PrefBlog

Here’s another good reason to avoid working for a bank:

Treasury Secretary Timothy Geithner said federal bank regulators and the Securities and Exchange Commission will play key roles in the administration’s effort to change the way financial executives are paid.

Geithner said the Obama administration is moving ahead with its guidelines on corporate compensation, part of a broader plan for an overhaul of financial regulation that will be announced next week. Changes are needed so bank executives aren’t enticed to take on too much risk, he said.

You will note that regulators are the chosen method of enforcement, not ownership – so efforts to repay TARP funds will only go so far. It will be most interesting to see how this plays out … will the big banks start contracting out work they want done properly? Or will they embrace the Canadian cult of mediocrity?

DBRS today revised its methodology for Secured Leveraged Loans:

Under the revised policy, the result of any notch-up of the instrument rating for a high-yield issuer will be limited to an instrument rating of BBB (low), regardless of the level of the recovery rating that may have been assigned to the instrument.

In assigning ratings to leveraged finance (i.e., high-yield) issues, DBRS first assigns an issuer rating that reflects the default risk of the issuer itself, then assigns separate recovery ratings and instrument ratings to the issuer’s specific debt instruments. The instrument rating is a blend of both the issuer rating and the recovery rating and, therefore, may be notched up from the issuer rating in cases where the recovery rating reflects above-average post-default recovery prospects. Likewise, the instrument rating may be notched down in cases where the recovery rating reflects diminished recovery prospects.

The likelihood of default is more remote for investment-grade issuers, which is why DBRS only assigns recovery ratings to non-investment-grade issuers. The effect of this policy refinement is to lessen the weighting of recovery on the instrument ratings of non-investment-grade credits that are on the cusp of becoming investment grade. DBRS believes – and empirical data demonstrates – that default is a substantial possibility for issuers in the B category and below; therefore, the recovery outlook should weigh relatively heavily on the instrument rating. As a company moves through the BB range and approaches investment grade, the likelihood of default is significantly less, and it is appropriate to restrict the beneficial impact of the recovery rating on the final instrument rating outcome.

This resulted in changes of rating for Sears MTNs:

In Sears Canada’s case, the Company was originally assigned an issuer rating of BB. However, based on DBRS’s recovery analysis, expected recovery is 90% to 100% for the MTN holders in a post-default scenario. This level of recovery equates to a recovery rating of RR1 and an MTN rating of BBB, or three notches above the issuer rating (see the DBRS rating report dated September 19, 2008).

In reviewing our leveraged finance methodology, DBRS noted that as a company moves through the BB rating range and approaches investment grade, the likelihood of default is significantly less; therefore, DBRS felt it appropriate to restrict the beneficial impact of the recovery rating on the final instrument rating outcome. Thus, the effect of this policy refinement is to lessen the weighting of recovery on the instrument ratings of non-investment-grade credits that are on the cusp of becoming investment grade.

The revised leveraged finance methodology has therefore capped Sears Canada’s MTN rating at BBB (low), two notches above the issuer rating.

… and Domtar:

Domtar was originally assigned (and maintains) an Issuer Rating of BB. However, based on DBRS’s recovery analysis, the Secured debt was assigned a recovery rating of RR1, which assumes an expected recovery of 90% to 100% in a post-default scenario. The RR1 equated to a Secured rating of BBB, or three notches above the issuer rating (see rating report dated May 12, 2009).

In reviewing our leveraged finance methodology, DBRS noted that as a company moves through the BB rating range and approaches investment grade, the likelihood of default is significantly lower. Therefore, DBRS felt it appropriate to restrict the beneficial impact of the recovery rating on the final instrument rating outcome. The effect of this policy refinement is to lessen the weighting of recovery on the instrument ratings of credits that are on the cusp between investment grade and non-investment grade.

The revised leveraged finance methodology has therefore capped Domtar’s Secured rating at BBB (low), which is effectively a two-notch upgrade above the issuer rating.

Connor Clark has announced:

the closing of the initial public offering of Canadian Banc Capital Securities Trust (“Canadian Banc” or the “Fund”). The Fund raised gross proceeds of $96,289,000 from the issuance of 3,600,000 Class A Units and 251,560 Class F Units (collectively the “Units”) at a price of $25.00 per Unit.

Excuse me for living, but this product looks completely insane to me. Expenses are:

• 5.25% New issue selling commission on the Class A units. (one-time)
• About maybe 0.7% issue expenses (one-time)
• Management fee of 0.50%
• Service fee of 0.40% on Class A units
• 0.35% Counterparty fee
• Ongoing expenses of 0.15%

Amortizing the issue expenses over the five year life of the fund and assuming all units are Class A gives you an MER of 2.45%. The counterparty fee is there because the fund is structured to pay the income as return of capital / capital gains.

