May 22, 2008

Accrued Interest has a good piece today, elaborating his thoughts on the GSEs (which he insists on spelling with an apostrophe).

Did Freddie Mac move their ABS portfolio into Level 3 because they didn’t like the bid indications they were using for valuation? The company says no.

Buddy Piszel, CFO: We made a determination in the first quarter, that given how widely the pricing we were getting on the ABS portfolio, that it no longer made sense to leave that in Level 2…. We were still using the mean price that we were getting from the pricing services and the dealers. So we are not using a model price

So if you believe what he’s saying, that means that the actual valuation would be the same either way. By moving to Level 3, they are saying they no longer believe the valuations represent “observable inputs.”

It seems clear that The Financial Accounting Standards Board is feeling some heat about Level 3, the so-called “Mark to Make-Believe” level of financial assets. They have published an article rather desperately titled Some Facts about Fair Value:

Like the many other estimates used in financial reporting (some of which require complex calculations), Level 3 estimates can be difficult and require the use of significant judgments. However, many investors clearly have indicated that such estimates provide more relevant and useful information than alternatives that ignore current economic conditions and that can introduce management bias into the estimation process (for example, alternatives that involve “smoothing” techniques and predicting recoveries in value).

To increase investor awareness about Level 3 estimates, SFAS 157 requires expanded disclosures about the Level 3 estimates used for financial assets and liabilities that are reported at fair value on an ongoing basis. Those disclosures focus on the effect of the estimates on reported earnings and financial position. More recently, the staff of the Securities and Exchange Commission issued a letter that encourages public companies to provide additional disclosures about the Level 3 estimates used for financial assets (including asset-backed securities, loans, and derivatives) in their Management Discussion & Analysis. The letter does not, as some have asserted, interpret, amend, or otherwise change the application of SFAS 157.

The SEC letter referred to has been published in generic form by the SEC:

Depending on your circumstances, the following disclosure and discussion points may be relevant as you prepare your MD&A:

  • The amount and reason for any material increase or decrease in Level 3 assets and liabilities resulting from your transfer of assets and liabilities from, or into, Level 1 or Level 2.
  • If you transferred a material amount of assets or liabilities into Level 3 during the period, a discussion of:
    • the significant inputs that you no longer consider to be observable; and
    • any material gain or loss you recognized on those assets or liabilities during the period, and, to the extent you exclude that amount from the realized/unrealized gains (losses) line item in the Level 3 reconciliation, the amount you excluded.

It was Bloomberg that first – I think – broke the story about $157-billion in Level 3 assets, and an example of the kind of comments it has attracted is:

Freddie told investors right to their faces, “We manipulated the numbers,” and investors applauded like a bunch of idiots, pushing Freddie Mac shares up more than 9%. I wish this was the end to the tragic comedy, but Freddie’s conference call was even more ridiculous.

And Freddie Mac just moved its entire Asset-Backed Security [ABS] portfolio to Level 3.

As a result, its Level 3 assets ballooned from $39 billion to over $157 billion in the first quarter. Its reasoning? The pricing the market was giving these securities varied too much. In other words, when the market was responsible for figuring out how much these assets were worth, the price fluctuated dramatically, providing the potential for major losses. So Freddie moved these assets to Level 3, where the market no longer has any say in their value. It’s yet another nail hammered into the coffin of what was supposed to be a capitalist free market.

The author is a newsletter writer, not (so far as I can tell) a portfolio manager.

The “smoking gun” in the financials is note 3, page 13 of Financial Statements and Core Tables:

At March 31, 2008, our fair value results were impacted by several changes in our approach for estimating the fair value of certain financial instruments, primarily related to our valuation of our guarantee obligation as a result of our adoption of SFAS 157 on January 1, 2008. These changes resulted in a net increase in the fair value of total net assets of approximately $4.6 billion (after tax).

See update below for more Freddie

Anyway … one man’s pain is another man’s gain! I mentioned the UBS Close-Out Special at about 68 cents on the dollar yesterday … today, Naked Capitalism observes that Bank Hapoalim has done the same:

the second largest bank in Israel, sold its entire portfolio of MBS to Pimco for 75 cents on an already-written-dollar (or in this case, shekel). Note that the previous writedowns were at least $90 million on an portfolio valued before the sale at $3.42 billion.

