February 21, 2008

Naked Capitalism reprints a WSJ editorial that concludes:

A financial system runs on trust, and the credit crisis is continuing in part because there is so much mistrust about the magnitude of potential losses and where those losses reside. By encouraging bond insurers to unilaterally rewrite their contracts, Messrs. Spitzer and Dinallo are only creating more mistrust and uncertainty. We assume the banks that bought the bond insurance and signed the contracts will take their insurers to court.

Holy smokes, if this thing doesn’t get reasonably resolved, things are going to get messy! I can only assume that Dinallo is simply engaging in brinksmanship, with the actual object being a recapitalization of the monolines. The trouble with brinksmanship, of course, is that if it doesn’t work, things have become worse.

MBIA has announced:

it withdrew from its trade association because of differences over the direction of the industry.

“We believe that the industry must over time separate its business of insuring municipal bonds from the often riskier business of guaranteeing other types of securities,” MBIA’s new Chairman and Chief Executive Officer Jay Brown said in a statement today. The company also disagrees with the Association of Financial Guaranty Insurers’ “positions on the appropriateness of monoline financial guarantors insuring credit default swaps.”

The press release on the MBIA site states:

For one thing, we believe that the industry must over time separate its business of insuring municipal bonds from the often riskier business of guaranteeing other types of securities, such as those linked to mortgages. Additionally, we disagree with AFGI’s positions on the appropriateness of monoline financial guarantors insuring credit default swaps and the ability of U.S. financial guarantors to reinsure U.S. domestic financial guarantee insurance transactions with foreign affiliates without paying U.S. corporate tax rates.

The AFGI has posted a review of the industry dated November 2007 and the website FAQ includes asset backed securities as a field of future growth for monolines. I don’t see anything specific about Credit Default Swaps.

There was a further indication that the CDS market is strange:

Credit markets were thrown into fresh turmoil on Wednesday as the cost of protecting the debt of US and European companies against default surged to all-time highs.

The sharp jump, which rivalled the sell-off at the height of last summer’s credit market turmoil, came as traders rushed to unwind highly leveraged positions in complex structured products.

The sell-off was triggered partly by fears of more unwinding to come as investors rushed to exit before conditions worsen. As losses have snowballed, further unwinding has been triggered.

The cost of insuring the debt of the 125 investment-grade companies in the benchmark iTraxx Europe rose more than 20 per cent to as high as 136.9 basis points, before closing at 126.5bp. That compares with a level of about 51bp at the start of the year, according to data from Markit Group.

In contrast to this, let’s take a quick glance at some recent BoC research into CDS Pricing:

The paper examines three equity-based structural models to study the nonlinear relationship between equity and credit default swap (CDS) prices. These models differ in the specification of the default barrier. With cross-firm CDS premia and equity information, we are able to estimate and compare the three models. We find that the stochastic barrier model performs better than the constant and uncertain barrier models in terms of both in-sample fit and out-of-sample forecasting of CDS premia. In addition, we demonstrate a linkage between the default barrier, jump intensity, and barrier volatility estimated from our models and firm-specific variables related to default risk, such as credit ratings, equity volatility, and leverage ratios.

At best, this study represents a good try – the data for determining the value of a CDS through a cycle simply does not exist. Despite my interest in the asset class, I’m not convinced that the CDS market is ready for prime time. If their main attraction is the ability to lever up a portfolio significantly, then a huge degree of uncertainty is introduced into pricing, in addition to the uncertainty introduced by debt decoupling. I continue to wrestle with the idea, but these twin, undiversifiable uncertainties probably introduce a required risk premium that makes inclusion of these instruments, long or short, in a fixed income portfolio uneconomic.

It’s all very complicated and I’m a simple kind of guy! The complexity was noted in a Financial Times article by Aline Van Duyn and Gillian Tett excerpted by Naked Capitalism:

The fundamental problem is that this decade’s wave of banking innovation has created a financial system that is not just highly complex but also tightly interlinked in ways that policymakers and investors sometimes struggle to understand.

