It was an interesting day, with a number of cross-currents resulting in a strong day for bonds at the expense of stocks.
The day started with a thump, as the Financial Post reported a gloomy sentiment from Edward Devlin of PIMCO:
The vast majority of about $35-billion of non-bank ABCP is backed by risky bets on credit default rates that are now so far underwater that investors could be looking at losses as high as 50 on the dollar
With all respect to Mr. Devlin, I’ll repeat my tired old refrain of “I wanna see more detail”! Readers will remember the sad story of Global DIGIT’s suspension of redemptions, which fits his story quite well – they’re leveraged to hell and gone on credit-default-swaps on the dreaded sub-prime (senior tranches only, so they claim). Global Digit issued a press release on August 28, stating:
The Trustee has now received from the Bank the indicative price which will be used to calculate the NAV as at August 31, 2007. If that indicative price, which was based on market conditions known on August 28, 2007, had been used to calculate the NAV as at July 31, 2007, the NAV would be $7.92, representing a reduction of about 12.5% from the NAV calculated based on the July 16, 2007 market conditions.
So, on the cheerful side, we can say that August 28 was pretty close to the height of the hysteria and the loss, while not likely to make the equity holders very happy, are not yet eating into the security of the ABCP holders. Now, there’s problems with this statement. In the first place, “indicative prices” don’t necessarily mean very much, as most rookie bond guys find to their consternation sometime before their tenth trade. And, of course, many many bad things can happen before those CDSs in the DG.UN portfolio unwind. And there’s no indication that DG.UN is representative of the kind of problem that Mr. Devlin refers to. Lots of uncertainty … but uncertainty with respect to Mr. Devlin’s statement as well. Details! Give me details!
This topic arose during a lunch I had today with a PrefLetter subscriber (He bought! I wish to take this opportunity, firstly to thank him, and secondly to encourage subscribers and others to buy me lunch at every opportunity!). We were talking about Tier 1 Capital Ratios, and the National Bank’s purchase of ABCP, preferred shares and how all those things related. My friend made the comment that ABCP buyers – buying assets that were levered 10+:1 – got everything they deserved. But, as I have now confirmed, such leverage is normal! Royal Bank’s financials reveal $537-billion in assets supported by $22-billion in equity, a gearing of 24:1.
They have a perfectly adequate Tier 1 Capital Ratio nonetheless, because not all assets are created equal. I’ve looked at a document from BIS that gives a few formulae and rules of thumb for calculating capital adequacy … on Page 160 of the document, for instance, we get the risk weights for various terms of bonds, while Page 156 gives the risks weights for various grades of issuer. As may be understood by comparing RBC’s asset-to-equity gearing with its Tier 1 Capital Ratio, the RBC assets have an average risk-weight of about-maybe 33%.
So – I’m not drawing any conclusions about the riskiness of ABCP or of RBC paper, but I’m just pointing out … there’s risk and then there’s risk; the leveraging factor in and of itself conveys some of the answer, but not all.
In news today with implications on the FedFunds rate, the Beige Book was released:
“Outside of real estate, reports that the turmoil in financial markets had affected economic activity during the survey period were limited,” the Fed said in the survey, which concluded before Aug. 27 and was released today in Washington. “Economic activity has continued to expand” nationwide, the Fed said in the Beige Book, named for the color of its cover.
Another perspective is available from the WSJ Economics Blog which also produced a summary by district. ADP is projecting a lousy jobs number for Friday’s release.
Longer term, the OECD released a report stating that in the US:
slower job creation, mortgage-rate resets and tighter credit standards will prompt a slowdown in the second half of the year that will drag annual growth down to 1.9%, from 2.1% forecast previously
The author does not believe a US recession is imminent.
A suggestion that banks pool and securitize their LBO debt caught Tom Graff’s attention, but another solution was implemented by AstroZeneca:
AstraZeneca Plc, the U.K.’s second- largest pharmaceutical company, sold $6.9 billion of bonds in the biggest U.S. debt offering in more than five years.
AstraZeneca will use proceeds from the sale to pay back commercial paper that financed the $15.2 billion purchase of U.S. biotechnology firm MedImmune Inc. in June
That’s the way to reduce liquidity risk on your balance sheet! Bite the bullet and extend term, even if it hurts.