And all for what? A FIVE YEAR investment in PERPETUAL SECURITIES. That fact alone makes my hackles rise; you can just bet it’s being sold to Granny as a five year investment. They justify this in the prospectus by using pretend-maturities:

The Portfolio Manager uses the first date upon which the securities may be called at par (rather than the legal maturity) in order to calculate duration. Based on this approach, the duration of the Indicative Portfolio is approximately 6.4 years.

The preferred share market had another strong day today, as FixedResets continued their march towards a zero percent yield-to-call!

More evidence that the credit markets are mending, this time from the CDO market:

A “remarkable change” in investor sentiment has doubled the price of some collateralized loan obligation securities in the past month, according to Morgan Stanley analysts.

CLOs are a type of collateralized debt obligation that pool high-yield, high-risk, or junk, loans and slice them into securities of varying risk and return. Pieces graded AA, the third highest-level of investment grade, rose from 23 cents on the dollar to 47 cents in the past month, Morgan Stanley analysts led by Vishwanath Tirupattur wrote in a June 5 report. Securities ranked A have gained 13 cents from 10 cents since the end of last month, the report said.

Ares Management LLC and Boston-based Sankaty Advisors LLC are among investors that started bidding on CLO securities in late April and the first week of May. Prices for the single-A portions had dropped 90 percent since the financial crisis began in 2007 even as the loans packaged in them had regained some their value. The S&P/LSTA U.S. Leveraged Loan 100, an index of loans rated below investment grade, rose 12 cents from Dec. 31 to 73.6 cents on the dollar on May 1. Loans have since increased in value to 79 cents.

“The continuing rally in underlying leveraged loans has been a major driver of this change in investor sentiment,” on CLOs, the analysts wrote in the report. A “fierce rally” is under way, they wrote.

The top-rated CLO bonds have risen from 71 cents on the dollar to 77 cents since May, the report said.

At the same time, hedge fund financing is getting a little harder:

HSBC Holdings Plc’s U.S. securities division will no longer extend structured financing to hedge-fund investors to leverage their investments, a person familiar with the company’s plans said.

The bank is halting the financing by its structured-funds products division and eliminating an unspecified number of jobs in New York, said the person, who asked not to be identified because the information hasn’t been made public. The group reports to Steven Phan, global head of the investment access and solutions groups in London, the person said. Phan declined to comment.

Remember those charts comparing the current bear to others? They’re looking a lot better now, but into the breach step Barry Eichengreen & Kevin H. O’Rourke, just in case anybody’s feeling cheerful, with a piece on VoxEU A Tale of Two Depressions:

This is an update of the authors’ 6 April 2009 column comparing today’s global crisis to the Great Depression. World industrial production, trade, and stock markets are diving faster now than during 1929-30. Fortunately, the policy response to date is much better. The update shows that trade and stock markets have shown some improvement without reversing the overall conclusion — today’s crisis is at least as bad as the Great Depression.

Click for big

Click for big

On a brighter note, equities were rescued from a bad day by Nobel Laureate Paul Krugman:

The U.S. economy probably will emerge from the recession by September, Nobel Prize-winning economist Paul Krugman said.

“I would not be surprised if the official end of the U.S. recession ends up being, in retrospect, dated sometime this summer,” he said in a lecture today at the London School of Economics. “Things seem to be getting worse more slowly. There’s some reason to think that we’re stabilizing.”

FixedResets had another good day, bringing the median YTW down to 4.81%. Since 5-Year Canadas have now gapped up to 2.69%, it is interesting to speculate on the terms of the next FixedReset issue. Could a bank do something at 5.00%+230?

The recession is getting worse more slowly than expected:

Payrolls fell by 345,000, the least in eight months, after a revised 504,000 loss in April, the Labor Department said today in Washington. The jobless rate increased to 9.4 percent, the highest since 1983, in part as more people joined the labor force to look for work.

“The recession is very close to an end,” said Nariman Behravesh, chief economist at IHS Global Insight in Lexington, Massachusetts, whose payrolls forecast matched the closest estimate in a Bloomberg News survey. “The labor market is still pretty awful, but vastly better than it was.”

The jobs number had an immediate effect on Treasuries:

Yields on two-year Treasuries increased 28 basis points to 1.24 percent, the biggest one-day increase since Sept. 20. The price on the benchmark 0.875 percent note maturing in May 2011 fell 17/32, or $5.31 per $1,000 face value to 99 98/32, according to BGCantor Market Data.

