September 25, 2008

Henry Blodgett of Clusterstock emphasizes a point I made September 23 regarding market value vs. intrinsic value of the securities targetted for TARB purchase in a post Warren Buffet reveals bailout’s dirty little secret:

Bernanke and Paulson want to pay a phantom “hold-to-maturity” price that is above the prices at which the banks are currently valuing their trash assets. The logic is that the banks’ carrying value is somehow artificially depressed by a lack of liquidity. (This logic is weak: If anything, the banks are trying to conceal how badly off they are by overstating the value of the assets).

Hat Tip: Naked Capitalism. Thanks to the miracles of modern hagiography, Mr. Blodgett sees no need to provide analysis supporting his thesis that banks are engaged in a coverup. Mr. Buffet is quoted (irelevantly) in the same post, so it must be true.

Dealbreaker is usually both vulgar and entertaining; on occasion they publish analysis that reflects their roots in the trading community. This is one of those times:

Mark-to-market accounting incentivizes markets to go illiquid when asset prices sink, exactly when liquidity is critical. You create an environment where an institution isn’t just poised to lose the difference between their current mark on the instrument they are selling and the transaction price, but a large multiple of that as that transaction triggers markdowns on the rest of the toxic paper. How do you handle that as a institution holding sludge? Wait. And if you see some sludge that is offered so cheaply that you couldn’t normally resist buying it? Wait, if you are holding similar assets. Liquidity has been frozen up to prevent revealing that many of these institutions might be insolvent at the current market prices. That’s the kind of thing that is going to happen when the institutions likely to go insolvent control most of the liquidity.

In general, huge corrections like this usually only reverse when prices get so low that value investors and their ilk creep out and cant help but start buying. The problem here is that there isn’t enough price discovery to tempt them out, or that the normal buyers (Goldman, etc.) face mark-to-market triggers that prevent them wanting any transactions at all. Buffett seems mercifully free of both constraints.

The opportunities TARP affords for this sort of unsupported assertion is one reason why I don’t like the plan and would prefer to see Treasury – if necessary – purchasing senior preferred shares with a punitive distribution and a proviso that shares junior to the new issue get no dividends while the issue is outstanding. If Treasury buys so much as a nickel’s worth of sub-prime paper, debate over side-issues will overwhelm any practical benefits. Even if they make a collosal profit, the move will be decried as ‘too risky but lucky!’ and condemned on grounds of idealogical impurity.

There are reports that TARP will be approved, one way or another, complete with politically driven executive compensation limits and maybe even a 25bp tax on stock trades. Fearless prediction: TARP will fail for the same reason MLEC failed: a politically satisfactory backstop makes no business sense for the participants.

Willem Buiter, writing in VoxEU, sees the problem as being one of insolvency, not illiqudity:

As the full horror story of the bad investments and bad loans made by so many American banks has gradually been revealed, it is clear that the US banking sector faces an insolvency crisis and not just an illiquidity crisis. The number of impaired mortgages is exploding, and not just in the subprime and Alt-A categories, but across the whole residential mortgage spectrum. Impaired commercial and industrial mortgages are rising fast. Bad loans to the construction industry and to developers are mushrooming. ABS backed by automobile loans, by credit card receivables are tottering in growing numbers as are many other unsecured household loans. With the economy slowing down and probably entering recession soon, even exposures to the non-financial corporate sector will become more vulnerable.

In a nutshell, the US banking sector needs recapitalisation.

That leaves just two sources of capital. The first is the US federal government. It could inject capital into US banks, say by purchasing preference shares. I would uncouple such a capital injection from Paulson’s toxic asset purchase plan. The market illiquidity problem is related to but not the same as the banks’ capital deficiency problem. The government could implement a system-wide capital injection by specifying maximum leverage ratios (or minimum capital ratios) for various categories of financial institutions. It could then inject capital in return for preference shares to bring all these leverage ratios down to the maximum levels (all the capital ratios up to the minimum levels).

Finally, there is my preferred solution to the capital deficiency problem: the compulsory conversion of some of the banks’ debt into equity. Again, this could be done by the government specifying maximum leverage ratios (or minimum capital ratios) for various categories of financial institutions. Different kinds of debt then would be mandatorily converted into equity (preference shares or ordinary shares) with the proportion of each category of debt to be converted into stock inversely related to the seniority of the debt. These proportions would have to satisfy the requirement that all leverage ratios be brought down to the maximum levels (all capital ratios up to the minimum levels).

