October 26, 2007

CDOs (Collaterallized Debt Obligations) were in the news today, as Bloomberg reported that Moody’s cut a batch of ratings. The Bloomberg story doesn’t mention some important context, presumably since that would make the story less interesting. According to the unexpurgated press release:

it has downgraded $33.4 billion of securities issued in 2006 backed by subprime first lien mortgages, representing 7.8% of the original dollar volume of such securities rated by Moody’s. Of the $33.4 billion downgraded securities, $3.8 billion remain on review for further downgrade. Moody’s also affirmed the ratings on $258.6 billion of Aaa-rated securities and $21.3 billion of Aa-rated securities, representing 74.7% and 52.0% of the original dollar volume of such securities rated in 2006, respectively.

The Aaa- and Aa-rated securities that have been placed on review for possible downgrade are generally not expected to move by more than three notches. The most heavily impacted securities were originally rated Ba, Baa, or A. Rating migrations have been much more severe for the more deeply subordinated tranches of 2006 subprime deals.

Accrued Interest, which has an excellent primer on CDOs, has made a rather breathtaking suggestion:

the ratings agencies simply shouldn’t rate CDOs at all.

Furthermore, the ratings agencies could still model CDO deals in their Monte Carlo simulators for a fee. Investors could then run the Monte Carlo themselves, inputting default and recovery rates, default patterns, and correlation as they see fit. Rather than getting one or two perspectives on what the default/recovery/correlation patterns should be, investors could impose their own stresses.

I’ve discussed the results of such simulations in the post Loan Default Correlation.

Sadly, Accrued Interest’s suggestion doesn’t have a chance of working. As I keep reiterating here, investors (as a group, with lots of exceptions) do not want to do any analysis. And they don’t want to spend any money on useless, profitless credit analysis, or any time understanding what it is they’re doing. They want to buy something that goes up because it’s good.

There are no possible regulations that will enforce this. Adding more rules will not make this a better world. All market regulators should have a form letter: “Yeah, you’re #$%^! bankrupt because you’re #$%^! stupid.” to be sent by the busload to complainers. They should also be much more willing to pull investment management licenses on the basis of incompetence.

This last thing is hard to do. If my investment theme is that demographics are going to cause a boom in granola, I tell all my clients this, they give me money and I promptly blow it all levering up granola futures 100:1: this doesn’t necessarily make me incompetent. Wrong, yes, but being wrong is simply part of the investment management game (which is why my other theme in this blog is the chaotic nature of financial markets). If, however, they inspect my records and find that my carefully estimated granola consumption growth rate was a little off because I used “15” as a factor rather than as a percentage … well, then I’m incompetent and should be civilly liable and should lose my license.

Investment managers should be held strictly accountable for adhering to the Prudent Man Rule. But you know something? I think a lot of investment funds are run in the same way as Greek pension plans:

Board members of Greek pension funds are appointed by the government, labor unions and employers, often on a part-time basis, without specific professional or educational qualifications. The country has about 200 pension funds with assets of more than $44 billion, according to finance ministry estimates.

Quis custodiet ipsos custodes? While specific professional or educational qualifications are nice to have, I’m not as impressed by them as the reporter seems to be … but they are, at least, an indicator. With respect to the particular Greek Tragedy reported, I agree with:

C. Kerry Fields, a professor of business law at the University of Southern California’s Marshall School of Business in Los Angeles, said JPMorgan appears to have acted lawfully in its handling of the sale to North Asset Management and bears no responsibility for what happened later.

“The foolish people are the buyers because they paid so much,” Fields said.

What’s needed on pension boards are people with the guts to ask questions, the intelligence to Think Useful Thoughts about the answers and the ruthlessness to fire those who don’t measure up. Those are the qualifications I like.

On another front, Naked Capitalism reviews the political pressure for a Fannie Mae / Freddie Mac bail-out. We can only hope that this pressure is successfully resisted – as has been argued by James Hamilton of Econbrowser:

it is equally clear to me that the correct instrument with which to achieve this goal is not the manipulation of short-term interest rates, but instead stronger regulatory supervision of the type sought by OFHEO Director James Lockhart, specifically, controlling the rate of growth of the GSEs’ assets and liabilities, and making sure the net equity is sufficient to ensure that it’s the owners, and not the rest of us, who are absorbing any risks.