The five-year 5.4 percent debt priced to yield 130 basis points more than Treasuries of similar maturity; the 10-year 5.9 percent securities have a yield premium of 145 basis points; and the 30-year 6.45 percent bonds paid a spread of 170 basis points.
…
AstraZeneca’s debt is rated A1 by Moody’s Investors Service, the fifth-highest investment grade and AA- by Standard & Poor’s, the fourth-highest ranking.
In this context, it’s worth noting that the Treasury 10-year to Baa spread, highlighted by James Hamilton a while ago, doesn’t appear to have moved much: the Fed is now showing Baa paper at 6.60%, which is actually less than each of the three most recent monthly observations. Granted, Treasury 10-years are down a lot but while spread-to-treasuries is important, spread-to-business risk is even more important. This looks like good insurance for the issuer.
Citigroup is closing a poorly performing hedge fund; it should be noted that while it underperformed its peers, it’s down only slightly on the year. It’s not all hedge funds that will blow up over the next few months … only some of them. Particularly those who are forced to sell their assets at whatever they will fetch in this environment.
The losers will be replaced:
The amount of debt in the Merrill Lynch distressed bond index tripled in July to $13.8 billion, and about doubled again in August to $24.8 billion. In addition to Residential Capital and WCI, the debt of New York-based amusement park operator Six Flags Inc., and pizza chain Uno Restaurant Corp. of West Roxbury, Massachusetts, is distressed based on their yields.
Investors specializing in distressed debt are gearing up for more opportunities. They raised $23 billion this year through Aug. 17, breaking 2006’s record of more than $16 billion, according to London-based Private Equity Intelligence Ltd.
There’s another good quote in that story too, that will help give some perspective on the Credit Rating Agency controversy:
Moody’s in January 2005 predicted the default rate would rise to 2.7 percent by the end of that year from 2.2 percent. Instead, it fell to 1.8 percent. Moody’s then forecast it would rise to 3.3 percent by the end of 2006. It fell again, to 1.7 percent, the lowest year-end level in a decade.
“The last couple of years we always used to say `Gee, isn’t it crazy, we’re seeing top of market behavior and this can’t be sustained,”’ Marshella said. “It did go on longer and we were wrong. You always thought there’d be an inflection point and, finally, an inflection point came,” he said, referring the increase in financing costs caused by the contamination of asset- backed securities by subprime mortgages.
US equities fell, as financials are now out of favour; Canadian stocks also fell on fears of a credit crunch. LIBOR just won’t go down!
Treasuries had a banner day; Canada didn’t do quite so well but there was a major steepening.
I wasn’t able to update the index values today, although I did update the index constituents. Tomorrow, I promise!
Note: Somehow … don’t ask me how … I managed to screw up the input of the Volume and Price Change tables so completely that my software has given up. Sorry.
Update, 2007-09-07
| Note that these indices are experimental; the absolute and relative daily values are expected to change in the final version. In this version, index values are based at 1,000.0 on 2006-6-30 | |||||||
| Index | Mean Current Yield (at bid) | Mean YTW | Mean Average Trading Value | Mean Mod Dur (YTW) | Issues | Day’s Perf. | Index Value |
| Ratchet | 4.95% | 4.90% | 1,953,508 | 15.52 | 1 | 0.0000% | 1,043.7 |
| Fixed-Floater | 4.87% | 4.77% | 111,825 | 15.83 | 8 | +0.4181% | 1,028.6 |
| Floater | 4.46% | 3.19% | 89,009 | 10.68 | 4 | +0.2733% | 1,041.4 |
| Op. Retract | 4.83% | 3.79% | 76,720 | 2.97 | 15 | +0.1418% | 1,026.6 |
| Split-Share | 5.12% | 4.69% | 102,728 | 3.90 | 13 | +0.0614% | 1,047.4 |
| Interest Bearing | 6.29% | 6.84% | 66,115 | 4.56 | 3 | -0.8367% | 1,031.1 |
| Perpetual-Premium | 5.47% | 5.03% | 92,494 | 6.21 | 24 | +0.2696% | 1,031.0 |
| Perpetual-Discount | 5.08% | 5.11% | 262,414 | 15.31 | 38 | +0.1613% | 979.0 |