February 19, 2008

A number of continuing stories today …

Accrued Interest reviewed a recent batch of Auction Rate Municipal auctions:

There was absolutely no rhyme or reason to what failed vs. succeeded and what rates resulted. The City of New York (rated Aa3/AA) had three issues auctioned, all three of which were fully tax-exempt. The rates were 5%, 5.25%, and 6%. Energy Northwest, a municipal power provider in Washington State, which is rated Aaa/AA-, had their ARS fail, and got a rate of 6.23%. Meanwhile, at one healthcare institution with a Baa3 rating and Radian insurance had their auction succeed with a 4.67% yield.

Meanwhile, I’ve received many e-mails from people interested in how one can play these ARS failures. One interesting idea is closed-end funds. Most closed-end bond funds are leveraged, usually in the 1.2-1.5x area, and they commonly use auction-rate preferred to create this leverage.

And yet closed-end muni funds are getting hammered, with several falling more than 5% today. I looked at the worst performers on the day, all of which had leverage created with auction-rate preferreds with 7-day auctions. The highest reset number I found was 3.3%. Excuse me if I don’t panic.

In times like these, the baby tends to go out with the bathwater! Naked Capitalism pours scorn over the entire idea of Auction Rates and notes:

The Wall Street Journal reports that organizations facing big funding cost increases are quickly trying to raise money at the longer maturities they should have borrowed at in the first place:
Turmoil in an obscure corner of the credit markets is expected to lead to a wave of refinancing by institutions that are in danger of finding themselves paying abnormally high interest rates on their bonds.

One of the first to queue up is the University of Pittsburgh Medical Center, which yesterday announced plans to refinance as much as $430 million of bonds. The medical center offered to buy back $92 million of bonds after market rates on some of its existing auction-rate debt topped 17% last week — threatening the center with extra weekly interest costs of as much as $605,000.

In the comments, Naked Capitalism goes even further and brands the issuers of Auction Rate Securities as speculators:

Municipalities get approval from taxpayers (either directly by approving bond issues or indirectly via who they elect) to enter into certain projects deemed useful for the community. They weren’t authorized to speculate with the public’s money, which is what this sort of thing is.

I cannot agree with such absolutism. Diversification of funding sources for an issuer is just as important as diversification of investments for an investor. I would have enormous reservations if it were suggested that all funding took place via Auction Rates, but I have no problem with a small piece being done that way.

A good example is floating rate mortgages and HELOCs in Canada. Many people have them and I’ve been asked many times about whether floating rate or fixed rate is better. It has been shown – and sorry, I don’t remember the reference – that, usually, floating rate is cheaper. This only makes sense; when you go floating rate then, ceteris paribus you should save money on the term premium. The risk you run is that rates will rise.

The advice I have given people to to imagine that they go for floating rate and immediately the rate doubles on them. If this is going to wipe them out and cost them their home … stick to fixed rate! On the other hand, if they will simply mutter to themselves and say ‘Oh, shoot, this investment didn’t work out’ … then go for floating rate because the odds are with them.

It’s the same with issuers. It would be most interesting to compare the overall cost of the funding over, say, a twenty-year period, and I’ll bet there are all kinds of graphs and figures in the brochures the treasurers get from their underwriters. Naked Capitalism is being more than just a little simplistic in this instance.

This issue is being raised on Bloomberg:

State officials, who are reviewing the $4 billion of auction bonds sold by six different authorities as well as by the state in 2002-2004, said the debt was the least expensive type of debt in the two years ended Sept. 30, according to a Dec. 12 report. Since then, it has become the most expensive.

The auction-rate turmoil represents a reversal for state fiscal officials. As recently as Jan. 22, Louis Raffaele, a chief budget examiner who helps manage New York’s borrowing, said higher rates on auction bonds across the country could benefit the state. “Because of our high ratings and unblemished record,” he said, the state could attract investors fleeing lower-rated issues.

I suggest that Mr. Raffaele’s remarks of Jan. 22 will ultimately be supported by the marketplace … albeit not without a period of dislocation of unknown length.

Another story that has crept back into the headlines is Structured Investment Vehicles, or SIVs. Standard Chartered’s USD 7-billion vehicle is close to default, while there has been an announcement that Bank of Montreal is committing 12.7-billion to prop up Links Finance.