This could result in the businesses of companies such as Ambac, MBIA and FGIC being split into two, to ensure that bond insurers can ringfence the riskier assets (such as mortgages) from the municipal guarantee business.

But although such a split currently seems attractive in political terms – most notably because it would enable policymakers to protect the municipal bond market in an election year – it will not necessarilly prevent further turmoil on Wall Street. On the contrary, as Jeffrey Rosenberg, analyst at Bank of America, says: “A split may limit losses in the municipal market, but it would likely exacerbate losses to structured finance… To the extent that those losses further constrain financial institutions’ balance sheets, broader credit constaint may follow.”

Cowboys, cowboys! Playing with things they don’t really understand, and sometimes doing quite well for several years. I think they’re wonderful … selling them liquidity is a very profitable endeavor.

As I suggested when the news first came out on January 24, Kerviel’s status as a “rogue trader” must forever be preceded by the qualifier “so-called”. A SocGen report on the loss has reported:

“Controls in place were conducted without triggering a strong or persistent enough alert to enable the identification of the fraud,” the e-mailed report said.

It did say that compliance officers rarely went beyond established routine checks.

They “don’t have the reflex to inform their superiors or the front office of anomalies, even if they concern large amounts,” the report said.

There weren’t any follow-up checks on cancelled or modified transactions, and no limits on nominal positions, just on net positions, it found.

While procedures were respected and questions were asked, “no initiative was taken to check JK’s assertions and corrections he suggested, even when they lacked plausibility,” the report said. “When the hierarchy was alerted, it didn’t react.”

The committee said there were 75 red flags between June, 2006, and the beginning of 2008 that should have alerted managers to Mr. Kerviel’s unauthorized trades. The warning signs included a trade with a maturity date on a Saturday, bets with “pending” counterparties and missing broker names, the report said.

The actual SocGen report contains a marvellous graph of reported vs. actual P&L for Kerviel’s positions (page 11 of the PDF). 

In other words, SocGen risk management is a complete joke. And in response, of course, SocGen and many other firms are requiring complete ignorance of operations, rather than simply preferring it. This will also serve to emphasize to the traders that operations personnel are low-life scum, who may be ingored, lied to and sworn at with impunity. Brace yourselves for more blow-ups!

A very quiet day today, but the market continued strong. PerpetualDiscounts are now up 3.34% on the month-to-date and 3.76% on the year-to-date. They have had exactly two down days this month (so far!), both less than a beep’s worth.

To my astonishment, there have been no new issue announcements this week, in defiance of my February 15 prediction. Well, perhaps tomorrow will salvage my reputation …

I’m of two minds whether or not to write another post devoted to the BNA issues … the BNA.PR.A closed with a ludicrously strong bid, and the yield on BNA.PR.C is now lower than the equal-credit-shorter-term BNA.PR.B.

