PrefBlog

S&P cut a whack of bank ratings today, on the following grounds:

• overall assessment of industry risk has been increased
• sensitivity of ratings model to reliance on short term funding has increased
• levels of stress are expected to be higher than typical cycles
• model emphasizing risk-adjusted capital; developing framework that is more risk-sensitive than Basel I and more conservative than Basel II, particularly with respect to market risk and private equity risk.
• “Systemically important” banks will have potential government support recognized

Rating changes were:

• Bank of America, AA- from AA
• Barclays, AA- from AA
• Citibank, A+ from AA
• Credit Suisse, A+ from AA-
• Deutsche Bank, A+ from AA-
• Goldman Sachs, A from AA-
• HSBC, AA (negative outlook) from AA (stable)
• JPMorgan, AA- from AA
• Morgan Stanley, A from A+
• Royal Bank of Scotland, A+ from AA-
• UBS, A+ from AA-
• Wells Fargo, AA+ (negative outlook) from AAA (Watch negative)

Some pretend-managers, very upset by Deutsche Bank’s refusal to execute an out-of-the-money call are very upset:

Deutsche Bank AG’s decision to pass up an opportunity to redeem 1 billion euros ($1.39 billion) of bonds is a setback for financial market stability, according to U.K. and German investment management and insurance groups.

The bank’s choice “will weigh on the markets for months,” said Andreas Fink, a Frankfurt-based spokesman for the BVI German Investment and Asset Management Association, whose 92 members oversee about 1.4 trillion euros of assets.
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“This is a setback for the stabilization of banking markets and is likely to increase funding costs for banks generally,” Jonathan French, the London-based spokesman for the Association of British Insurers, said in an e-mailed statement to Bloomberg News.

S&P’s note on their bank downgrades stated:

We believe that the difficult operating environment will increase payment deferral risk of most regulated financial institutions’ hybrid capital securities in the U.S. and Europe, including the large systemically important banks covered in this review. This is because the difficult environment is expected to pressure financial performance.

Both Sarkozy and our very own Spend-Every-Penny are grandstanding about what a great banking system there would be if only they ran it. However, not all Canadian politicians have their ideas forgotten! California’s civil servants will get Rae days!

Accrued Interest brings an update on the new Term Auction Loan Facility; it looks like the Fed is desperate to get the securitization market started again.

Via Dealbreaker comes a link to a NYT article, Even Winners May Lose with Madoff:

One client said he invested more than $1 million with Mr. Madoff over a decade ago. As his portfolio rose in value, he took out several million dollars. While his statements showed several million dollars in his Madoff account when the fund collapsed last week, the client still ended up ahead.
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But previous court rulings regarding financial frauds suggest the winners could be forced to give up some of their gains to losers.
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Yet even Mr. Madoff’s most fortunate clients may wind up having to give back some of their gains, as investors might have to do in another recent financial fraud, the collapse of the hedge fund Bayou Group in 2005.

In the Bayou case, in which investors lost $400 million, a bankruptcy judge ruled that investors who withdrew money even before Bayou collapsed might have to return their profits, and possibly some of the initial investments, to the bankruptcy trustee overseeing the unwinding of Bayou.

The returned money is to be distributed among all investors, who are expected to receive only about 20 to 40 percent of their original investments.

Mr. Madoff’s winning clients are likely to face similar legal challenges. In fact, the Madoff client who profited from his investment spoke on the condition that he not be identified, out of concern that he might be sought out to repay some of his gains to the receiver or bankruptcy trustee for Mr. Madoff.

This is the worst thing that can happen in a fraud like this. The highlighted investor, it would seem, did everything right (except due-diligence, and nobody does that; it’s too expensive and if you do do it, you’ve got to listen to some whiny little geek who can’t even sell investment strategies tell you that you can’t put your [client’s] money into a sure thing with a great story): he regarded his hedge fund investment as high-risk and rebalanced regularly, taking his money off the table. He has adjusted his investment portfolio – and quite possibly his entire lifestyle – as a result of his ethereal winnings and now has to give them back.

I was once part (a very small, clerical level part) of an investigation of a stockbroker who had been naughty. Little Joe & Jane Lunchbucket had gone out and bought houses – retired, even, if memory serves – on the basis that their accounts were worth lots of money and would support them. The firm made good on actual losses, but not on fictitious winnings. It was a really, really bad situation.

There’s a marvellous post regarding the Madoff scandal on Bronte Capital and a thoroughly fascinating letter to the SEC via the WSJ.

What-Debt? is musing about a $30-billion deficit. I don’t have any problems with a deficit of that size, and I support Econbrowser‘s James Hamilton’s call for the stimulus to take the form of unrestricted grants to lower levels of government. I would go farther than that: there are hospitals and charities (a friend specifically mentioned Habitat for Humanity) who can get shovels in the ground next week if they can get some funding. There should be controls, of course, to ensure that the capital projects are actually useful (unlike Japan’s Ibaraki Airport discussed on December 4); but speed in spending the money is important.

No, my problem with a $30-billion deficit is that we don’t have the money already. Planned debt reduction of $3 billion per year for 2010–11 to 2012–13 based on rosy forecasts of continued good times won’t pay for a lot of recessions. But What-Debt? and Spend-Every-Penny have crippled Canada’s ability to maintain a surplus through a normal business cycle, importing the simplistic US Republican thesis that tax cuts are always good, particularly if the cuts are completely bone-headed, like the GST cut. Throw the rascals out!

