September 14, 2007

Retail Sales in the US were unexpectedly weak in August, adding to the rationale for a Fed Rate cut (although the numbers are considered highly adjustable by some). Tom Graff uses a Taylor Rule (parameterized as a trading indicator, not as a policy gauge) to estimate the future Fed Funds Rate as 3.75% down 150bp from current, while emphasizing that he considers it a qualitative measure of direction, rather than an actual prediction. Fed Funds Futures are now predicting a value of about 4.5% at year-end. The use of the Taylor rule to determine neutrality – and the effects of getting it wrong – was discussed at the recent Jackson Hole conference. Economic chatter leans to a 25bp cut.

It will be most interesting to see the reaction of USD LIBOR and USD CP rates to whatever the Fed ends up doing. There are definite indications that USD ABCP investors are anticipating a rate cut – perhaps the next weekly Federal Reserve report on ABCP will not show such a huge decline. That will annoy the banks! Cushioning fear-driven liquidity shocks is their bread and butter:

This paper argues that banks have a unique ability to hedge against market-wide liquidity shocks. Deposit inflows provide funding for loan demand shocks that follow declines in market liquidity. Consequently, one dimension of bank “specialness” is that banks can insure firms against systematic declines in market liquidity at lower cost than other financial institutions. We provide supporting empirical evidence from the commercial paper (CP) market. When market liquidity dries up and CP spreads increase, banks experience funding inflows. These flows allow banks to meet increased loan demand from borrowers drawing funds from pre-existing commercial paper backup lines, without running down their holdings of liquid assets. Using bank-level data, we provide evidence that implicit government support for banks during crises explains the funding flows.

From the same paper, incidentally:

Banks’ functioning as liquidity insurance providers originated early in the development of the commercial paper market. In 1970, Penn Central Transportation Company filed for bankruptcy with more than $80 million in commercial paper outstanding. As a result of their default, investors lost confidence in other large commercial paper issuers, making it difficult for some of these firms to refinance their paper as it matured. The Federal Reserve responded to the Penn Central crisis by lending aggressively to banks through the discount window and encouraging them, in turn, to provide liquidity to their large borrowers (Kane, 1974). In response to this difficulty, commercial paper issuers thereafter began purchasing backup lines of credit from banks to insure against future funding disruptions (Saidenberg and Strahan, 1999).

David Dodge is quoted in The Economist as saying:

He acknowledged that the Bank of Canada may itself have played a role in stoking the excesses by not raising interest rates enough. “One can see in retrospect that we should have been driving those rates harder than we did, because in reality credit conditions were being eased by increased securitisation and movement of stuff off balance [sheet],” he says.

Presumably, therefore, decreased securitization and movement of stuff onto balance sheet is a de facto tightening.

Meanwhile, China is hiking rates due to inflation concerns. There is evidence that the effect of high levels of imports from China is shifting to inflationary from deflationary. And Brad Setser is puzzled about the current account deficit and how it relates to the investment income balance:

Since the US has a borrowed a lot more – about $ 5 trillion more — than it has lent out, mathematically, a constant deficit on the interest balance implies that either that the interest rate on US lending has to be rising faster than the interest rate on US borrowing or that the interest rate on US borrowing has to be falling faster than the interest rate on US lending.

If I did all the calculations correctly, it turns out that the implied interest rate on US lending has been constant (at around 4.7%) while the implied interest rate on US borrowing is actually falling, from a bit under 4.4% in 2006 to 4.25% in the first half 2007.

The Credit Rating Agencies are beginning to take a little more action to polish their public profile. Moody’s has published some reflections on liquidity and flight to quality, and promise more. They note:

The need for a liquid and transparent secondary market for structured product may delay a recovery in primary issuance as investors will avoid purchasing an asset in the primary market if a similar asset can be purchased in the secondary market at a lower price. Therefore, greater transparency will be required of the secondary market as well as lower prices (or better protection) in the primary market. The liquidity risk premium is going to be higher and investors will be reluctant to buy these products unless there is some degree of standardization and secondary market liquidity. Marked to market actors may be reluctant to buy customized product, and higher risk premia could temporarily reduce the economic attractiveness of securitization for certain classes.

Illiquidity was highlighted as one of six “key vulnerabilities” of the UK financial system in the Bank of England’s Financial Stability Report of April 2007:

Unusually low premia for bearing risk, especially in credit markets. Benign current economic conditions, the greater dispersal of credit risk and confidence that market liquidity will remain high may have weakened risk assessment standards. If risk perceptions were to adjust, unexpectedly large shifts in market liquidity might lead to sharper asset price changes than anticipated by market participants, with knock-on effects on counterparty credit risk.

