March 27, 2008

In a post remarkable for its vitriol, Naked Capitalism has attacked a rather innocuous article by Robert Shiller that mounted a defense of financial innovation. So today I’ll comment on the commentary and try to get past the slogans du jour.

Shiller: The entire sub-prime market is largely a decade-old innovation – the word “sub-prime” did not exist in any language before 1994 – built on such things as option adjustable-rate mortgages (option-ARM’s), new kinds of collateralized debt obligations, and structured investment vehicles. Previously, private investors in the US simply did not lend to mortgage seekers whose credit history was below prime.
Naked CapitalismFirst, option ARMs are not a subprime product; they were targeted to prime borrowers (see here and here from the esteemed Tanta). This is a striking error from a supposed expert on housing markets. Second, financial innovation does not equal “securitization of subprimes” which is what his second paragraph implies. CDOs frequently contain heterogeneous assets; many CDOs contain only corporate bond exposures.

Naked Capitalism is factually correct – option-ARMS (these are adjustable rate mortgages in which the borrower has an option regarding how much principal to repay … this can be a negative amount, giving rise to negative amortization) are not a sub-prime product.

As Table 9 in Ashcraft’s paper (reviewed on PrefBlog) shows, Option-ARMs have next-to-no representation in subprime MBS pools. However, the proportion of option-ARMs in Alt-A pools increased rapidly in recent times: from 1.7% in 2003 to 42.3% in 2006. Given that the second Calculated Risk post referenced by Naked Capitalism notes a 15% delinquency rate in Yuba City (north of Sacremento) I don’t quite see that this slight inaccuracy detracts from the credibility of the piece as a whole.

I am completely mystified regarding NC‘s second point: Shiller does not mention “securitization of subprimes” at all, despite NC‘s quotation marks. And while tranching and CDOs have been seen before, the widespread adoption of tranching in creating AAA securities from junk via subordination, which has confused so many commentators, is indeed a new thing.

Naked Capitalism then goes into a long rant, taking issue with Shiller’s statement that:

A study published in 2005 by economists Geert Bekaert, Campbell Harvey, and Christian Lundblad found that when countries liberalize their stock markets, allowing them to operate freely without government intervention, economic growth rises by an average of one percentage point annually.

NC claims a strong belief that this is in reference to a paper titled Growth Volatility and Financial Liberalization, going in to great detail to show why the paper does not show this. Unfortunately, a thirty second search of the SSRN site turns up a paper by the same three authors titled Does Financial Liberalization Spur Growth?, with the abstract:

We show that equity market liberalizations, on average, lead to a one percent increase in annual real economic growth. The effect is robust to alternative definitions of liberalization and does not reflect variation in the world business cycle. The effect also remains intact when an exogenous measure of growth opportunities is included in the regression. We find that capital account liberalization also plays a role in future economic growth, but, importantly, it does not subsume the contribution of equity market liberalizations. Other simultaneous reforms only partially account for the equity market liberalization effect. Finally, the largest growth response occurs in countries with high quality institutions.

It would seem that NC is very eager to confound financial liberalization with depredations of investors! There are other problems with his post; mainly attempts to portray innovation as the antithesis of regulation, but I’ll leave those as an exercise for the student.

Fascinating disclosure about Bear Stearns’ ownership today:

Bear Stearns Cos. Chairman James “Jimmy” Cayne sold his shares in the firm prior to a shareholder vote on the company’s pending takeover by JPMorgan Chase & Co.

Cayne sold 5.6 million shares at $10.84 a piece on March 25 on the New York Stock Exchange, according to a regulatory filing today. Bear Stearns spokesman Russell Sherman had no comment on why or to whom Cayne sold his shares.

I think I’ve mentioned my interest in CIT Group before; a number of interesting things have happened recently. They announced they were tapping their bank lines to build up cash and pay off their un-rollable commercial paper; short interest skyrocketted; Option volatility went way up; the price of CDSs soared (it’s a member of the investment grade high volatility index); and bonds tanked.