More happily, Naked Capitalism has toned down the hysteria regarding negative non-borrowed reserves and is now focussing concern where it belongs: on the concept of the TAF itself:

We’ve called the TAF a discount window without stigma (and in fact, the Fed implemented the TAF because banks weren’t using the discount window even when they should have). Banks can post a wide range of collateral, borrow on a non-disclosed basis, and can hold on to the cash for a while (by contrast, the discount window is overnight)

But are things all that rosy? The Financial Times today raises some concerns, noting that banks are indeed using the TAF to use crappy collateral for borrowing,

And note that, with no announcement I can recall, the facility has been increased to $50 billion even though the year end crunch has passed. That too is not a good sign.

Naturally, we cannot let a day go by without a reference to the monolines! The Bank of America has forecast years of litigation if the monolines are split:

“Despite the regulatory interest in separating the exposures, the essential fact remains that all policy holders, whether municipal or structured finance, entered into contracts backed by the entire entity,” analysts led by Jeffrey Rosenberg in New York wrote in a note to investors dated Feb. 15. A breakup is “likely to lead to significant legal challenges holding up the resolution of the monoline issues for years.”…..

“The fact that one group of policy holders’ exposures has imperiled the policies of the other does not mean they should forfeit the value of their claims altogether,” the Bank of America analysts said.

Investors in credit-default swaps based on the bond insurers may also seek damages to compensate for losses, according to the research note.

 Accrued Interest has admitted to complete befuddlement over the question of what will happen to Credit Default Swaps on the pre-split companies. And again, Naked Capitalism provides a good round up of opinion (basically, everybody is saying that a monoline split will unleash the lawyers) and pours scorn on the idea:

Now, Ambac is seeking to raise money. It hopes to split up, but gee, we aren’t certain we can do that, and even if we can, we aren’t exactly sure yet how this will work.

Is any one with any sense going to invest in a proposition like that? You have absolutely no idea what you are getting into. This whole discussion of a breakup plan has increased uncertainty enormously and raised the specter of litigation risk. Those are not exactly comforting to investors.

Microsoft has long used FUD, Fear, Uncertainty, and Doubt, to paralyze its competitors. This bunch has managed to introduce a ton of FUD into something they want to move forward. Good luck.

Frankly, I don’t see how one can begin to consider a split ethical prior to bankruptcy and complete wipeout of the monoline’s shareholders. After all, preferential treatment of investors is generally considered a naughtiness. Never-the-less, there are rumours that MBIA is discussing joining the happy throngs.

VoxEU has an interesting article by Levich and Pojarliev on currency trading and the value of active management:

In the last year, both Deutsche Bank and Citibank have introduced several indices that track returns from several well-defined trading strategies.

  • Carry – To reflect the returns on the well-known strategy of borrowing a low interest rate currency and investing in a higher interest rate currency
  • Trend following – To reflect the returns of strategies related to identifiable patterns in currency movements
  • Value – To reflect the returns on taking short positions in overvalued currencies and using the proceeds for long positions in undervalued currencies

While theoreticians may argue over whether currency risk, like equity risk, always deserves a risk-premium, as a practical matter, institutional investors willing to hold currency risk can do so using a variety of simple trading strategies. Many of these strategies have been profitable recently and exchange-traded funds built on those strategies have been launched for the retail market. It is questionable whether professional currency managers can continue to charge higher management and performance fees while delivering cheaper-to-obtain beta returns. However, our results show that even when evaluated against the higher standard, some currency managers show superior performance, and true alpha. How they achieve this may in part be due to superior market-timing ability, trading in emerging market currencies, or some other factors. Whatever their formula, their returns appear unrelated to some conventional simple trading strategies. These true “alpha generators” may deserve their fees after all.

The actual paper costs money and I’m not really that interested … but if anybody does buy the paper, I’d be very interested in learning how the authors corrected for survivor bias. I will also note the critical sentence of the authors’ conclusion:How they achieve this may in part be due to superior market-timing ability, trading in emerging market currencies, or some other factors. Until this question is resolved, any analysis is of the “Look, Mummy, I got a spreadsheet!” variety.

