PrefBlog

Willem Buiter was last mentioned in PrefBlog on January 25 in connection with inflation concerns. He’s back again today, preaching not just the likelihood, but the necessity of a US recession:

Therefore, to restore a sustainable external balance and to accumulate the financial assets that will support a greying US population in the style it would like to and hopes and expects to be accustomed to, the US private and public sectors must save more. To get to a higher saving and wealth trajectory, the US economy will first have to pass through the valley of the shadow of deficient effective demand, rising excess capacity and growing unemployment. Postponing the necessary adjustment will just make the pain of the eventual unavoidable correction that much greater.

The trouble with such a prescription is that it runs headlong into the American “can do” attitude. This attitude is admirable and has served them well … but sometimes it comes a cropper. “Reduce taxes and the deficit while increasing services? Can do!” “Bring Western Democracy to regions where even those who understand it don’t want it? Can do!”.

The failure of a few auctions for American Auction Rate Municipals has attracted some notice lately. Accrued Interest explains the situation … it all comes down to the monolines!

The bank was only willing to provide liquidity if there was some additional credit support. No problem, thought the municipal bond bankers! We’ll bring in a monoline insurer! The bank would therefore agree to provide liquidity so long as the bond insurer was rated at some minimal credit rating level. What that level is depends on the deal. Might be AA, might be A. I haven’t seen any that were actually AAA but they could be out there.

But what happens if the unthinkable happens? A monoline insurer gets downgraded? Well, the bank’s liquidity agreement becomes null and void. Where does that leave bond holders? It leaves them with no credit support at all. Only the issuer itself would remain.

Auction rate securities are a recurring niche in the markets – I remember (a long, long time ago) there were some Hees (remember Hees?) MAPS – Monthly Auction Preferred Shares. It’s really just another mechanism whereby issuers can finance long at short rates and investors can pretend they’re money-market superstars by outperforming the 3-month benchmark with 100-year paper … for a while.

And the mention of monolines reminds me of a funny story … remember MBIA’s line in the sand, discussed on January 31? Well, the tide’s come in:

MBIA Inc., the world’s biggest bond insurer, plans to raise an additional $750 million by selling about 50.3 million common shares, bolstering capital in an attempt to retain its AAA credit rating.

Investment firm Warburg Pincus will backstop the offering by purchasing as much as $750 million of convertible participating preferred stock, the Armonk, New York-based company said in a statement today. MBIA, which has already raised at least $1.5 billion since November, said it would contribute most of the proceeds to its MBIA Insurance Corp. unit.

Another article highlighted by Naked Capitalism delivers a rather vague exhortation for increased bank regulation while one particular example purporting to show the need concerns some recent problems with Wachovia:

AmeriNet was a “payment processor,” a company that creates unsigned checks on behalf of telemarketers to withdraw funds automatically from customer accounts. Such checks, once widely used by businesses collecting monthly fees, are legal if customers approve the transactions.
…
In 2006, an executive at Citizens Bank wrote via e-mail that thieves were routing unauthorized checks through Wachovia that stole from Citizens account holders.

“We have spoken to many of our customers who have been victimized by this scam,” wrote the Citizens executive, according to court documents. “We would appreciate it if you would shut down accounts of any customers of yours that may be engaging in improper activity.”

But Wachovia kept that account open until it was frozen by a federal court a few weeks later, as part of a government lawsuit against the client.

This is just more nonsense from the “Everything will be better with just a few more rules” camp. It is very tempting to believe that a few more rules will bring the new millennium, but those who argue in favour of this have never seen what happens in real life. Rules such as this – shutting down accounts due to suspicions of fraud – are not investigated by dispassionate keen-eyed investigators who have the evidence weighed by judicious descendents of Solomon. It is, in fact, a virtually random process in which facts become secondary to ass-covering.

In the quoted text above, the Citizens Bank executive should not have been contacting Wachovia – if they became involved at all, I suggest that police are generally considered the proper authorities for investigation of impropriety.

A bank clerk is not a cop I trust. A branch manager is not a judge I trust. And wishing won’t make it so.

But, that’s what happens when stuff hits the headlines – everybody’s an expert:

Regulators may restrict Moody’s Investors Service and Standard & Poor’s from advising banks on structured debt securities after criticism the firms failed to downgrade subprime-related debt as investor losses mounted.

Ratings firms may face a new code of conduct that limits their business and requires “reasonable steps” to ensure “a credible rating,” the International Organization of Securities Commissions in Madrid said in a statement today. IOSCO is the main forum for regulators, covering more than 100 countries from the U.S. to Japan.

I sure wish there was a code of conduct for regulators forcing them to take reasonable steps to ensure credible regulation!

An IMF research group has summarized a paper on VoxEU arguing that the subprime crisis is not unusual:

The subprime experience demonstrates that even highly-developed financial markets are not immune to problems associated with credit booms.

What can be done to curb bad credit booms? Historically, the effectiveness of macroeconomic polices in reducing credit growth has varied (see, for example, Enoch and Ötker-Robe, 2007). While monetary tightening can reduce both the demand and supply of bank loans, its effectiveness is often limited by capital account openness. This is especially the case in small open economies and in countries with more advanced financial sectors, where banks have easy access to foreign credit, including from parent institutions. Monetary tightening may also lead to significant substitution between domestic and foreign-denominated credit, especially in countries with (perceived) rigid exchange rate regimes. Fiscal tightening may also help reduce the expansionary pressures associated with credit booms, though this is often not politically feasible.

Fiscal tightening didn’t have much chance under a Republican administration! When in doubt, assume the best, right? It is very interesting to speculate as to what might have happened under Prof. Taylor’s counterfactual scenario of Fed tightening during the boom. We are certainly seeing that sub-prime sucked in a lot of money from Europe even with the relatively loose Fed policy during that time.

A very good day for the preferred share market, although I don’t see how the S&P/TSX Index was able to improve by 0.55% … half that, sure, two-thirds, maybe, but I suspect that this is an artefact of calculation caused either by low closes yesterday or high closes today.

Be that as it may, it was a strong day, with volume picking up and good strength throughout the entire PerpetualDiscount index. This index now has an interest-equivalent yield of 7.62% (at a conversion factor of 1.4), which is Canadas +350bp, Long Corporates +180bp. This latter (and probably more meaningful) figure has narrowed in about 30bp since last reviewed October 30, but still has a long way to go before reaching last spring’s levels of Long Corporates + ~110bp.

Hmmmm …. 70bp x 14years duration = … I’ll take it!

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

This entry was posted on Wednesday, February 6th, 2008 at 10:52 pm and is filed under Market Action. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.