So … I’m trying to figure out investment strategies that would relate all thes data (bonds / CDSs is too easy. No marks for that one). I do recognize that all this could be happening completely independently … but I have real trouble believing that CDSs at +1300 is a rational response … even at +1000, that was being quoted at 25 points up front and 5 points a year. That’s not default risk – that’s “how much recovery will there be from the carcass?” What I’m saying is, I suspect that there’s some kind of amplification/transmission mechanism that’s operative and I’m trying to figure out how such a thing might work.

I’m not expecting to find a perfect arbitrage, I’m just trying to find a transmission mechanism. How about … short the stock at $10. Buy a call option with a $15 strike to cover. Sell 5-year Credit protection at 1000bp (net. get some points up front!). Do all this for $10-million notional on each position.

Scenario #1: CIT taken over. Stock goes way up, option exercised, loss $6-million. CDS comes in 700bp, gain about $3.5-million. Net -$2.5-million. Hmmm … maybe the hedge ratio on that one needs to be changed…

Scenario #2: CIT goes bust. Stock goes to zero, option expires worthless. Gain $9-million. CDS settles at 40% recovery. Loss $6-million. Net +$3-million Hedge ratio again … but this is beginning to look interesting.

Scenario #3: Nothing happens. Replace option, cost … Oh, call it $4 annually, or $4-million annually on the position. Receive credit protection payment of $1-million. Net loss $3-million annually

Scenario #4: Nothing happens, but you got 25 points up front. Wait one year, buy back the stock at $10, stop replacing options. Cost of options $4-million. Receive CDS payments of $2.5-million up front + $0.5-million for the year. Net loss $1-million; left with written CDS of 4-years at 500bp

So it doesn’t quite work (with these prices, which probably aren’t 100% executable), but I think there’s something there. And it’s the CDS prices I think are abnormal anyway, so that strategy’s in the wrong direction. How about … buy $10-million stock, buy $25-million notional credit protection?

Scenario 1: Company goes bust in one year. Lose $10-million on stock. Pay $6.25-million up front on CDS, pay $1.25-million annual charge. Make 60% (assumed) on notional CDS = $15-million. Net loss $2.5-million … $2.50/share

Scenario 2: Company taken over at $20. Make $10-million on stock. Pay $6.25-million up front on CDS, pay $6.25-million (total over 5 years) for four year’s credit protection on acquirer. Net = four year, $25-million CDS on acquirer for total cost $2.5-million = 25bp That’s very very cheap, could be sold for … um … 150bp? Then $25-million x 4 years x 125bp = $1.25-million profit. So the break-even takeover price is about $18.75, with full exposure up or down. You’re paying $8.75 for the chance at the other two scenarios.

Scenario 3: Nothing happens. Sell stock, no loss or gain. Have very expensive credit protection on CIT.

… Hmmmmm … still doesn’t quite work.

Any ideas for transmission between asset classes will be appreciated! I do appreciate that a drop in stock price accompanied by a rise in volatility will lead to a higher CDS price according to some models – I’ve mentioned the BoC study – but … but … I want something more direct.

Volume was light on the preferred market today, but there were some violent price moves amid a sharp decline. BCE issues did very well, but quite a few PerpetualDiscounts got hammered.

