February 12, 2008

The Street was alive today with news that Warren Buffet, out of the kindness of his heart, is willing to fix the monoline crisis:

Billionaire investor Warren Buffett said he offered to assume responsibility for $800 billion of municipal bonds guaranteed by MBIA Inc., Ambac Financial Group Inc. and FGIC Corp.

“The Buffett plan basically cherry picks out the only worthwhile parts of the portfolio,” said David Havens, a credit analyst at UBS AG in Stamford, Connecticut. “It leaves them with a terrible mix of business.”

Berkshire would put up $5 billion as capital for the plan and is offering to insure the municipal debt for 1.5 times the premium charged by the bond insurers to take on the guarantee. The insurers could accept the offer and back out within 30 days for a fee, Buffett said.

The secret of Buffet’s success? Do business only with those who are stupid and desperate.

AIG’s woes with Credit Default Swaps, which were mentioned yesterday, continued to attract attention today. AIG issued a press release:

AIG continues to believe that the mark-to-market unrealized losses on the super senior credit default swap portfolio of AIG Financial Products Corp. (AIGFP) are not indicative of the losses AIGFP may realize over time. Based upon its most current analyses, AIG believes that any losses AIGFP may realize over time as a result of meeting its obligations under these derivatives will not be material to AIG.

… and so did Fitch:

Fitch Ratings has placed American International Group, Inc.’s (NYSE: AIG) Issuer Default Rating (IDR), holding company ratings and subsidiary debt ratings including International Lease Finance and American General Finance on Rating Watch Negative.

AIG has relatively large exposure to the current U.S. residential mortgage crisis. Fitch believes the area of AIG most exposed to further deterioration in this market is the credit derivative portfolio within AIG FP, with its large net notional exposure of $505 billion at Sep. 30, 2007. Included in this total is $62.4 billion of collateralized debt obligations backed by structured finance (SF CDOs) collateral, mainly subprime U.S. residential mortgage-backed securities (RMBS).

Fitch has stated that it believes AIG will not be immune to potential losses from U.S. residential mortgage crisis, although at the present time the agency believes these losses should be absorbed by the existing capital base and future earnings stream. Today’s announcement brings additional uncertainty to the potential impact on the financial statements.

The actual SEC Filing states:

As disclosed in AIG’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007 (the “Form 10-Q”), AIGFP values its super senior credit default swaps using internal methodologies that utilize available market observable information and incorporate management estimates and judgments when information is not available. In doing so, it employs a modified Binomial Expansion Technique (“BET”) model that currently utilizes, among other data inputs, market prices obtained from independent sources, from which it derives credit spreads for the securities constituting the collateral pools underlying the related CDOs. The modified BET model derives default probabilities and expected losses from market prices, not credit ratings. The initial implementation of the BET model did not adequately quantify, and thus did not give effect to, the benefit of certain structural mitigants, such as triggers that accelerate amortization of the more senior CDO tranches.

As disclosed in the Form 10-Q, AIG did not give effect to these structural mitigants (“cash flow diversion features”) in determining the fair value of AIGFP’s super senior credit default swap portfolio for the three months ended September 30, 2007. Similarly, these features were not taken into account in the estimate of the decline in fair value of the super senior credit default swap portfolio through October 31, 2007 that was also included in the Form 10-Q because AIG was not able to reliably estimate the value of these features at that time. Subsequent to the filing of the Form 10-Q, through development and use of a second implementation of the BET model using Monte Carlo simulation, AIGFP was able to reliably estimate the value of these features. Therefore, AIG gave effect to the benefit of these features in determining the cumulative decline in the fair value of AIGFP’s super senior credit default swap portfolio for the period from September 30, 2007 to November 30, 2007 that was disclosed in AIG’s Current Report on Form 8-K/A, dated December 5, 2007 (the “Form 8-K/A”) filed after AIG’s December 5, 2007 Investor Conference.

In addition, during AIG’s December 5 Investor Conference, representatives of AIGFP indicated that the estimate of the decline in fair value of AIGFP’s super senior credit default swap portfolio during November was then being determined on the basis of cash bond prices for securities in the underlying collateral pools, with valuation adjustments made not only for the cash flow diversion features referred to above but also for “negative basis”, to reflect the amount attributable to the difference (the “spread differential”) between spreads implied from cash CDO prices and credit spreads implied from the pricing of credit default swaps on the CDOs.

So … as far as I can make out, this is more of a mark-to-market problem than an actual credit problem, but I’d have to do a lot more work before I bet a nickel on that scenario. The trouble is that AIG has shareholders equity of $104-billion and notional exposure of $505-billion. So just on this notional bond portfolio – of credit quality that I’m not looking at right now – they’ve levered up the company 5:1, on top of whatever leverage is implicit in their regular insurance operations.

There is a rather amusing section in their most recent 10Q:

As of October 31, 2007, AIG is aware that estimates made by certain AIGFP counterparties with respect to the fair value of certain AIGFP super senior credit default swaps and the collateral required in connection with such instruments differ significantly from AIGFP’s estimates.

Yeah, I’ll just bet!

Quite frankly, I don’t understand their investment strategy … or, I should say, I don’t understand how it makes sense. Why would an operating company seek to make money simply by levering up to hell-and-gone? I can certainly see them having a trading portfolio, and I can certainly see them having a greater value of tradeable instruments on the books than the value of their capital … but these CDSs were not – and, importantly, are not – tradeable … not in the same way regular bonds are tradeable, anyway, since you’ve got counterparty risk in there that cannot – usually – be transferred. CDSs are not fungible.