The moral of the story is: liquidity is a risk! Investors may intend to buy and hold but the consequences of having to sell (or wishing to sell due to credit concerns) into an illiquid market can be severe. The best defense is, as always, a broadly diversified portfolio with the individual elements bearing a wide variety of risk/reward profiles. Just look at HSBC: what they’re losing on sub-prime, they’re making up on insurance.

Thomson, issuer of the TOC.PR.B floaters, has been downgraded by Moody’s from A3 to Baa1. Moody’s did not specifically address preferred shares; I believe they have a mandate only for Thomson’s USD debt.

BCE holders will be interested in the latest news from junk-land. Prices on TXU and First Data common have gotten closer to the deal price on hopes that financing will not kill the deal. Several others have also narrowed, but poor old Sallie Mae is a wallflower, now that Dad’s cutting her allowance. The First Data bond deal is getting done, albeit at a spread almost 100bp more than originally intended, with more restrictive covenants. Investment grade issuers are issuing lots of paper, swallowing the high spreads; presumably they are calculating their spread to some kind of ‘non-panic’ government yield rather than actual market levels.

US Equities finished a great weak on a quiet note; as did stocks in Canada. Both Treasuries and Canadas were boring.

Volume in preferred shares was extremely light, which is leading to some strange pricing moves. The market looks quite sloppy, although now that the BCE issues are acting a little bit more like Pfd-2(lows) again, my curve-fitting is showing reasonable goodness-of-fit. It’s one of them conundrum thingies!

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 4.87% 4.83% 1,470,158 15.64 1 +0.0000% 1,044.5
Fixed-Floater 4.85% 4.76% 100,732 15.82 8 +0.0005% 1,031.5
Floater 4.48% 1.33% 87,071 10.77 3 +0.1645% 1,048.7
Op. Retract 4.84% 3.83% 75,358 3.07 15 -0.0200% 1,028.8
Split-Share 5.14% 4.91% 95,378 3.88 13 -0.2947% 1,045.5
Interest Bearing 6.26% 6.76% 64,304 4.54 3 +0.0752% 1,036.7
Perpetual-Premium 5.47% 5.01% 89,370 5.26 24 +0.0853% 1,033.1
Perpetual-Discount 5.05% 5.09% 251,510 15.07 38 +0.0100% 985.2
Major Price Changes
Issue Index Change Notes
BSD.PR.A InterestBearing +1.1038% On volume of – count ’em – 55 shares. Somebody moved the bid up and the fish still wouldn’t bite! Asset coverage of just under 1.8:1 as of September 7 according to Brookfield Funds. Now with a pre-tax bid-YTW of 7.54% (mostly as interest) based on a bid of 9.16 and a hardMaturity 2015-3-31 at 10.00.
Volume Highlights
Issue Index Volume Notes
FAL.PR.H Scraps (Would be PerpetualPremium, but there are credit concerns) 150,800 Scotia crossed 100,000 at 25.10, then Nesbitt crossed 50,000 at the same price. Now with a pre-tax bid-YTW of 5.39% based on a bid of 25.10 and a call 2008-4-30 at 25.00.
BAM.PR.N PerpetualDiscount 17,075 It seems to me that retail is nibbling away at these things since the price collapse. Now with a pre-tax bid-YTW of 5.96% based on a bid of 20.02 and a limitMaturity. Closed at 20.02-10, 6×45; the almost identical BAM.PR.M closed at 20.50-59, 1×1, on volume of 8,500. Which is one of my conundrums! Why pay fifty cents when you can pay ten?
BMO.PR.J PerpetualDiscount 16,820 Now with a pre-tax bid-YTW of 4.98% based on a bid of 22.78 and a limitMaturity.
MFC.PR.A OpRet 12,655 Desjardins crossed 10,000 at 25.50. Now with a pre-tax bid-YTW of 3.88% based on a bid of 25.40 and a softMaturity 2015-12-18 at 25.00.
BNS.PR.L PerpetualDiscount 11,040 Now with a pre-tax bid-YTW of 4.86% based on a bid of 23.45 and a limitMaturity.

There were NO other $25-equivalent index-included issues trading over 10,000 shares today.

One Response to “September 14, 2007”

  1. […] It has taken me far too long to find this reference! Therefore, I am re-posting under the Interesting External Papers classification the following (very slightly edited) comments from September 14! […]

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