PrefBlog

Accrued Interest notes that he’s hearing some chatter about credit markets finally troughing, and urges caution:

Anyway, as much as I’d like to believe in a bottom in credits, we need to get through mid April with some strength. April is going to be a key month for bank/finance earnings (translation, writedowns) Here are some earnings dates to mark on your calendar.

I’ll add my caution to his. Remember, it is in the interest of the sell-side to convince clients that a turning point has been reached and therefore that a rejigging of portfolios is in order. It is in the interest of the press to convince readers that right now this minute is quite possibly the most exciting time in the history of markets.

Be skeptical and remember Rule #1: Things are always less exciting than they seem. And if you take the view that things are getting worse, you can find big name support for that idea.

Felix Salmon reviewed the CDS market after an article in the NYT. Reasonable enough reviews; the NYT article made the point I’ve been making about the credit crunch:

But many speculators, particularly hedge funds, have flocked to these instruments to bet on a company failure easily. Before the insurance was developed, such a bet would require selling short a corporation’s bond and going into the market to borrow it to supply to the buyer.

The market’s popularity raises the possibility that undercapitalized participants could have trouble paying their obligations.

“The theme had been that derivatives are an instrument that helps diversify risk and stabilize risk-taking,” said Henry Kaufman, the economist at Henry Kaufman & Company in New York and an authority on the ways of Wall Street. “My own view of that has always been highly questionable — those instruments also encourage significant risk-taking and looking at risk modestly rather than incisively.”

I will not attempt to quantify the effect of the ability to short corporate debt easily has had in intensifying the damage of the credit crunch. But it’s there! This is not necessarily a bad thing, though; one of the great attributes of financial markets in general is that they tend to anticipate and intensify pain, thereby getting it over with more quickly so we can go back to work.

Stephen Cecchetti’s idea of forcing CDS trading onto exchanges (noted on PrefBlog on November 19 has found support from George Soros:

There is an esoteric financial instrument called credit default swaps. The notional amount of CDS contracts outstanding is roughly $45,000bn. To put it into perspective, that is about equal to half the total US household wealth and about five times the national debt. The market is totally unregulated and those who hold the contracts do not know whether their counterparties have adequately protected themselves. If and when defaults occur, some of the counterparties are likely to prove unable to fulfil their obligations. This prospect hangs over the financial markets like a sword of Damocles that is bound to fall, but only after some defaults have occurred. That must have played a role in the Fed’s decision not to allow Bear Stearns to fail. One possible solution is to establish a clearing house or exchange with a sound capital structure and strict margin requirements to which all existing and future contracts would have to be submitted. That would do more good in clearing the air than a grand regulatory reorganisation.

Sounds nice, but I’m not certain that there’s enough volume in the off-the-run CDSs to justify an exchange. And I’d really like to know who’s going to pay for it! I will admit that the notion of controlling counterparty risk by such a mechanism does have its attractions … but I suspect that most of the trouble in this department is coming from the esoteric swaps on sub-prime paper, of which maybe one or two will exist world-wide for any given tranche.

Several exchanges were reported in 2006 to be gearing up to trade CDSs:

Morgan Stanley, Deutsche Bank AG and Goldman Sachs Group Inc. risk losing their hammerlock on the most lucrative financial market when exchanges begin offering credit derivatives next year.

Paris-based Euronext NV, which is being bought by NYSE Group Inc., plans to create contracts based on credit-default swaps, making them cheaper to trade and easier to understand than the derivatives sold by banks. Credit-default swaps, used to speculate on credit quality, also top the product list for Chicago Mercantile Exchange Holdings Inc., the largest U.S. futures market, the Chicago Board Options Exchange and Frankfurt- based Eurex AG.

I don’t know why this initiative foundered – it may be fear of trying something new during a crunch, of course – but the NYSE is now promoting a service to report prices of such illiquid securities, presumably in competition with Markit.

There were further indications of skullduggery in the BSC implosion today:

The SEC opened probes last month into whether hedge funds and other investors spread false rumors in seeking to profit from declines in stocks of companies including Bear Stearns and Lehman Brothers Holdings Inc., people familiar with the inquiries said at the time.

“It looked like more than just fear, it looked like people wanted to induce a panic,” Bear Stearns Chief Executive Officer Alan Schwartz told the Senate panel today. “The minute we got a fact out, more rumors started or there was a different set of rumors.”
…
The SEC can’t yet say whether market manipulation was responsible for the run, Cox told the Senate committee. During the week it occurred, the Fed passed along “extremely helpful information” on rumors from a “variety of market sources,” he noted.

New York Fed President Timothy Geithner testified regarding the BSC / JPM deal today to the Senate Banking Committee today. Of most interest was the information regarding the BSC collateral:

The New York Fed presented a one-page description of the portfolio. The assets include investment-grade securities and residential and commercial mortgage loans, all of which were current on principal and interest as of March 14.

The portfolio also holds collateralized mortgage obligations, most of which are bonds of government-sponsored enterprises such as Freddie Mac and Fannie Mae. The holdings include asset-backed securities, adjustable-rate mortgages, commercial mortgage-backed securities and collateralized mortgage obligations issued by companies other than government-chartered companies.

The (rather general) statement of collateral and the full testimony is available from the NY Fed. His main point is that action was necessary to break the cycle:

What we were observing in U.S. and global financial markets was similar to the classic pattern in financial crises. Asset price declines—triggered by concern about the outlook for economic performance—led to a reduction in the willingness to bear risk and to margin calls. Borrowers needed to sell assets to meet the calls; some highly leveraged firms were unable to meet their obligations and their counterparties responded by liquidating the collateral they held. This put downward pressure on asset prices and increased price volatility. Dealers raised margins further to compensate for heightened volatility and reduced liquidity. This, in turn, put more pressure on other leveraged investors. A self-reinforcing downward spiral of higher haircuts forced sales, lower prices, higher volatility and still lower prices.

Pity the Fed! It’s a thankless task at the best of times, second-guessed by every granny who buys a short-term bond, but the worst part must be having to tolerate grandstanding politicians.

Lehman doesn’t want to follow the path of the Bear! They’ve raised $8-billion in two weeks, helped by securitizing a package of LBO debt.

Volume was light today, but prices were up nicely. Interestingly, the S&P/TSX Preferred Share index (and the NAV of CPD) was down, as closing bids (used by the HIMIPref™ indices) and closing prices (used by a few small outfits) moved in opposite directions.

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

This entry was posted on Thursday, April 3rd, 2008 at 9:12 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.