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 5.36% 5.36% 32,662 14.91 2 +0.2258% 1,097.0
Fixed-Floater 4.75% 5.40% 60,213 15.01 8 +0.9341% 1,048.8
Floater 4.97% 4.98% 77,269 15.55 2 -1.2127% 838.0
Op. Retract 4.84% 4.12% 77,258 3.13 15 +0.1015% 1,048.2
Split-Share 5.39% 5.98% 93,772 4.12 14 +0.0637% 1,024.3
Interest Bearing 6.21% 6.20% 65,987 3.93 3 +0.3406% 1,090.4
Perpetual-Premium 5.81% 5.64% 246,432 10.75 17 +0.2234% 1,020.0
Perpetual-Discount 5.63% 5.68% 291,386 14.37 52 -0.4194% 918.8
Major Price Changes
Issue Index Change Notes
BAM.PR.B Floater -2.4599%
SLF.PR.E PerpetualDiscount -1.9314% Now with a pre-tax bid-YTW of 5.57% based on a bid of 20.31 and a limitMaturity.
BMO.PR.K PerpetualDiscount -1.8014% Now with a pre-tax bid-YTW of 5.95% based on a bid of 22.35 and a limitMaturity.
MFC.PR.B PerpetualDiscount -1.7273% Now with a pre-tax bid-YTW of 5.40% based on a bid of 21.62 and a limitMaturity.
ELF.PR.G PerpetualDiscount -1.6828% Now with a pre-tax bid-YTW of 6.30% based on a bid of 19.28 and a limitMaturity.
BAM.PR.M PerpetualDiscount -1.5808% Now with a pre-tax bid-YTW of 6.19% based on a bid of 19.30 and a limitMaturity.
LFE.PR.A SplitShare -1.1364% Asset coverage of 2.2+:1 as of March 14, according to the company. Now with a pre-tax bid-YTW of 5.08% based on a bid of 10.07 and a hardMaturity 2012-12-1 at 10.00.
CM.PR.J PerpetualDiscount -1.1202% Now with a pre-tax bid-YTW of 5.80% based on a bid of 19.42 and a limitMaturity.
MFC.PR.C PerpetualDiscount -1.1034% Now with a pre-tax bid-YTW of 5.27% based on a bid of 21.51 and a limitMaturity.
HSB.PR.D PerpetualDiscount -1.0917% Now with a pre-tax bid-YTW of 5.54% based on a bid of 22.65 and a limitMaturity.
TCA.PR.Y PerpetualPremium (for now!) +1.0776% Now with a pre-tax bid-YTW of 5.51% based on a bid of 49.95 and a limitMaturity.
BCE.PR.I FixFloat +1.1591%  
DFN.PR.A SplitShare +1.2168% Asset coverage of 2.3+:1 as of March 14, according to the company. Now with a pre-tax bid-YTW of 4.82% based on a bid of 10.25 and a hardMaturity 2014-12-1 at 10.00.
BCE.PR.G FixFloat +1.3384%  
BCE.PR.Z FixFloat +3.2038%  
Volume Highlights
Issue Index Volume Notes
PWF.PR.H PerpetualPremium (for now!) 77,000 CIBC crossed 40,000 at 25.00, then another 35,000 at the same price. Now with a pre-tax bid-YTW of 5.86% based on a bid of 24.93 and a limitMaturity.
TD.PR.R PerpetualDiscount 69,935 Anonymous crossed 10,000 at 24.89. Now with a pre-tax bid-YTW of 5.67% based on a bid of 24.89 and a limitMaturity.
MFC.PR.B PerpetualDiscount 60,375 Now with a pre-tax bid-YTW of 5.40% based on a bid of 21.62 and a limitMaturity.
ELF.PR.F PerpetualDiscount 19,900 Now with a pre-tax bid-YTW of 6.55% based on a bid of 20.70 and a limitMaturity.
CM.PR.I PerpetualDiscount 19,489 Now with a pre-tax bid-YTW of 5.91% based on a bid of 19.90 and a limitMaturity.

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

19 Responses to “March 27, 2008”

  1. prefhound says:

    If BMO.PR.K is yielding 5.95%, does this mean the new BMO 5.8% issue might open underwater when it closes? Perhaps James can tell us where the other BMO prefs sit.

  2. davejphys says:

    I read Naked Capitalism a lot but I think the person (woman?) is biased. This person like Mish or Roubini clearly hate this version of capitalism that we have (whatever it is) and want it to die.