Fannie Mae & Freddie Mac (the “GSEs” – Government Sponsored Enterprises) walk like banks and talk like banks … but they are not regulated like banks because grandstanding politicians such as Charles Schumer want to have all the fun of providing services to constituents without having to bother with trivial little details like paying for them (which in this case means, one way or the other, ensuring that the GSEs are capitalized like banks).

We have seen in recent months how a problem that’s relatively small (US Sub-prime mortgages) in the grand scheme of things (the world financial system) can act as a flashpoint for a major paradigm shift (if that metaphor makes any sense). Let’s not increase the potential for a major bankruptcy by allowing the GSEs to lever up even further beyond the bounds of prudence.

On a somewhat related note, I was amused to see the tone Bloomberg adopted when reporting the continued decline of American home ownership:

Homeownership in the U.S. dropped for a fourth consecutive quarter, the longest decline since at least 1981, suggesting more Americans will miss their best chance of building wealth.

“Owning a home in this country has been a principal source of wealth creation for low- and moderate-income people,” said Nicolas Retsinas, director of Harvard University’s Joint Center for Housing Studies in Cambridge, Massachusetts. “In the absence of home equity, families will inevitably spend less.”

Homeowners accumulate wealth faster than renters, with median net wealth for owners at $184,400 in 2004, compared with only $4,000 for renters, according to Federal Reserve figures.

Given the glee with which they regularly point out that everybody (except gullible investment managers) knew all along that housing was a bubble created by the Evil Credit Rating Agencies, the emphasis on these data is surprising! But they redeem themselves with an interesting factoid towards the end of the article:

Out of 297 townhouses in Springfield, Virginia, for sale last week, almost 80 were in the process of foreclosure or offered at a price lower than the mortgage balance, so-called short sales, said [Re-Max real estate agent Steve] Hawkins.

Two years ago there would have been about 50 such units offered in the same Washington suburb, with none in foreclosure, he said.

The long-term trend is clearly in homeowners’ favour – but, as the the WSJ reports, houses haven’t been doing too well lately:


On September 24 I noted that the US was testing pandemic preparedness, stressing the system with a simulated 49% absentee rate. The results are in and analysis is under way:

When asked “based on the lessons learned from the exercise, how effective are your organization’s business continuity plans for a pandemic,” 56% answered “moderately,” the next highest group was “minimally,” at 28%. Only 12% said their business continuity planning was very effective.

I have previously noted the various controversies about inflation measurement – but look at Argentina’s measurement problems:

Argentina’s benchmark inflation-linked bonds have tumbled 24 percent this year, making the country’s debt market the worst performer in the world, according to data compiled by JPMorgan Chase & Co. and Bloomberg.

Merrill Lynch & Co., the world’s biggest brokerage, estimates prices may be rising at a 17 percent annual pace, double the official rate.

Daniel Fazio, head of the employee union, said in February that a Kirchner political appointee had statisticians eliminate some details from the index and violate secrecy laws that prohibit the release of information during the data-gathering process. The union said federal prosecutor Carlos Stornelli is investigating the allegations. The prosecutor’s office has declined to comment.

I continued to work through the BoE Financial Stability report, but was sidetracked by a desire to investigate their “Box 2” further. What a great report that is! Crammed with information and references, but well written with a bias towards explaining the implications of important ideas from a policy perspective.

There’s a fascinating report that the credit rating agencies are being investigated for corrupt practices:

[Connecticut Attorney General Richard] Blumenthal’s office is investigating complaints that the ratings companies rank debt against issuers’ wishes, then demand payment, he said today. The state also is probing whether the companies threaten to downgrade debt unless they win a contract to rate all the issuer’s securities, as well as the practice of offering ratings discounts in return for exclusive contracts.

Quite the laundry list of charges! ‘Ranking debt against the issuers’ wishes’ is hardly a problem; ‘Demanding payment’ is not a problem [hint: say ‘No’]; ‘offering ratings discounts in return for exclusive contracts’ is not a problem; the only allegation that, if proven, is actually a Bad Thing is the threat to downgrade if they don’t get a contract for the entire issued portfolio.

