, total dividends and other investing activities.

BCE is also looking at a significant mark-to-market hit on its pension obligations.

Another fairly active day on the preferred market, with players trying to figure out where things are supposed to be! There are plenty of instances of yield relationships between issuers being completely haywire.

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

The Fed is pushing hard for a CDS Clearinghouse:

The Federal Reserve has given U.S. futures exchanges until Oct. 31 to present written plans on how they’ll make the $55 trillion credit swaps market less risky, according to four people familiar with the discussions.
…
Federal Reserve officials are not aiming to pick a winner to operate a clearinghouse, the people said. Rather, the central bank is hoping to set up a framework for the eventual winner.
…
The four groups vying to operate clearing operations include partnerships of Chicago-based CME Group and Citadel Investment Group LLC, and Intercontinental Exchange, dealer-owned Clearing Corp. and credit-swap index owner Markit Group Ltd. Eurex AG and NYSE Euronext also have submitted proposals.

The last major review of the clearinghouse on PrefBlog was my reaction to Accrued Interest‘s plan. On September 22 I deprecated his idea of trading only CDSs with a recovery lock.

On VoxEU, John Kiff, Paul Mills and Carolyne Spackman project a resurgence of covered bonds. While the essay suffers from the mind-set that the credit crunch happened because credit rating agencies are dumb and more rules will make them smart, the provide some interesting charts:

In a welcome piece of news, Bloomberg reports:

Sales of longer-term commercial paper soared 10-fold after the Federal Reserve began buying the corporate IOUs, a sign that the central bank’s efforts to unlock the market may be working.

Companies yesterday sold more than 1,500 issues totaling a record $67.1 billion of the debt due in more than 80 days, compared with a daily average of 340 issues valued at $6.7 billion last week, according to data published by the Fed. Most of the difference was probably absorbed by the Fed, said Adolfo Laurenti, a senior economist at Mesirow Financial Inc.

The source data from the Fed shows that the increase in issuance was almost entirely at the long-end, probably 90-day paper.

Accrued Interest looks at agency paper and likes it, despite the fact that position limits for Taiwanese insurers are being reduced:

The danger is that Asia doesn’t seem to agree. Selling of both Agency debt and MBS securities have been concentrated in Asia the last several days. We know that that Taiwanese insurance regulators are limiting allowable exposure to U.S. agency mortgage-backed securities, claiming the credit rating cannot be believed. If China or Japan were to come to the same conclusion, there would be real problems real fast.

The good news is that despite heavy selling from Asia, agency spreads (and MBS spreads for that matter) have moved wider slowly. Agency spreads are about 60bps wider this month, whereas corporate spreads have moved 117bps wider.

The Taiwanese rule change is:

Where previously there was no limit to investments in MBS issued by US federal housing loan agencies, namely Fannie Mae, Freddie Mac and Ginnie Mae, insurers will now be given a maximum ceiling of 50% of their offshore investment limit to such products by the three institutions. Maximum exposure to MBS and collateralised issues by any of the individual agencies will be set at 25%.

Now, this is the danger. On the weekend, I discussed the Fed’s balance sheet in terms of the Fed intermediating between the banks and credit risk, in the same manner as banks intermediate between Granny Oakum and credit risk. This is a natural thing and this is a good thing, but the Fed’s ability to do so is constrained by the ability to sell Treasury debt. Eight years of fiscal profligacy have eroded the available excess capacity … I don’t think we’re in trouble yet, but this is the type of thing that signifies trouble.

Just because equities were up so much today doesn’t mean we can relax! There are rumours that Barclays has foreclosed a hedge fund:

Barclays Plc, the U.K.’s second- largest bank, is seeking bids for $1.5 billion of bonds and $3.5 billion of credit-default swap contracts held by a hedge fund, according to people with knowledge of the auction.

The bank is selling bonds from European, Asian and U.S. issuers, according to the people, who asked not to be identified because the sales aren’t being made public. Barclays is also selling $970 million of assets, primarily high-yield, high-risk loans, the people said. Bids on both portfolios are due today.

Somewhat to my chagrin, I see that FixedReset issues are trading as if they were actually 5-year paper, rather than as perpetual paper with a five year call. The recently announced new issues offer a 5.60% coupon, with a continued reset to 5.60 if 5-year Canadas remain unchanged; rather than falling a lot, to offer equivalent perpetual yields, extant Fixed-Resets have fallen a little, to offer equivalent five-year yields with the assumption of a call at par.

In fact, yields to first call of the extant fixed resets are in excess of 5.60%, implying that the new issues will trade at an immediate (small) discount, rather than at the premium they would command otherwise. It’s a funny old world.

Another day of heavy volume, with a number of dealers crossing significant blocks.

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