It’s a very well written article in Mr. Buiter’s inimitable style. But although his concerns about solvency may well be justified, he presents no evidence that this is indeed the case. In any event, I have grave concerns about due process with respect to his mandatory conversion programme … this is insolvency restructuring stuff, usually carried out when the institution has, in fact, been proved to be insolvent. And, until somebody can show me otherwise, I will continue to believe that rumours of widespread insolvency in the US financial sector are greatly exaggerated.

In a speech available on the BoC website, Carney applauded TARP, albeit with very little discussion of its merits and alternatives:

Similarly, private asset sales have been limited by the complexity of the underlying assets, the ongoing impairment of securitization markets, difficulties in supplying financing to leveraged buyers and the desire of investors to “time the market.” In sum, banks have an increasing need for capital, but it has become more difficult to raise it.

In this environment, the U.S. government’s initiative to buy distressed assets is critically important. The plan announced by Treasury Secretary Paulson and being developed through discussions in the U.S. Congress is bold and timely. The size and breadth of support provided by this measure will help firms “rightsize” their balance sheets, re-liquefy closed markets and establish market prices for these distressed assets. This should eventually encourage private buyers to re-enter the market and complete the deleveraging process. A well-executed program will undoubtedly speed the resolution of this crisis and limit its economic cost.

But how urgent is the problem? Well, judging by the action at the discount window, pretty damn urgent!

Commercial banks and bond dealers borrowed $217.7 billion from the Federal Reserve as of yesterday, more than double the prior week, as the financial crisis worsened and private funding dried up.

Loans to commercial banks through the traditional discount window totaled $39.3 billion as of yesterday, up from $33.4 billion, the Fed said. Borrowing by securities firms totaled $105.7 billion, up from $59.8 billion. Under a new emergency program announced Sept. 19, banks borrowed $72.7 billion as of yesterday to buy commercial paper from money-market mutual funds.

The figures are from the Fed’s H.4.1 Statistical Release. It’s not clear to me, however, how much of that borrowing is happening because the banks can’t get funding anywhere else, and how much is because it’s cheap credit. We can assume that the AIG need is real, though!

The three-month London Interbank Offered Rate in dollars was 3.77 percent today, the highest since January. Commercial banks can take out up to 90-day loans from the Fed at 2.25 percent. Primary dealers pay the same rate for overnight loans. The AIG loan accrues interest at three-month Libor plus 8.5 percentage points.

In 2001, the discount rate was a half-point below the Fed’s benchmark federal funds rate. In 2003, the Fed reset the discount rate at 1 percentage point above federal funds. The Fed reduced the spread to a half point in August 2007 and to a quarter point in March 2008.

We shall see how it all works out. There is opposition to TARP from a group of economists and a group of Republicans. Meanwhile Fortress Investment Group is building a war-chest to go shopping for distressed paper:

Fortress has risen 38 percent in the past two weeks in New York trading as investors anticipate private-equity and hedge- fund firms will profit from financial turmoil by snapping up companies and assets at distressed prices. Fortress rose 51 cents, or 3.9 percent, to $13.50 in New York Stock Exchange composite trading today.

Private-equity firms are shifting from the large leveraged buyouts that dominated Wall Street during 2006 and 2007, raising funds to snap up distressed debt and mortgage securities. Fortress oversees about $35 billion.

… and rumours are floating that JPMorgan will buy up WaMu’s deposits. The will be a major announcement tonight, of some kind anyway:

JPMorgan Chase & Co. (NYSE: JPM) will host a conference call at 9:15 p.m. (Eastern Time) tonight, September 25, 2008. You may access the conference call by dialing 1-877-238-4671 (U.S. and Canada) / 1-719-785-5594 (International) – access code: 814030 or via live audio webcast at under Investor Relations/Investor Presentations. Materials and further communication will be available on this website at the time of the call.

A replay of the conference call will be available beginning at approximately 1:00 a.m. on September 26 through midnight, Thursday, October 9 by telephone at (888) 348-4629 (U.S. and Canada); access code: 942856 or (719) 884-8882 (International). The replay will also be available via webcast on under Investor Relations, Investor Presentations.