And the war between the Credit Analysis Department and the Market Price Department continues:

Based on the model supplied by the company, the Bank applied an even more severe scenario in which housing prices in the USA (excluding California and Florida) fell by about 30% from their peak (by 22% when compared with the present price level) and in California and Florida by about 40% from their peak (by 28% when compared with the present price level). Given such an severe scenario and assuming that the rate of default by mortgage takers will be about 47%, the accumulated loss from the portfolio is liable to reach about 340 million US Dollars over the life span of the securities.

The loss on sale was $870-million. I said it about Blackrock … I’ll say it about PIMCO … they’re going to make out like bandits. These well-publicized moves into the asset class by “real money” accounts bode well for normalization of the credit markets – although I will admit that Hapaolim’s 3.5-billion portfolio is a small part of the 1,400-billion problem.

Those who take my encouraging words about normalization as being the ravings of a Pollyanna are reminded that “normal” does not mean “good”. Spreads are still elevated and credit is still relatively scarce … and corporate defaults are rising. By “normalizing”, I mean that the chances of apocalyptic financial meltdown are declining, that’s all.

But real money is big-time sub-prime:

Gross, 64, anticipated the collapse of the U.S. housing market and the Fed’s subsequent interest-rate cuts. He shunned riskier corporate debt in 2006, a call that caused his fund to lag behind peers. Gross’s $128 billion Total Return Fund slipped as much as 4 percent in the first half of 2006.

The decision to sidestep subprime-linked debt has helped the fund surge 12 percent in the past year to beat 95 percent of its rivals, according to data compiled by Bloomberg.

Earlier this year, Gross started piling back into mortgage bonds to take advantage of slumping prices. In April, he lifted his holdings in mortgage-related debt to the highest since 2000, and lowered his stakes in U.S. Treasuries after calling them “overvalued.”

As of April 30, Gross’s Total Return Fund held 65 percent in mortgage debt, according to data posted on the firm’s Web site. The fund also holds 6 percent of assets in emerging-market debt. This year, Gross’s Total Return Fund has returned 4.1 percent, beating 94 percent of peers, Bloomberg data show.

As expected after the court ruling on BCE / Teachers’, BCE stock got slaughtered today, while Credit Default Swaps came in to 315bp from 595bp. Now, that’s a move! It appears that frenetic trading (over 26-million shares) gave the new Quantum trading system a work-out … BCE was halted in the mid-afternoon … a glitch this morning caused many issues (including CPD) to be temporarily halted. Finally, the TSX announced:

TSX Group has determined the root cause of a service disruption that affected trading on 37 of the more than 2100 issues trading on Toronto Stock Exchange.

The interruption was caused by a trading message protocol issue with one invalid message, and was entirely unrelated to TSX Quantum performance or capacity.

Corrective measures have been implemented.

Shares of BCE Inc. were halted at 2:14 p.m. to address data integrity concerns.

TSX expects trading in shares of BCE Inc. to open as usual tomorrow morning.

Not a lot of detail there, but there never is. It strikes me that if the system was compromised by a single “trading message protocol issue with one invalid message”, then Quantum probably needs a better input editor to prevent these data issues from fouling up the internal engine … but there isn’t enough information to make that conclusion firm.

There’s a bit more colour on BCE / Teachers’ … Bloomberg reports that a failure would help unwind the LBO crisis:

The potential cancellation of BCE Inc.’s C$52 billion ($52.9 billion) leveraged buyout may help loan prices recover by removing the largest portion of high- yield, high-risk debt banks need to sell from last year’s deals.

“If BCE is canceled it reduces the amount of debt on bank balance sheets substantially,” Chris Taggert, an analyst at fixed income research firm CreditSights Inc. in New York said in a telephone interview. “It’s the largest piece of the pipeline out there and would be a boost to the market.”

Loan prices have climbed as banks this year found a way to reduce their pipeline of loans promised last year to private- equity firms to $81.6 billion from $156 billion, according to Standard & Poor’s. Loans backing the acquisition of Montreal- based BCE, Canada’s biggest telephone company, comprise $16.8 billion, or 20.6 percent of the backlog.