Another day of very heavy volume and … the sixth straight decline in PerpetualDiscounts, which now yield 8.31%; edging closer to their recent high of 8.63%. The former, current, figure is equivalent to 11.63% interest at the standard conversion factor of 1.4x; given that long corporates yield about 7.50%, the pre-tax interest-equivalent spread is an astonishing 413bp.

PerpetualDiscounts are currently down 1.48% total return on the month; Split-shares have had a better time of it and are now up 13.11% on the month; probably due to the market’s discovery of monthly retraction possibilities.

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

There’s an amusing story today about bonus policies at Credit Suisse:

Credit Suisse Group AG’s investment bank has found a new way to reduce the risk of losses from about $5 billion of its most illiquid loans and bonds: using them to pay employees’ year-end bonuses.

The bank will use leveraged loans and commercial mortgage- backed debt, some of the securities blamed for generating the worst financial crisis since the Great Depression, to fund executive compensation packages, people familiar with the matter said. The new policy applies only to managing directors and directors, the two most senior ranks at the Zurich-based company, according to a memo sent to employees today.
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Credit Suisse is the first to use the debt to pay employees. Outside investors may also be permitted to invest in the facility, according to the people familiar with the matter, who declined to be identified because the plan hasn’t been made public. The bank will boost the potential for returns by providing leverage to the facility, and will be paid back first, according to the people.

If I am correct – with the support of the BoE – and bank assets have, in general, been written down to far below fundamental value, this is a clever way for the executives to (a) earn brownie points, and (b) give themselves enormous bonuses.

In sad news for bond investors, General Electric’s debt ratings are at risk. This is particularly grievous because GE has long had a well-deserved AAA rating but has yielded like a single-A … and any time you can pick up free credit quality is a Good Time.

Allan Greenspan opines in an Economist op-ed Banks need more capital:

As recently as the summer of 2006, with average book capital at 10%, a federal agency noted that “more than 99% of all insured institutions met or exceeded the requirements of the highest regulatory capital standards.”

Today, fearful investors clearly require a far larger capital cushion to lend, unsecured, to any financial intermediary. When bank book capital finally adjusts to current market imperatives, it may well reach its highest levels in 75 years, at least temporarily (see chart). It is not a stretch to infer that these heightened levels will be the basis of a new regulatory system.

Note that the chart shows “Book equity as % of book assets”. I believe that this is equal to the FDIC’s ratio “Equity capital to assets”. The FDIC defines this as “Total equity capital as a percent of total assets”, whereas the more commonly referenced “Leverage Ratio” is

Tier 1 (core) capital as a percent of average total assets minus ineligible intangibles.

Tier 1 (core) capital includes: common equity plus noncumulative perpetual preferred stock plus minority interests in consolidated subsidiaries less goodwill and other ineligible intangible assets. The amount of eligible intangibles (including mortgage servicing rights) included in core capital is limited in accordance with supervisory capital regulations. Average total assets used in this computation are an average of daily or weekly figures for the quarter.

The equity capital ratio for all FDIC insured institutions was reported in their 3Q08 Report to be 9.63%, compared to 10.45% (3Q07); 10.25% (3Q05); and 9.13% (3Q03). Note that Mr. Greenspan’s chart forecasts a massive increase in this ratio without this forecast being justified in the text.

Moody’s cut Citigroup from Aa3 to A2:

Moody’s Investors Service lowered the debt ratings of Citigroup Inc. (senior debt to A2 from Aa3) and the ratings on its lead bank, Citibank N.A. (long-term bank deposits to Aa3 from Aa1). The financial strength rating on the bank was lowered three notches to C from B, which translates to a change in the baseline credit assessment to A3 from Aa3. The outlook on the bank financial strength rating is negative and the rating outlooks on the deposit and debt ratings at both the bank and the holding company are stable.
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Moody’s said that its downgrade of Citigroup’s debt and deposit ratings was moderated by Moody’s opinion that Citigroup enjoys a very high probability of systemic support from the U.S. government. The benefits of this systemic support partially offset the deterioration in Citigroup’s stand-alone credit quality, which is driven by worsening asset quality and the likelihood that Citigroup could see further decline in its tangible capital base in the next two years.

This had immediate contagion effects, with HSBC getting hammered in Hong Kong. Look out below!

Holy smokes, what a day. Very heavy volume and the market tanked. An Assiduous Reader wrote in:

Another dismal day for PerpetualDiscounts on fairly big volume. Could this downward momentum be caused by margin calls…forced selling…or panicking investors and their advisors?

I’m ready to pull the sell trigger myself….Clients will be in disbelief with Dec 31st statements.

Well … I still like the tax-loss-selling hypothesis. It fits with the season, volume and direction. Margin calls and forced selling, not so much, because I don’t think a lot of prefs are bought on margin, or are held in margin accounts that are levered to the max (I could be wrong. It would be interesting to see some figures). Panicking clients? I would think that any client with the guts to hang in this long will consider recent declines to be a mere bagatelle, but panicking advisors sounds more possible. There will be a fair number of clients who haven’t received a statement since September and things …. are a little different now.

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