PrefBlog

Another nervous day

Continuing the recent pattern, Yvon Charest, Industrial Alliance’s President and Chief Executive Officer, gave his portfolio managers a kick in the teeth by usurping their responsibilities. They’re just plain flat out buying the ABCP in their mutual funds – there is no indication as to whether the portfolio managers want to sell (and look, I know that’s a pretty good bet, OK? That’s not the point). Mr. Charest’s track record as a portfolio manager was not disclosed; we can expect unit-holders not to care until conflicts of interest are resolved in a way they don’t like and a newspaper headline tells them to care.

If Mr. Charest wants to play at “Portfolio Managers”, there is nothing to prevent him from issuing index-linked PPNs, and doing it all on his own balance sheet. But if there’s to be a separate balance sheet there has to be independence.

There is no indication as yet that anybody besides me thinks this is important; analyst independence is just so 2002.

On the sub-prime front, large bets are being made agains ResCap’s survival – and ResCap is a big player:

At the end of June, ResCap had tapped those [ABCP] markets for about $5.5 billion in financing, according to regulatory filings.

ResCap has about $18.5 billion in committed financing, CreditSights analyst David Hendler wrote in an Aug. 7 note.

Mortgage companies without any sub-prime on their books, such as Ottimo Funding LLC, are experiencing financing difficulties.

The default reports for July have been released and Fitch has placed $92.1-billion under review. Last month they reviewed $118-billion and downgraded $13-billion of it. There are more calls coming out for a review of the ratings agencies, as the politicians seem to have agreed on a convenient scapegoat. There are more calls for increased regulation of banks, as well.

Yves Smith has published a balanced review of the various critiques of Central Bank actions. Put me in the third camp: Realist (although I would prefer “Pragmatist”). The market is faced with a situation in which nobody will even look at riskier or more complicated debt. The central banks must first ensure that the commercial banks can, in fact, make investment decisions with reasonably assured financing. Then they must increase the spread between government and commercial paper to the point where real investors (as opposed to mere dealers) will at least be interested enough to look at it. Finally, once the normal routine of examining credit and making an actual decision between safe-but-low-yielding and riskier-but-higher-yielding securities has been re-established, we can get back to fighting inflation. And don’t worry, once people start looking at risk/reward with a more jaundiced eye, there will be plenty of losers. But if the credit markets lock up and everybody in the world has to dump assets on the market at give-away prices in order to de-lever, we’re talking deflation. And deflation is bad.

Tom Graff seems to be in so-far-so-good camp as well, while James Hamilton applauds the Fed’s methodology thus far.

There is some speculation that the liquidity crisis is over and we can all go home; fortunately there are cooler heads at the Fed:

“Financial market volatility, in and of itself, doesn’t require a change in the target federal funds rate,” [Richmond Fed President] Lacker said at a luncheon of the Risk Management Association of Charlotte. “Policy needs to be guided by the outlook for real spending and inflation.”

And, in boring news about the real economy, the Cleveland Fed reminds us that inflation, while still worrisome, is showing signs of responding favourably to the Fed’s policies of moderate restraint. 

True to form, however, US equities were up on takeover speculation, so it would seem that some are hopeful the whole episode was just a bad dream. Canadian equities followed.

Canadian banks re-affirmed their committment to providing credit support to their own Asset Backed Commercial Paper (ABCP) products. I can only imagine they’re having difficulty rolling the paper and are attempting to (i) reduce their conduit’s cost of borrowing, and (ii) keep the assets & liabilities off their own balance sheets. Given that their cost of funding, as measured by the September BAX on the Montreal Exchange has risen to about 4.6% (and I’ve seen them much higher), I’m sure they’re about ready to try anything. Note that the Canadian 3-month WI T-Bills are at 4.00% … that’s an amazing spread – according to RBC, the spread was 30bp on August 10, 62bp on August 17.

US 3-month T-Bills finally increased in yield but the 2-10 curve steepened anyway – so let’s not say it’s over just yet! The Canadian 2-10 spread steepened again and is now at 30.5bp. Hank Cunningham provides some historical context.

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

A nervous day in the market today – best illustrated by the fall in US 3-month T-Bills to 3.09%, down 66bp on the day with a Treasury auction coming in at 2.85%.

A serious affront to analyst/portfolio manager independence was delivered by National Bank in the context of their purchase of Asset Backed Commercial Paper that was sold to certain client or held by National Bank branded money market funds:

As a result, our clients can be reassured that the funds will not hold any ABCP until we are convinced of the quality and liquidity of the paper, whether or not it is issued by a major bank.
…
National Bank of Canada, mindful of the best interests of the unitholders of the National Bank Mutual Funds, preferred not to have its clients bear the brunt of this uncertainty and therefore decided to initiate the transaction announced today.

Excuse me? National Bank decided? And ABCP won’t be held until “we” (under the National Bank letterhead) are happy about the credit quality?

I may be a little dense, but Morningstar lists the portfolio manager as Richard Levesque and he works for Natcan, which is registered by the OSC as “Investment Counsel/Portfolio Manager”. He is the only one entitled to make decisions regarding fund investments within the context of the fund’s mandate and the mandate is the sole province of the unitholders. National Bank, CEO Louis Vachon, and any miscellaneous bozos from marketting have no say in the matter.