Prices are up to an average 91.86 cents on the dollar, from a record low of 86.3 cents in February, according to S&P. Private-equity firms including Blackstone Group LP and Apollo Management LP have bought loans from banks, and the risk of financial institutions failing has subsided.

“This is good news for” Toronto-Dominion, Desjardins Securities analyst Michael Goldberg wrote in a note to investors today. “A new deal or no deal would mean that TD would not experience losses on the syndication of its financing.”

The bank has probably marked down its BCE financing commitment by about C$150 million, mostly in the past two quarters, Goldberg said. The bank has said it agreed to finance about 10 percent of the equity portion of the BCE purchase, or about C$3.3 billion.

The excitement of the day was BCE, but the enormous price moves occurred on small volume. Apart from this name, the market was off slightly – not a lot, but enough to notice – on average volume.

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 4.64% 4.68% 51,303 16.13 1 +0.1210% 1,084.1
Fixed-Floater 4.86% 4.76% 67,552 15.89 7 -3.9192% 1,029.7
Floater 4.15% 4.20% 63,264 16.96 2 -0.3960% 909.1
Op. Retract 4.83% 2.62% 91,077 2.47 15 +0.0034% 1,055.8
Split-Share 5.27% 5.56% 70,329 4.17 13 -0.3147% 1,055.9
Interest Bearing 6.09% 6.09% 53,515 3.81 3 +0.1678% 1,112.3
Perpetual-Premium 5.89% 5.73% 134,630 4.69 9 +0.0090% 1,022.0
Perpetual-Discount 5.65% 5.70% 299,921 14.20 63 -0.1229% 926.9
Major Price Changes
Issue Index Change Notes
BCE.PR.A FixFloat -6.9383%  
BCE.PR.R FixFloat -4.8971%  
BCE.PR.C FixFloat -4.6474%  
BCE.PR.G FixFloat -4.4362%  
BCE.PR.I FixFloat -3.6885%  
BCE.PR.Z FixFloat -2.8992%  
BNA.PR.A SplitShare -2.6984% Asset coverage of just under 3.2:1 as of April 30, according to the company. Now with a pre-tax bid-YTW of 7.08% based on a bid of 24.52 and a hardMaturity 2010-9-30 at 25.00. Compare with BNA.PR.B (6.96% to 2016-3-25) and BNA.PR.C (6.40% to 2019-1-10).
CIU.PR.A PerpetualDiscount -1.2195% Now with a pre-tax bid-YTW of 5.71% based on a bid of 20.25 and a limitMaturity.
FFN.PR.A SplitShare -1.0732% Asset coverage of 2.0+:1 as of May 15, according to the company. Now with a pre-tax bid-YTW of 5.08% based on a bid of 10.14 and a hardMaturity 2014-12-1 at 10.00.
BMO.PR.K PerpetualDiscount -1.0323% Now with a pre-tax bid-YTW of 5.73% based on a bid of 23.01 and a limitMaturity.
W.PR.H PerpetualDiscount +1.0748% Now with a pre-tax bid-YTW of 5.88% based on a bid of 23.51 and a limitMaturity.
Volume Highlights
Issue Index Volume Notes
FTS.PR.E Scraps (would be OpRet, but there are credit concerns) 100,000 CIBC crossed 100,000 at 25.45 in the day’s only trade. Now with a pre-tax bid-YTW of 4.67% based on a bid of 25.41 and a softMaturity 2016-8-31 at 25.00.
SLF.PR.B PerpetualDiscount 84,200 Nesbitt bought 73,300 from National Bank at 21.71. Now with a pre-tax bid-YTW of 5.51% based on a bid of 21.71 and a limitMaturity.
BNS.PR.M PerpetualDiscount 79,400 Nesbitt crossed 50,000 at 20.81. Now with a pre-tax bid-YTW of 5.47% based on a bid of 20.80 and a limitMaturity.
TD.PR.R PerpetualDiscount (for now!) 55,500 “Anonymous” bought 10,000 from “Anonymous” at 25.24 … perhaps the same “Anonymous”, perhaps not. Now with a pre-tax bid-YTW of 5.66% based on a bid of 25.18 and a limitMaturity.
BNS.PR.L PerpetualDiscount 42,801 Now with a pre-tax bid-YTW of 5.48% based on a bid of 20.75 and a limitMaturity.
BMO.PR.L PerpetualDiscount (for now!) 37,550 Now with a pre-tax bid-YTW of 5.86% based on a bid of 25.12 and a limitMaturity.