    I am not buying every crappy bank stock but I own AIG shares and one other bank. I don’t think the financial world is coming to an end and I don’t think our system is too terrible to save. These people who want to abolish the Fed and wanted Bear Stearns to die simply have an agenda because they are short. Sure, letting BSC fail would have taught Wall Street a lesson but it also would have resulted in all sorts of problems and harmed all sorts of people who have nothing to do with Wall Street. Some little old ladies in Topeka might have lost their pensions.

  3. kaspu says:

    at 22.4 bid BMO.K has a current yield of 5.914, but a YTW of 5.826, not much different from the new BMO pref. It will, however, be paying a dividend earlier, on may 26.

  4. madequota says:

    again, the trading perspective almost certainly overrides the yield analysis comparisons . . . consider these facts:

    no financially issued pref over the last 5 years has opened at a premium (except that BNS reset thing which is obviously not a comparable)

    there are a number of fiprefs currently yielding over 5.8% in the market

    Merrill Lynch’s fire sale of prefs continues with vigour

    ph, the BMO 5.8% pref will under no imaginable circumstances open above par . . . I would put it slightly lower than TD.PR.R currently @ $24.90 . . . the TD issue is only a 5.6% div, but has a considerably higher perceived value than BMO on the ABCP liability issue.

    BMO 5.8’s will open, and stay in the $24.65 – $24.75 range


  5. kaspu says:

    “no financially issued pref over the last 5 years has opened at a premium ”

    BNS O, opened 1/31/08 at 25.03, thereafter, until 2/27/08, as high as 25.68
    TD q, opened 1/31/08, at 25.13, thereafter, until 2/26/08, as high as 25.70

  6. jiHymas says:

    prefhound … the other BMO issues were left as an exercise for the student … but I might post something later, because they’re all over the place!

    davejphys … Naked Capitalism runs an excellent clipping service, that overlaps very well with my own interests. While I do not think much of his opinions, he does represent a constituency. Bear Stearns? I don’t think the shareholders are exchanging high-fives and congratulating each other about putting one over on the Fed. I suggest that shareholders have been taught an object lesson; teaching the same lesson to bondholders would have involved bankruptcy of a major firm at a time of financial system stress. I don’t think the game would have been worth the candle.

    kaspu … I’m not sure where you’re getting your numbers from. BMO.PR.K pays 1.3125, so a price of 22.40 implies a current yield of 5.86%. Are you looking at Bloomberg’s “Strip Yield”? While it’s better than Current Yield, I don’t think it’s an analytically useful number.

    A Yield calculation of any nature based on cash flows should provide a higher number, since the current-yield calculation implicitly assumes the longest possible time to the next receipt of income.

    madequota … things do indeed look rather grim for the new BMO 5.8s.

  7. kaspu says:

    Sorry, JH, you are quite correct, I was looking at the strip yield….I’ve just got to change that font colour….

  8. madequota says:

    very well, a slight inaccuracy in my sweeping statement . . . nevertheless, identifying 2 issues opening a tad over par in 5 years is just a little pointless, isn’t it, k? and the other thing is that those two issues started trading in the midst of that Carrick-enspired mini pref rally that, as we now know, was pretty short lived.

    stop looking at this thing through rose-coloured glasses; the pref market offers great yield, with tax friendly dividends as well . . . but BMO will open under water . . . for sure.

    and btw, BMO.PR.K is now offerred by Merrill in unlimited numbers at $22.30 . . .


  9. kaspu says:

    Whenever the broader equity markets drop like stone, various members of my extended family inevitably remember my incessant boring lectures about the beauty of waterfalling good quality fixed income (bonds and prefs), and raise the possibility of my managing their portfolios. Inevitably, my wife, with a shining 2% management fee dancing before her greedy little eyes, yells at me when I politely decline. Hence, the purity of my advice and my soul. Rose-coloured, or not, despite icebergs etc., the purchase of quality prefs at significant spreads to government bonds, consistently brings decent returns year after year. To be honest, whether the new BMO prefs open at less than 25, and trade there for a few days, weeks, or months, who the hell cares? I have found that averaging down on prefs has always yielded an ultimately positive capital return.