Assiduous Readers will be aware that Naked Capitalism‘s opinions often meet a severe reception on PrefBlog, but as a clipping service, it’s excellent! Northern Rock has been nationalized by the UK government, generating a lot of discussion.

However, the article that most caught my eye on the weekend was a long piece on the Credit Default Swaps market and the fact that it may, ultimately, be dragged down by operational inefficiency:

In a credit default swap, two parties enter a private contract in which the buyer of protection agrees to pay the seller premiums over a set period of time; the seller pays only if a particular credit crisis occurs, like a default. These instruments can be sold, on either end of the contract, by the insurer or the insured.

But during the credit market upheaval in August, 14 percent of trades in these contracts were unconfirmed, meaning one of the parties in the resale transaction was unidentified in trade documents and remained unknown 30 days later. In December, that number stood at 13 percent. Because these trades are unregulated, there is no requirement that all parties to a contract be told when it is sold.

As investors who have purchased such swaps try to cash them in, they may have trouble tracking down who is supposed to pay their claims.

“This is just a giant insurance industry that is underregulated and not very well reserved for and does not have very good standards as a result,” said Michael A. J. Farrell, chief executive of Annaly Capital Management in New York. “I think unregulated markets that overshadow, in terms of size, the regulated ones are a real question mark.”

I dispute the notion that the lack of attention to the most basic detail is due to under-regulation … I claim that it is due to the practice of putting know-nothings on the the trading desks; and, what’s worse, promoting these know-nothings to managerial roles. Lack of knowledgeable supervision can, I suspect, also be fingered as the cause of mark-to-market “errors”.

I mentioned on February 13 my distaste for a system in which traders in securities not only boasted of their ignorance of operations, but made such ignorance a condition of entry to the elect. These operational issues with CDSs illustrate the first logical consequence of such ignorance … and I will admit, there is a large part of me that wants to see a big House go bankrupt over these issues, throwing those effete cowboys on welfare where they belong!

BMO has announced another writedown involving preferred shares – I have updated the post regarding preferred performance in 2007. In another update to an old post, I’ve added some information to Seniority of Bankers’ Acceptances … which I find particularly interesting in view of concerns over the monoline business model. Finally, the most recent post re ABK.PR.C has been updated … everything is proceeding as anticipated.

As noted in the comments to Feb 15, bonds got nailed today:

Treasuries fell, pushing the 10-year note’s yield to the highest level in more than a month, on speculation accelerating inflation will prompt the Federal Reserve to be less aggressive in cutting borrowing costs.

The yield on the benchmark 10-year note, more sensitive to inflation than shorter-term debt, was 1.84 percentage points higher than two-year rates. The spread was 1.93 percentage points on Feb. 14, the most since July 2004, reflecting a steepened yield curve.

Consumer prices rose at an annual rate of 4.2 percent in the 12 months through January after a 4.1 percent pace through the previous month, according to the median forecast of 31 economists surveyed by Bloomberg News. Excluding food and energy, prices rose 2.4 percent in the year through January, economists forecast. The Labor Department will release the report tomorrow.

…  and the Fed Funds contract backed off its more dramatic predictions.

Fed funds futures on the Chicago Board of Trade indicated a 100 percent chance policy makers will cut the 3 percent target rate for overnight loans by a half-percentage point at the March 18 meeting, compared with 66 percent odds on Feb. 15. The chance of a three-quarter-point reduction was 34 percent on Feb. 15.

Another good, solid day for the preferred share market, although volume continued light.