I am all in favour of big financial institutions providing liquidity – as dealer normally do, by keeping positions on their books for as long as it take to find somebody who wants to take the other side – but AIG was not, strictly speaking, providing liquidity except in the most general and useless sense.

Well, it’s easy to be wise after the event! But given the oppobrium in which large brokerage houses (and their stock prices) are now held, it will be most interesting to see whether any of the big-big-big public ones go private in the near future in a reversal of recent trends:

The private partnerships that once dominated Wall Street guarded their capital, used less leverage and limited their risk to trading blocks of stock for clients and shares of companies in mergers, said Roy Smith, a finance professor at New York University’s Stern School of Business and a former partner at Goldman Sachs Group Inc. Since raising money from the public, many of the biggest firms have abandoned that caution.

There was TAF auction today, which at least one news source thinks is new money. In fact, this auction, which resulted in a stop-out rate of 3.01%, simply rolls over the loans from the January 14 auction. It is interesting to compare this with the Fed Funds Rate of 3.00% … the next FOMC meeting is March 18, which is after the maturity of these loans. It would appear that:

  • No intra-meeting activity is anticipated
  • there is no term premium being paid on this money

Pedants may wish to point out that this is not necessarily the case, since these two effects might be equal and opposite; I will apply sophisticated quantitative analysis in my rejoinder: So’s your old man! Ray Stone of Stone & McCarthy Research Associates notes:

“The TAF program was an ingenious approach to solving a serious problem” of strained money markets, Mr. Stone says in a note to clients. “That said, it is not clear that the TAF program should be employed except in the extraordinary circumstances that have prevailed in recent months.” The TAF credit weakens the Fed’s balance sheet because the collateral offered at auction is inferior to the Fed’s other holdings, he says. And the result of the two January auctions — with interest rates below the federal funds target — “raises a philosophical issue as to whether the Fed’s provision of reserves at a rate below the target debases the role of the FOMC,” he says.

Note, however, that Bernanke has stated:

Based on our initial experience, it appears that the TAF may have overcome the two drawbacks of the discount window, in that there appears to have been little if any stigma associated with participation in the auction, and–because the Fed was able to set the amounts to be auctioned in advance–the open market desk faced minimal uncertainty about the effects of the operation on bank reserves. The TAF may thus become a useful permanent addition to the Fed’s toolbox.* TAF auctions will continue as long as necessary to address elevated pressures in short-term funding markets, and we will continue to work closely and cooperatively with other central banks to address market strains that could hamper the achievement of our broader economic objectives.

*With the footnote: “Before making the TAF permanent, however, we would seek public comment on its design and utility.”

The Fed Funds Futures are projecting a massive easing at the March meeting, to hit 2.5% in April before bouncing back (although the later contracts are low-volume). You know something? This is all very strange.

Not the most interesting of days. Volume was light and there wasn’t much price movement.

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 5.50% 5.52% 45,706 14.60 2 -0.2207% 1,082.7
Fixed-Floater 5.03% 5.67% 80,956 14.70 7 +0.2877% 1,019.7
Floater 4.98% 5.04% 77,262 15.41 3 -0.4226% 848.3
Op. Retract 4.82% 3.36% 80,726 2.91 15 +0.0521% 1,043.4
Split-Share 5.29% 5.51% 99,718 4.22 15 +0.1142% 1,039.3
Interest Bearing 6.25% 6.44% 60,582 3.37 4 +0.0254% 1,080.3
Perpetual-Premium 5.73% 4.70% 391,027 5.20 16 +0.1306% 1,027.4
Perpetual-Discount 5.39% 5.43% 292,994 14.76 52 -0.0019% 953.0
Major Price Changes
Issue Index Change Notes
TOC.PR.B Floater -1.2987%  
ELF.PR.F PerpetualDiscount +1.0879% Now with a pre-tax bid-YTW of 6.01% based on a bid of 22.30 and a limitMaturity.
BNA.PR.C SplitShare +1.8220% Asset coverage of 3.6+:1 as of December 31, 2007, according to the company. Now with a pre-tax bid-YTW of 7.45% based on a bid of 19.56 and a hardMaturity 2019-1-10 at 25.00. Compare with BNA.PR.A (6.07% to 2010-9-30) and BNA.PR.B (7.45% to 2016-3-25).
BCE.PR.G FixFloat +2.5918 On zero volume!
Volume Highlights
Issue Index Volume Notes
MFC.PR.C PerpetualDiscount 303,710 RBC bought 57,200 from Nesbitt in three tranches at 22.63. Now with a pre-tax bid-YTW of 5.07% based on a bid of 22.53 and a limitMaturity.
BNS.PR.O PerpetualPremium 41,690 Now with a pre-tax bid-YTW of 5.45% based on a bid of 25.38 and a call 2017-5-26 at 25.00.
RY.PR.D PerpetualDiscount 26,200 Now with a pre-tax bid-YTW of 5.20% based on a bid of 21.65 and a limitMaturity. 
CM.PR.I PerpetualDiscount 24,047 Now with a pre-tax bid-YTW of 5.67% based on a bid of 20.92 and a limitMaturity.
BAM.PR.B Floater 21,400  

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

One Response to “February 12, 2008”

  1. […] As far as the overall health of the banking system is concerned, let’s look at the Fed’s Term Auction Facility. The last one was reported on February 12; there was one today. The very low premium on this money relative to Fed Funds – and the continuing drop in the TED Spread – leads me to conclude that insolvency, potential or undiscovered, is not a problem in the banking system. It’s illiquidity, pure and simple. […]

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