  10. kaspu says:

    not that taking management fees indicates a lack of purity (Yeesh!… that came out the wrong way….)

  11. madequota says:

    You would probably not believe this, but my investment habits are strangely a lot like yours. I just like to fine tune the buying price to reflect the best possible entry point.

    Back in the full service broker days, I used to deal with this guy that would always tell me that if I paid too much to buy something, as long as I held it for the long term, who cares?

    If you go out and buy 5 or 6 yards of BMO as an IPO, and it opens at $24.75 . . . even if it goes to $26 in a year, you paid $1000 too much to buy it. This broker I used to deal with didn’t get why that would have annoyed me, even after the stock would go to $26.

    So I would say you should care; there’s nothing wrong with improving your return by buying right.

    And this broker should have cared . . . I fired him.


  12. jiHymas says:

    Back in the full service broker days, I used to deal with this guy that would always tell me that if I paid too much to buy something, as long as I held it for the long term, who cares?

    If you go out and buy 5 or 6 yards of BMO as an IPO, and it opens at $24.75 . . . even if it goes to $26 in a year, you paid $1000 too much to buy it.

    Spoken like a true Quant! This is my philosophy exactly – though I would also emphasize the price received for the securities sold to buy the IPO in the first place. It’s the spread between the two that’s important.

  13. madequota says:

    Wow . . . pinching myself . . . I think that might be the first time you ever agreed with anything I’ve said here, Mr. H! . . . continuing on the +ve side, prefs are having their best day since BMO’s IPO, and for all those arbers out there, BAM.PR.M and BAM.PR.N are trading roughly on par with each other for the first time in a long time! . . . hopefully, the good vibes will continue in the pref market this afternoon!


    p.s. hopefully the price received for the original securities sold was higher than the price paid!

  14. […] 2008-3-28: There have been some comments made about BMO.PR.K falling out of bed, with speculation about the implications for the opening price of […]

  15. jiHymas says:

    As seen in the above (generated) comment, I have updated the BMO New Issue post with some estimates and comparables, in response to overwhelming public demand.

  16. jiHymas says:

    hopefully the price received for the original securities sold was higher than the price paid!

    Frankly, it’s not something I pay too much attention to … it only becomes an issue when I value the fund and work out capital gains distributions.

    As a long-term fully-invested investor, my return is going to be the coupon plus or minus an increment.

    I can’t do anything about the coupon, so I don’t worry about it. I worry about the increment and whether a particular trade has enough chance of adding to it to be worthwhile.

  17. prefhound says:

    I made a brief check of my records and here are some fiprefs that opened at/above par:
    Jan 2003: CM.PR.D; NA.PR.K
    Jan 2005: RY.PR.W; TD.PR.M
    Apr 2005: TD.PR.N
    Oct 2005: POW.PR.D
    Nov 2005: HSB.PR.D
    Oct 2006: ELF.PR.G
    Aug 2006: PWF.PR.L
    Jan 2007: BNS.PR.L

    It does seem that more opened below par, however. The trend seems to be that the first new issue in a long time is well received, but subsequent new issues struggle more. AND, of course, it depends on interest rate movements in the 3-4 weeks prior to closing.

    Anyway, it is not a disaster, as far as I can tell.

  18. prefhound says:

    Thanks, too to Kaspu for pointing out the arb trade exit on BAM.PR.M/N. From an entry 17 days ago at 81 cents (shorting M and buying N) I got out late today at 4 cents. Total costs were about 4 cents for a net gain of 73 cents on committed capital of $19.30.

    Now I can afford to renew my PrefLetter subscription….

  19. […] I’m sulking. All those comments for March 27 and nobody explained to me why, given prices for all the other instruments, CIT CDSs have to be so […]

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