As always, there’s no telling what the real story is (the press release may have been released in unseemly haste and poorly edited with an emphasis on brevity), but I trust that all unitholders, regulators and trade associations will do what they can to ensure they know just who is running the fund, whose interests are held paramount at all times and how much influence National Bank management has over portfolio management decisions.

Some readers will not consider this a major issue. Some readers are encouraged not to come running to me when the interests of mutual funds and their corporate sponsors  become intertwined in a manner they don’t like.

In less important news, a lot of children are being thrown off sleds to the sub-prime wolves. Capital One is taking a big charge to close its Alt-A mortgage unit, KKR Financial is seeking equity after selling a big chunk of sub-primes, and Thornburg sold a whack of mortgage-backeds in a frantic attempt to delever. Solent Capital may be forced to join them, after investors wouldn’t buy their ABCP. In short, the market is working as it should, although fear continues to rule greed: money market funds are piling into those famous 3% Treasury Bills, and SachsenLB needed emergency liquidity of 17.3-billion Euros.

The blame game continues, with calls for more regulation in Europe and America. Blaming the Fed is always popular. I haven’t seen calls for more regulation in Canada yet, possibly because they’re still trying to find something that isn’t regulated.

The WSJ reminds us that all this has happened before. Brad Setser reports on current Fed thinking on how this will all resolve – which doesn’t appear to involve more regulation, thank heavens – while Jim Hamilton looks at low-investment-grade spreads and wonders where all the risk is being priced. My guess is simply that contagion from lower-quality sub-prime, while knocking hell out of higher-rated sub-prime and affecting investment-grade corporates to some degree … simply has run out of steam.

US Equities experienced a few swings, but closed up on the day, followed by their Canadian counterparts.

Treasury news was dominated by the plunge in short-end yields, while Canada continued steepening. I like steepening.

A quiet day for preferreds, although Nesbitt was able to accomplish some crossing in size. The perpetualPremium sector did well, led by BMO.PR.H and CL.PR.B.

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

All indices were assigned a value of 1000.0 as of December 31, 1993.

Index Constitution, 1999-11-30, Pre-rebalancing

Index Constitution, 1999-11-30, Post-rebalancing

Well, that’s the end of another week-and-a-half! I said the same thing August 10 … I’m gonna start putting in for overtime.

The big news of the day was the Fed cut the discount rate. As the WSJ admirably explains the discount rate is the rate at which financial institutions can borrow directly from the Fed:

Banks were reluctant to access the window because it was associated with a stigma usually reserved for distressed banks. A few years ago the Fed overhauled the discount window to try and alleviate that stigma; the rate was then set one percentage point above the funds rate and subject to far fewer conditions. In spite of that, discount window borrowing has remained paltry.

Discount lending averaged just $11 million in the week ended Aug. 15. Although that was up from $1 million in the prior week it was puny compared to the billions of dollars the Fed has regularly injected into the financial system through open market operations.

There has been some jeering that this is a mere gesture; but some cheering for such a public (and cheap!) jawboning that certainly had an effect on the markets today. The Fed even actively encouraged eligible institutions to take advantage of the cut.

The discount cut sent a message that the Fed will consider Fed Funds Target cuts, which was received loud and clear, although the Fed Funds Futures market seemed a little disappointed that the gesture was only symbolic (what a bunch of cowboys those guys are!). While data for today is not yet posted, the Fed maintained a rate of about 5% in the actual Fed Funds market yesterday, and the low yesterday was 2%, much more reasonable than the recent 0% nonsense. Goldman Sachs changed its prediction again:

Goldman Sachs Group Inc. said the Federal Reserve will cut the overnight target interest rate to 4.5 percent from 5.25 percent this year
…
Until June, Goldman had expected the Fed to cut rates 75 basis points this year. They changed the forecast in June saying the Fed would hold rates at 5.25 percent through year-end

The analyst’s track record was not disclosed, possibly due to confusion regarding just exactly which track record.

At any rate, this signal was considered to be a sign that the world was not about to come to an end and both American and Canadian equities soared, led by financials.

Not surprisingly, government bonds had a super day, with Treasury two-years dropping 6bp in yield and ten-years 2bp, to bring the term premium to 50bp. Canada followed:

The two-year bond added 12 Canadian cents to C$99.25 to yield 4.188 percent, while the 10-year bond gained 23 Canadian cents to C$96.76 to yield 4.411 percent.

The yield spread between the two-year and 10-year bond moved to 22.3 basis points from 17.2 at the previous close.

The 30-year bond fell 28 Canadian cents to C$109.05 to yield 4.448 percent.

Readers might not fully empathize with my joy at seeing a real-live actual term spread again, after all this time … but believe me, it’s there.

A major – and worrisome – fly in the ointment is that the market for asset-backed paper has dried up and now:

The gap between similarly rated asset-backed and direct- issued paper is 79 basis points, the most since Bloomberg began keeping the indexes in 1999.

Brad Setser explains some of characteristics of ABCP and its relevance to the current kerfuffle. Connoisseurs of the preferred share market will recognize some degree of similarity between the two basic types of commercial paper and the preferred share types of “Operating Retractible” and “Split Share”.

Retail ABCP aversion is very pronounced to the point where not having any is a competitive advantage for Canadian money-market funds.

Sadly, I must leave devotees of the preferred share market in suspense. I have a dinner engagement and prices were not available from the source until about 7:30pm. I’ll update tomorrow … but fear not! Today, while volatile, was actually a pretty good day.

Update, 2007-08-17

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