I find the idea a little hard to swallow, frankly. Transition matrices are holy and I don’t think the agencies would put them at risk in order to make an extra nickel or two. It might possibly be a deliberate mis-interpretation (either by the rating agency salesman or the issuer) of a threat to downgrade unless more information is made available to the agency … but we will see. It’s worthwhile to note the recent General Electric / DBRS kerfuffle, reported on the DBRS site as:

Given the level of investor interest, DBRS believes it is important to provide clarity as to its decision to withdraw the ratings on General Electric Company (GE), GE Capital Canada Funding Company (GE Capital Canada), Heller Financial Canada and Heller Financial, Inc.

DBRS had recently been in discussions with GE to ensure that DBRS would continue to receive adequate resources, including time and attention, from GE to support DBRS’s ratings and that there would be no issue with DBRS assigning ratings to GE Capital Corporation (GECC), the guarantor of GE Capital Canada.

Ultimately, GE decided that it was not fully supportive of adding a third rating agency for GECC, and GE formally requested that DBRS withdraw all ratings related to GE.

It’s easy to see how a bad relationship could quickly get worse given worst-case interpretations of such negotiations. But we’ll see!

In technical news that some (wierdos) might find of interest, the NYSE is eliminating rule 80A, which was enacted as part of the volatility damping package deemed necessary after the crash of 1987:

Rule 80A (a) and (b) require that, for any component stock of the S&P 500 Stock Price IndexSM, whenever the NYSE Composite Index® (“NYA”) advances or declines by a predetermined value from its previous day’s closing value, all index arbitrage orders to buy or sell (depending on the direction of the move in the NYA) must be entered as either “buy minus” or “sell plus”.

The Exchange is making this change since it does not appear that the approach to market volatility envisioned by the use of these “collars” is as meaningful today as when the Rule was formalized in the late 1980s. Rule 80A addresses only one type of trading strategy, namely index arbitrage, whereas the number and types of strategies have increased markedly in the last 20 years and may as well contribute to the increase in or lack of volatility.

The rule has been applied 15 times on 13 days this year; the peak was 1998, with 366 occurances on 227 days.

And, holy smokes, I almost let an entire post go by without mentions SIVs! Naked Capitalism provides a round-up and some commentary; still quite convinced (perhaps correctly – who knows?) that Super-Conduit is a nefarious plot of some kind that is unlikely to attract investors.

The TD New Issue announced October 9 now has an estimated fair value of $23.76. It will not be a happy opening!

By one definition, Great-West and SunLife Financial are now distressed companies: GWO.PR.I closed at 19.90-98, 12×3 on volume of 47,085; SLF.PR.E closed at 19.92-18, 4×3, on volume of 11,750. I wonder what the Globe will have to say about this tomorrow?

Month-to-date, the PerpetualDiscount index is down 4.93% (on the week, it’s down 2.18%) and has gained on only two of nineteen trading days. On the other hand, the PerpetualPremium index has managed to grovel back over its 6/30 starting figure of 1,000.00, and is down only 1.89% on the month. On the other hand, there’s some very strange things going on in that index. What the HELL is CU.PR.B doing, being bid at 26.12 for a pre-tax bid-YTW of 5.17, when PWF.PR.I has the same coupon and a redemption schedule that differs by one month and one day, AND has a one-notch higher credit rating (DBRS) to put it into widows-and-orphans grade … and is bid at 25.31 to yield 5.71%?

However, as a participant on Financial Webring said today:

No, it’s because the market is an ass. Preferreds are retail driven with about half of the purchasers not even aware what they’re buying. We see it on this board all the time. They got lumped into the whole subprime/ABCP mess in my opinion by boneheads who think they have a connection to it. Down goes the price…………

Ah, Grasshopper, when you can take the pebble from my hand, it will be time for you to trade.

The market will normalize eventually. It always does. But DAMN, the waiting can be aggravating – and it probably wouldn’t irritate me so much if HIMIPref™ hadn’t indicated valuations were severely out of whack a little too early!