Implied yields on eurodollar futures as well as federal fund futures contracts, both used to speculate on changes in central-bank policy, surged, with further-deferred contracts posting the largest increases. The yield on the December 2009 eurodollar contract rose 26 basis points today to 1.26 percent, while the December federal-funds futures contract yield increased 21 basis points to 0.54 percent.

Fed-funds futures contracts, which traded on the Chicago Board of Trade, show traders see a 65.7 percent probability the central bank will lift its target rate for overnight bank borrowing by at least 0.5 percent by November from its current zero-to-0.25 percent range. That’s up from 26.8 percent odds yesterday.

But Across the Curve thinks this is ludicrous:

Someone just pointed out that typically the Federal Reserve does not raise rates and unravel an ease until there has been at least six months of job growth. So any possibility of the FOMC raising rates this year is virtually nil.

The trade today is about position management. The entire world is (was) long the yield curve. Profit taking began and forced more profit taking as investors and traders dis not want to watch profits evaporate.

The Canadian jobs picture was awful, but you will look in vain for any worst-case scenarios in 5-year-old government budget documents to assess the effectiveness of contingency planning.

The Kansas City Fed has released its Spring 2009 edition of TEN, it’s general-readership publication. It reprints a speech by Thomas Hoenig, the President, titled “Too Big has Failed”, which mainly addresses current and future cures, rather than prevention. He does note:

We must also look for other ways to limit the creation and growth of firms that might be considered “too big to fail”.

… without making any suggestions. There’s also an article on the markets in water which many will find of interest; I continue to believe that Cleveland will rise again due to its proximity to the Great Lakes; just maybe not this century.

In these uncertain times, it is difficult for regulators to decide what to do. There’s no rule-book, precedents are scarce and there is a high risk of unintended consequences. It is therefore a pleasure to see that in the case of Bank of America, increased regulatory scrutiny – not to mention increased regulatory bullying, with Hank Paulson as the primary enforcer, as mentioned on May 14 – has achieved its objective:

Bank of America Corp., facing the biggest projected losses among lenders subjected to stress tests, will remake its board by adding two ex-regulators and two former bankers as directors.

The new directors are Susan Bies, 62, a former Federal Reserve Board governor; Donald Powell, 67, an ex-Federal Deposit Insurance Corp. chairman;

Now all they have to do is get rid of those damn bankers…

The preferred market continued its ascent today on continued good volume.

I noted yesterday that there had been a huge rally in junk bonds fuelled – at least in part – by issuer bids. The same thing is happening in asset-backeds:

European companies have increased purchases of their asset-backed bonds tenfold this year, taking advantage of prices that slumped 70 percent and signaling to investors that the worst of the recession may be over.

HSBC Holdings Plc, Europe’s biggest bank, is offering to buy as much as 4 billion pounds ($6.5 billion) of its notes secured by company loans. Canary Wharf Group Plc bought 119.8 million pounds of debt backed by offices in London’s second financial district in April.

All told, more than $1.8 billion of the debt was repurchased through public auctions this year by banks, real estate companies and the owner of the Greene King pub chain, according to data compiled by Bloomberg. That’s up from $164 million in all of 2008.

The Bank of Canada kept the overnight rate at 25bp:

Information received since the Bank’s April Monetary Policy Report (MPR) is broadly consistent with the Bank’s medium-term outlook for output and inflation in Canada. The economy is undergoing major restructuring in a number of sectors. The already significant output gap will continue to widen through the third quarter, putting downward pressure on inflation. The Bank continues to expect that the global and Canadian recoveries will be more muted than usual.

In recent weeks, financial conditions and commodity prices have improved significantly, and consumer and business confidence have recovered modestly. If the unprecedentedly rapid rise in the Canadian dollar (which reflects a combination of higher commodity prices and generalized weakness in the U.S. currency) proves persistent, it could fully offset these positive factors.

The outlook is subject to considerable uncertainty. While the underlying macroeconomic risks are roughly balanced, the Bank judges that, as a consequence of operating at the effective lower bound, the overall risks to its inflation projection remain tilted slightly to the downside.

Conditional on the outlook for inflation, the target overnight rate can be expected to remain at its current level until the end of the second quarter of 2010 in order to achieve the inflation target.

After today’s gains, PerpetualDiscounts now yield 6.31%, equivalent to 8.83% interest at the standard equivalency factor of 1.4x. With all these gains they still lagged long corporates, which now yield 6.7%, so the pre-tax interest-equivalent spread is now about 213bp.