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 5.56% 5.61% 42,778 14.5 2 -0.0617% 1,071.5
Fixed-Floater 5.00% 5.66% 76,078 14.70 7 +0.0032% 1,025.3
Floater 4.95% 5.01% 71,830 15.44 3 -0.0763% 853.7
Op. Retract 4.81% 2.51% 78,237 2.79 15 -0.1482% 1,045.8
Split-Share 5.27% 5.41% 99,208 4.09 15 +0.0584% 1,044.7
Interest Bearing 6.24% 6.45% 59,528 3.56 4 +0.5350% 1,081.5
Perpetual-Premium 5.73% 4.44% 369,713 4.34 16 -0.0522% 1,029.5
Perpetual-Discount 5.35% 5.39% 284,212 14.83 52 +0.1689% 960.6
Major Price Changes
Issue Index Change Notes
DFN.PR.A SplitShare -1.8095% Asset coverage of just under 2.5:1 as of January 31, according to the company. Now with a pre-tax bid-YTW of 4.79% based on a bid of 10.31 and a hardMaturity 2014-12-1 at 10.00.
PWF.PR.J OpRet -1.7918% Now with a pre-tax bid-YTW of 4.15% based on a bid of 25.76 and a softMaturity 2013-7-30 at 25.00. 
GWO.PR.F PerpetualPremium -1.6406% Now with a pre-tax bid-YTW of 5.37% based on a bid of 25.78 and a call 2012-10-30 at 25.00.
MFC.PR.C PerpetualDiscount -1.5473% Now with a pre-tax bid-YTW of 5.13% based on a bid of 22.27 and a limitMaturity.
SBN.PR.A SplitShare -1.4493% Asset coverage of just under 2.2:1 as of February 7 according to the company. Now with a pre-tax bid-YTW of 4.93% based on a bid of 10.20 and a hardMaturity 2014-12-1 at 10.00.
BAM.PR.I OpRet -1.4122% Now with a pre-tax bid-YTW of 5.02% based on a bid of 25.83 and a softMaturity 2013-12-30 at 25.00.
BAM.PR.B Floater -1.0989%
PWF.PR.I PerpetualPremium +1.0081% Now with a pre-tax bid-YTW of 5.02% based on a bid of 26.05 and a call at either 25.25 on 2011-5-30, or 25.00 on 2012-5-30 … take your pick.
SLF.PR.D PerpetualDiscount +1.1253% Now with a pre-tax bid-YTW of 5.04% based on a bid of 22.02 and a limitMaturity.
SLF.PR.A PerpetualDiscount +1.1898% Now with a pre-tax bid-YTW of 5.09% based on a bid of 23.25 and a limitMaturity.
BSD.PR.A InterestBearing +1.3800% Asset coverage of 1.6+:1 as of February 15, according to Brookfield Funds. Now with a pre-tax bid-YTW of 7.07% (mostly as interest) based on a bid of 9.55 and a hardMaturity 2015-3-31 at 10.00.
MFC.PR.A OpRet +1.4112% Now with a pre-tax bid-YTW of 3.71% based on a bid of 25.87 and a softMaturity 2015-12-18 at 25.00.
SLF.PR.B PerpetualDiscount +1.4175% Now with a pre-tax bid-YTW of 5.13% based on a bid of 23.31 and a limitMaturity.
SLF.PR.C PerpetualDiscount +1.4847% Now with a pre-tax bid-YTW of 5.01% based on a bid of 22.15 and a limitMaturity.
FBS.PR.B SplitShare +1.6461% Asset coverage of 1.6+:1 as of February 14, according to TD Securities. Now with a pre-tax bid-YTW of 5.39% based on a bid of 9.88 and a hardMaturity 2011-12-15 at 10.00.
SLF.PR.E PerpetualDiscount +2.0871% Now with a pre-tax bid-YTW of 5.04% based on a bid of 22.28 and a limitMaturity.
Volume Highlights
Issue Index Volume Notes
SLF.PR.D PerpetualDiscount 102,766 Nesbitt crossed 100,000 at 22.10. Now with a pre-tax bid-YTW of 5.04% based on a bid of 22.02 and a limitMaturity.
BNS.PR.L PerpetualDiscount 47,475 Now with a pre-tax bid-YTW of 5.19% based on a bid of 21.88 and a limitMaturity.
BAM.PR.N PerpetualDiscount 35,710 Now with a pre-tax bid-YTW of 6.47% based on a bid of 18.68 and a limitMaturity.
BNS.PR.0 PerpetualPremium 32,620 Now with a pre-tax bid-YTW of 5.53% based on a bid of 25.44 and a call 2017-5-26 at 25.00.
BNS.PR.M PerpetualDiscount 22,435 Now with a pre-tax bid-YTW of 5.20% based on a bid of 21.83 and a limitMaturity.

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

One Response to “February 19, 2008”

  1. […] Even the nationalization of Northern Rock in the UK (very briefly mentioned on February 19 – as the ultimate consequence of illiquidity and a subsequent run on deposits – has not been due to insolvency: it has been due to illiquidity, which is not the same thing. […]

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