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

Update: The specific disclosure of the move to level 3 is in the Supplement:

At March 31, 2008, we measured and recorded on a recurring basis $156.8 billion, or approximately 23% of total assets, at fair value using significant unobservable inputs (Level 3), before the impact of counterparty and cash collateral netting across the levels of the fair value hierarchy. Our Level 3 assets consist of non-agency residential mortgage-related securities and our guarantee asset. We also measured and recorded on a recurring basis $113 million, or less than 1% of total liabilities, at fair value using significant unobservable inputs, before the impact of counterparty and cash collateral netting across the levels of the fair value hierarchy. Our Level 3 liabilities consist of derivative liabilities, net.

During the first quarter of 2008, our Level 3 assets increased because the market for non-agency mortgage-related securities became less liquid, resulting in lower transaction volumes, wider credit spreads and less transparent pricing for these assets. In addition, we have observed more variability in the quotations received from dealers and third-party pricing services. Consequently, we transferred $153.8 billion of Level 2 assets to Level 3 during the first quarter of 2008. These transfers were primarily within non-agency mortgage-related securities backed by subprime and Alt-A mortgage loans where inputs that are significant to their valuation became limited or unavailable. We concluded that the prices on these securities received from pricing services and dealers were reflective of significant unobservable inputs. We recorded $11.2 billion in additional losses primarily in AOCI on these transferred assets during the first quarter of 2008, which were included in our Level 3 reconciliation. See “NOTE 14: FAIR VALUE DISCLOSURES— Table 14.2 —Fair Value Measurements of Assets and Liabilities Using Significant Unobservable Inputs” to our consolidated financial statements for the Level 3 reconciliation. For discussion of types and characteristics of mortgage loans underlying our mortgage-related securities, see “CREDIT RISKS” and “CONSOLIDATED BALANCE SHEETS ANALYSIS—Table 15 —Characteristics of Mortgage Loans and Mortgage-Related Securities in our Retained Portfolio.”

Update, 2008-5-23: Split-Share Performance, 2008-5-23

6 Responses to “May 22, 2008”

  1. cowboylutrell says:

    Multiple sales on the bid, as well as quite a few orders on the bid side getting cancelled: we’re finally having a nice down day for many of the split preferreds.

  2. jiHymas says:

    I confess, I don’t see it … at least, not as far as end-of-day pricing is concerned. I have uploaded the split-share index for 5/23 (see the main post, above) … there was only one loser.

  3. cowboylutrell says:

    I must say that I was a tad surprised to see the split share index up by a quite substantial 0.39% today (May 23), tough it’s true I didn’t witness a generalized move down today. But since I’m always on the lookout for a change of paradigm in the split preferreds sector, especially when the stock market is down for a few days in a row like it is now, I was following with interest the move down that was developping on the bid price on good quality issues such as DF.PR.A and DFN.PR.A, among a few others, at some point in the afternoon (as well as a few sales on the bid price for lesser quality issues SBC.PR.A and XCM.PR.A and other names). But it was probably just a false alert (for now, at least!).

    All in all, it seems like my above comment was, at best, a bit early. Sorry.

  4. jiHymas says:

    No worries – not only is the HIMIPref™ universe not a full reflection of the split share universe, but there’s only a fraction of THAT that I really follow with any interest … but all patterns are golden.

    SBC.PR.A looks to be reasonably good quality … I don’t really have a good reason for not tracking it. Maybe I should add it! The asset coverage is superior to many of its competitors … and now that PIC.PR.A is out of the index, perhaps an addition is advisable. Same goes for DF.PR.A …

  5. […] issue was noted by Assiduous Reader cowboylutrell in the comments to May 22. The more I thought about the issue, the fewer good reasons I could think of to justify its […]

  6. […] issue was noted by Assiduous Reader cowboylutrell in the comments to May 22. The more I thought about the issue, the fewer good reasons I could think of to justify its […]

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