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 5.51% 5.55% 41,791 14.5 2 -0.0205% 1,081.5
Fixed-Floater 5.01% 5.68% 73,766 14.66 7 -0.0911% 1,023.0
Floater 4.95% 5.01% 70,323 15.42 3 -0.0137% 853.3
Op. Retract 4.80% 2.19% 78,412 2.87 15 +0.1295% 1,047.9
Split-Share 5.29% 5.37% 99,536 4.06 15 -0.0987% 1,042.9
Interest Bearing 6.23% 6.37% 58,665 3.34 4 -0.1000% 1,083.1
Perpetual-Premium 5.71% 4.27% 358,559 4.28 16 +0.1244% 1,032.4
Perpetual-Discount 5.34% 5.38% 279,492 14.84 52 +0.0956% 963.0
Major Price Changes
Issue Index Change Notes
BCE.PR.G FixFloat -2.6667%  
PWF.PR.I PerpetualPremium -1.2957% Now with a pre-tax bid-YTW of 5.18% based on a bid of 25.90 and a call 2012-5-30 at 25.00.
LFE.PR.A SplitShare -1.1321% Asset coverage of 2.4+:1 as of February 15, according to the company. Now with a pre-tax bid-YTW of 4.21% based on a bid of 10.48 and a hardMaturity 2012-12-1 at 10.00.
BAM.PR.I OpRet -1.0062% Now with a pre-tax bid-YTW of 5.23% based on a bid of 25.58 and a softMaturity 2013-12-30 at 25.00 
CIU.PR.A PerpetualDiscount +1.0688% Now with a pre-tax bid-YTW of 5.31% based on a bid of 21.75 and a limitMaturity.
CM.PR.H PerpetualDiscount +1.1055% Now with a pre-tax bid-YTW of 5.52% based on a bid of 21.95 and a limitMaturity.
BNA.PR.C SplitShare +1.7128% Asset coverage of 3.3+:1 as of January 31 according the company. Now with a pre-tax bid-YTW of 6.91% based on a bid of 20.19 and a hardMaturity 2019-1-10 at 25.00. Compare with BNA.PR.A (3.08% (!) to 2010-9-30) and BNA.PR.B (7.25% to 2016-3-25). Assiduous Reader prefhound will be putting on another long/short position if this keeps up!
MFC.PR.A OpRet +1.9714% Now with a pre-tax bid-YTW of 3.41% based on a bid of 26.38 and a softMaturity 2015-12-18 at 25.00. 
BAM.PR.G FixFloat +2.4378%  
Volume Highlights
Issue Index Volume Notes
TD.PR.Q PerpetualPremium 43,901 TD bought 15,600 from Anonymous at 25.60. Now with a pre-tax bid-YTW of 5.37% based on a bid of 25.55 and a call 2017-3-2 at 25.00.
BNS.PR.O PerpetualPremium 39,355 Now with a pre-tax bid-YTW of 5.40% based on a bid of 25.50 and a call 2017-5-26 at 25.00.
GWO.PR.G PerpetualDiscount 31,676 Nesbitt crossed 25,000 at 24.90. Now with a pre-tax bid-YTW of 5.30% based on a bid of 24.86 and a limitMaturity.
BAM.PR.M PerpetualDiscount 29,785 Now with a pre-tax bid-YTW of 6.40% based on a bid of 18.89 and a limitMaturity.
BNS.PR.M PerpetualDiscount 27,802 National Bank crossed 20,000 at 21.86. Now with a pre-tax bid-YTW of 5.22% based on a bid of 21.77 and a limitMaturity.

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

3 Responses to “February 21, 2008”

  1. madequota says:

    National Kiss your Market Maker Day Update

    Good afternoon! With the bond market flat to up, and the pref market also generally flat to up, traders are celebrating this “unofficial” holiday by savagely pounding Royal Bank, and their preferred shares.

    I presume the general reason behind this is yesterday’s announcement that RBC will be taking Phillips Hager & North private in an all-stock (I assume all common stock) deal. Is there any chance that RBC will issue the long-awaited . . . and Hymas-predicted . . . next issue of RBC preferreds to help fund this deal? If they do, maybe they’ll follow the lead of their predecessor issuers and offer this issue at a horrific discount to market. We haven’t had a pref share mini-crash for quite some time . . . a couple of months at least!

    Maybe RBC’s upper management has been following these blogs, and finally realize that their fund management side needs some new blood!

    An interesting sidebar to the activity on RBC’s prefs today, is for the first time in a very long time, RBC themselves are absent from the sell side. Hmmm.


  2. jiHymas says:

    Oh dear, the Hymas-predicted perp issuance! *sigh* Yet another failed prophecy.

    RBC’s fund management side may well need some new blood, but they won’t get it through acquisition! What happens in a bank takeover is that first of all the HR people rush to the bulletin board and make it totally precious. Then all the guys who love investment management and are good at it are told to go to Tuktoyuktuk for the Volunteer Fire Department’s annual dinner, “Because they’re a good client and Bob thinks we should have a full table”.

    A lot of the commentary I’ve seen worries about fees. I’d be more worried about performance. Banks are not in the business of building a great product and charging a good price for it. They are in the business of making acceptable products and branding them.

  3. […] 2008-4-3: It’s linked in the comments, but I should highlight the February 21 review of some BoC Research into CDS […]

Leave a Reply

You must be logged in to post a comment.