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 4.91% 4.88% 456,335 15.53 1 0.0408% 1,044.1
Fixed-Floater 4.89% 4.82% 100,785 15.75 7 -0.1041% 1,038.5
Floater 4.52% 3.87% 69,207 10.66 3 -0.6244% 1,038.9
Op. Retract 4.87% 3.72% 80,049 3.35 15 -0.1427% 1,026.3
Split-Share 5.19% 5.08% 86,413 4.10 15 -0.2426% 1,038.3
Interest Bearing 6.25% 6.29% 62,072 3.60 4 -0.4221% 1,059.0
Perpetual-Premium 5.75% 5.63% 102,020 9.87 17 +0.1706% 1,000.5
Perpetual-Discount 5.59% 5.63% 320,711 14.47 47 -0.3132% 903.4
Major Price Changes
Issue Index Change Notes
ELF.PR.F PerpetualDiscount -2.3928% Now with a pre-tax bid-YTW of 6.17% based on a bid of 21.62 and a limitMaturity.
ELF.PR.G PerpetualDiscount -2.0192% Now with a pre-tax bid-YTW of 6.18% based on a bid of 19.41 and a limitMaturity.
GWO.PR.G PerpetualDiscount -1.9214% Now with a pre-tax bid-YTW of 5.85% based on a bid of 22.46 and a limitMaturity.
GWO.PR.I PerpetualDiscount -1.7284% Now with a pre-tax bid-YTW of 5.72% based on a bid of 19.90 and a limitMaturity.
BAM.PR.K Floater -1.6764%  
BSD.PR.A InterestBearing -1.6649% Asset coverage of just under 1.8:1 as of October 19 according to Brookfield Funds. Now with a pre-tax bid-YTW of 7.14% (mostly as interest) based on a bid of 9.45 and a hardMaturity 2015-3-31 at 10.00.
CM.PR.I PerpetualDiscount -1.5603% Now with a pre-tax bid-YTW of 5.68% based on a bid of 20.82 and a limitMaturity.
PIC.PR.A SplitShare -1.3106% Asset coverage of 1.7:1 as of October 18, according to Mulvihill. Now with a pre-tax bid-YTW of 5.61% based on a bid of 15.06 and a hardMaturity 2010-11-01. That’s right, 5.61% (interest-equivalent of 7.85%) on a well-secured three-year note.
RY.PR.F PerpetualDiscount -1.2136% Now with a pre-tax bid-YTW of 5.48% based on a bid of 20.35 and a limitMaturity.
PWF.PR.F PerpetualDiscount -1.0841% Now with a pre-tax bid-YTW of 5.78% based on a bid of 22.81 and a limitMaturity.
IAG.PR.A PerpetualDiscount -1.1994% Now with a pre-tax bid-YTW of 5.75% based on a bid of 20.25 and a limitMaturity.
W.PR.H PerpetualDiscount +1.6066% Now with a pre-tax bid-YTW of 5.88% based on a bid of 23.40 and a limitMaturity.
PWF.PR.L PerpetualDiscount +1.8519% Now with a pre-tax bid-YTW of 5.83% based on a bid of 22.00 and a limitMaturity.
Volume Highlights
Issue Index Volume Notes
PWF.PR.F PerpetualDiscount 515,700 Now with a pre-tax bid-YTW of 5.78% based on a bid of 22.81 and a limitMaturity.
MFC.PR.C PerpetualDiscount 360,300 Now with a pre-tax bid-YTW of 5.35% based on a bid of 21.30 and a limitMaturity.
MFC.PR.B PerpetualDiscount 123,865 Now with a pre-tax bid-YTW of 5.38% based on a bid of 21.80 and a limitMaturity.
NA.PR.K PerpetualDiscount 84,976 Now with a pre-tax bid-YTW of 6.00% based on a bid of 24.41 and a limitMaturity.
SLF.PR.B PerpetualDiscount 53,100 Now with a pre-tax bid-YTW of 5.46% based on a bid of 22.20 and a limitMaturity.

There were thirty-two other index-included $25.00-equivalent issues trading over 10,000 shares today.

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