Bloomberg reports that this will happen by fiat of the FDIC. Flash! JPMorgan buys WaMu’s deposits for a premium of about 1%! Now … that’s what I call a bargain. Cash is king! Flash! JPM is marking down WM’s assets by $30-billion (out of $296-billion assets at WM carrying value) as part of the transaction. See page 18 of the presentation.

Covered bonds in the States are not having a nice time:

Bank of America Corp. was the last U.S. bank to issue the bonds, selling $1.5 billion of the securities in June 2007. The spread on the Charlotte, North Carolina-based lender’s three-year notes has widened almost eight-fold to 184 basis points, according to Citigroup Inc. prices on Bloomberg.

The only other U.S. issuer is Washington Mutual, which put itself up for sale last week. Its 6 billion euros ($8.8 billion) of covered bonds were downgraded one level to Baa1, the third- lowest investment-grade ranking, by Moody’s.

The spread on its $2 billion of 4.375 percent bonds due 2014 has surged to 678 basis points, from 26 basis points when the notes were sold in May 2007, according to Royal Bank of Scotland Group Plc prices on Bloomberg.

Speaking of bear markets, how about that California real-estate, eh?:

California home prices tumbled a record 41 percent in August from a year earlier as foreclosure sales pushed down values in the biggest U.S. state.

The median price of an existing, single-family detached home fell to $350,140 and will likely fall further, the Los Angeles- based California Association of Realtors said today in a report. Sales increased 56.7 percent from August 2007 and 1.8 percent from July.

And the sales number! Far be it from me to put any credence in technical analysis, but that’s consistent with mass forced liquidation near the bottom of the market. And, bless their hearts, the guys at Dealbreaker have actually put together some numbers on housing bubble profits:

In summary, our incomplete and work-in-progress calculations figure for something like $2 trillion in fees flowing to various parties in the real-estate, mortgage, securitization and securitization^2 businesses between 2003 and mid-2008. That’s some serious swag, and you don’t have to look very far to see why no one was in much of a hurray to shut any of it down or to rock the boat.

In fact, the Dealbreaker guys did a fantastic job today, highlighting an extraordinarily testy letter from the FDIC to Bloomberg. Let’s have a little more honest reporting and a little less yellow journalism!

I’m searching for the precise metaphor to use regarding the backlash against hedge funds in the UK – should it be ‘shooting the messenger’ or ‘killing the goose that laid the golden eggs’?:

As Lehman Brothers Holdings Inc. filed for bankruptcy and HBOS Plc was pushed into a government-brokered takeover, U.K. regulators and lawmakers found a culprit: the estimated 980 hedge funds that reside in Britain, mostly in London. Harbinger Capital Partners Fund chief Philip Falcone was singled out by the Daily Mirror. The tabloid used a front-page story on Sept. 18 to brand him a “greedy pig” for short selling, or making bets that Edinburgh-based HBOS would lose market value.

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.
The Fixed-Reset index was added effective 2008-9-5 at that day’s closing value of 1,119.4 for the Fixed-Floater index.
Index Mean Current Yield (at bid) Mean YTW Mean Average Trading Value Mean Mod Dur (YTW) Issues Day’s Perf. Index Value
Ratchet N/A N/A N/A N/A 0 N/A N/A
Fixed-Floater 4.67% 4.74% 82,600 15.81 6 +0.5878% 1,097.1
Floater 5.40% 5.41% 49,314 14.81 2 -1.9683% 744.9
Op. Retract 5.00% 4.83% 128,034 3.49 14 +0.1492% 1,046.5
Split-Share 5.53% 6.73% 51,735 4.31 14 +0.1448% 1,013.4
Interest Bearing 6.57% 7.52% 52,928 5.18 2 +0.1149% 1,083.9
Perpetual-Premium 6.20% 5.89% 56,569 2.17 1 -0.7874% 1,000.9
Perpetual-Discount 6.13% 6.20% 178,816 13.60 70 -0.0927% 871.6
Fixed-Reset 5.06% 4.93% 1,297,601 14.26 10 +0.1004% 1,119.2
Major Price Changes
Issue Index Change Notes
BAM.PR.B Floater -3.8343% Whoosh! Definitely not a money market vehicle!
GWO.PR.H PerpetualDiscount -1.9277% Now with a pre-tax bid-YTW of 6.00% based on a bid of 20.35 and a limitMaturity.
ELF.PR.F PerpetualDiscount -1.8242% Now with a pre-tax bid-YTW of 7.65% based on a bid of 17.76 and a limitMaturity.
BAM.PR.N PerpetualDiscount -1.4163% Now with a pre-tax bid-YTW of 7.48% based on a bid of 16.01 and a limitMaturity.
FFN.PR.A SplitShare -1.2632% Asset coverage of just under 1.8:1 as of September 15 according to the company. Now with a pre-tax bid-YTW of 6.60% based on a bid of 9.38 and a hardMaturity 2014-12-1 at 10.00.
LFE.PR.A SplitShare -1.0152% Asset coverage of 2.2+:1 as of September 15 according to the company. Now with a pre-tax bid-YTW of 6.06% based on a bid of 9.75 and a hardMaturity 2012-12-1 at 10.00
BSD.PR.A InterestBearing +1.0274% Asset coverage of just under 1.5:1 as of September 19 according to Brookfield Funds. Now with a pre-tax bid-YTW of 8.43% (mostly as interest) based on a bid of 8.85 and a hardMaturity 2015-3-31 at 10.00.
BNA.PR.A SplitShare +1.0305% See BNA.PR.C, below
CM.PR.A OpRet +1.1462% Now with a pre-tax bid-YTW of 4.45% based on a bid of 25.37 and a call 2009-11-30 at 25.25.
SLF.PR.E PerpetualDiscount +1.1558% Now with a pre-tax bid-YTW of 6.16% based on a bid of 18.38 and a limitMaturity.
WFS.PR.A SplitShare +1.3001% Asset coverage of just under 1.6:1 as of September 18, according to Mulvihill. Now with a pre-tax bid-YTW of 7.95% based on a bid of 9.35 and a hardMaturity 2011-6-30.
BNA.PR.C SplitShare +2.4485% Asset coverage of 3.2+:1 as of August 31 according to the company. Coverage now of 2.7+:1 based on BAM.A at 28.38 and 2.4 BAM.A held per preferred. Now with a pre-tax bid-YTW of 10.25% based on a bid of 15.90 and a hardMaturity 2019-1-10 at 25.00. Compare with BNA.PR.A (7.55% to 2010-9-30) and BNA.PR.B (9.58% to 2016-3-25)
IAG.PR.A PerpetualDiscount +2.7933% Now with a pre-tax bid-YTW of 6.29% based on a bid of 18.40 and a limitMaturity.
BCE.PR.Z FixFloat +2.7945%  
Volume Highlights
Issue Index Volume Notes
BCE.PR.I FixFloat 887,316 Scotia crossed 884,000 at 24.55.
NTL.PR.F Scraps (would be ratchet, but there are credit concerns) 349,483 Scotia crossed 250,000 at 4.25.
RY.PR.I FixedReset 102,455 CIBC crossed 15,400 at 25.03, then bought 32,600 from RBC at 25.02, then Nesbitt bought 12,500 from RBC at 25.02.
BNS.PR.Q FixedReset 98,258 RBC crossed 80,000 at 25.00.
BAM.PR.O OpRet 61,765 TD bought 18,800 from Nesbitt at 21.90, then 10,000 from anonymous at the same price. Now with a pre-tax bid-YTW of 8.24% based on a bid of 21.90 and optionCertainty 2013-6-30 at 25.00. Compare with BAM.PR.H (6.55% to 2012-3-30), BAM.PR.I (6.38% to 2013-12-30) and BAM.PR.J (6.28% to 2018-3-30).
BNA.PR.A SplitShare 59,000 CIBC crossed 50,000 at 24.50. See BNA.PR.C, above.

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

3 Responses to “September 25, 2008”

  1. […] bullet and paying up to issue bonds before the strain on the Fed’s discount window (mentioned yesterday) will start to […]

  2. […] I noted on September 25, I would prefer a system whereby Treasury would buy senior preferred shares in distressed – but […]

  3. […] September 25 I predicted that TARP would fail for the same reason MLEC failed: disagreement over valuation of […]

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