Regulation

A Better Credit Rating Solution?

Christopher Cox, Chairman of the SEC was criticized in PrefBlog on February 8 for his apparent belief that what this world needs is more rules.

I was very happy to be alerted by Naked Capitalism to some remarks he has made that show a better appreciation of the problem:

So how would the SEC substitute — and diminish — the regulatory reliance on ratings?

Mr. Cox said “one means of substituting … would be to substitute the current definition of the rating currently provided by the rating itself.”

What that means is that the SEC is considering ways of setting criteria that gets away from the ratings but focuses instead on the underlying concept. For example, for some rules the SEC could require bonds to be liquid and then develop some measure by which to sort them other than a credit rating, says one person familiar with the matter.

I posted yesterday in Earth to Regulators: Keep Out! that there wasn’t much point in regulation. All the rules in the world won’t make anybody a better analyst … or, indeed, to avoid blow-ups of any kind in this uncertain world.

The problem the regulators face is that under Basel II there is a good chance that a pro-cyclical bias will be introduced to bank capital requirements:

Under Basel II, the capital requirements for the largest banks would be based on their current assessment of the probability of default of the borrower (ie rating) – Basel Committee of Banking Supervision (2003). There is a live policy debate over whether different rating approaches adopted by the banks would lead to different procyclical outcomes and if they did which approach banks would choose to adopt. We find that less forward-looking bank rating systems, conditioned on the point in the economic cycle, could lead to a substantial increase in capital requirements in recessions. Looking at the 1990–1992 recession, ratings based on a Merton-type model, which reflect the point in the cycle through the use of current liabilities, lead to a 40% to 50% increase in capital requirements. In contrast, Moody’s ratings which are more forward looking, lead to little increase in capital requirements.
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The new Accord which will be introduced in 2006 could, however, have a profound effect on the dynamics of bank minimum capital and lending in recessions. In contrast to the current Accord where, for a given quantum of lending to a particular set of borrowers, the capital requirement is invariant over time, under the new Accord the capital requirements will depend on the current assessment of the probability of default (PD) of those borrowers. If borrowers are downgraded by a bank in a recession, then the capital requirements faced by the bank will rise. This would be in addition to the possible reduction in the bank’s capital because of write-offs and specific provisions.

It’s amusing that the authors (Eva Catarineu-Rabell, Patricia Jackson and Dimitrios P. Tsomocos) of the quoted paper prefer the Ratings Agency style of attempting to rate “through the cycle” as opposed to the more dynamic Merton-style approach, but that’s beside the point for now.

There is only on legitimate reason that Credit Ratings might be of importance to regulators of any kind: the effect on bank capital requirements. And it should be noted that the only reason they have any effect on bank capital requirements is because the concept was written into the Basel Accords. And, of course, they were written into the Basel Accords because of the superb track-record (remember that concept? track record?) of the Credit Rating Agencies.

Not perfect, by any means. There are big blow-ups and minor whoopsees, but it’s an uncertain world dominated by human frailty. Get used to it.

So, I suggest, if the regulators wish to improve their legitimate regulation via new and improved credit ratings, it is only right and proper that they do it themselves, rather than imposed ludicrous constraints and requirements on private businesses in a horrific central planning exercise. Cox is on the right track.

Naked Capitalism takes a very dim view of the remarks:

Require bonds to be liquid?. That is the most deranged thing I have heard in a very long time, and this presumably coms from someone within the US’s top securities regulator. It confirms what I have long suspected: that the SEC is preoccupied with the equity market and knows perilous little about debt.

A simple illustration: just about all corporate bonds are illiquid. That’s one reason credit default swaps are popular. Investors can use CDS to create synthetic corporate bond exposures, which unlike the underlying bonds, can be readily traded. But Cox would have us write off the corporate bond market.

Corporate bonds are illiquid relative to, say, stocks. Sure. I discussed this on November 19, in relation to Prof. Cecchetti‘s desire to have all financial instruments traded on an exchange:

Looking at the topography of the financial system, we see several immediate candidates for migration to exchange trading.  I will mention two:  (1) bonds and commercial paper, and other fixed income securities; and (2) interest-rate swaps and other derivatives that are traded in large volume. Bonds as we know them have been around since at least 16th century.  And the quantities outstanding are substantial – in the United States there something like 4000 distinct corporate bond issues with a market value of roughly $10 trillion.  I can see no reason that these “fixed-income” instruments are not traded on an exchange.
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How can we encourage the movement of mature securities onto exchanges?  The answer is through a combination of information and regulation.  On the information side, it is important that less-sophisticated investors realise the importance of sticking with exchange-traded products.  The treasurer who manages the short-term cash balances for a small-town government should not be willing to purchase commercial paper, or any security, that is not exchange traded.

However … there are degrees of illiquidity! Assiduous Readers of PrefBlog will be very familiar with the idea that, while the average trading value (however calculated!) of a particular preferred share might be only $100,000, it is generally possible (for MOST issues, MOST of the time) to call a dealer and trade a block worth $10-million … maybe not right away, but, say, within a week.

So, subject to problems with measurement and control that must be addressed, I’m entirely comfortable with the SEC (or other regulators) coming up with some kind of way in which liquidity will be measured and applying some kind of concentration penalty on banks who hold a position that is too large to be regarded as liquid. This would be a little easier in the case of the States, which already has the NASD TRACE system in place.

There is also the potential for so-called liquidity guarantees to be put in place at time of underwriting. So-called? Well, the European Covered Bond market association called for suspension of the agreement on November 21 and there are current problems with liquidity on Auction Rate Municipals, as mentioned yesterday. I’ve mentioned my own problems in not being able to get a bid for less than a million of good quality corporate paper. So, while I would not put too much faith in the ability of the private sector to provide a bottomless pit of liquidity for bonds in general, liquidity could be enhanced … central banks, for instance, could enter into “liquidity provider of last resort” agreements and accept corporate and other bonds as collateral on a routine basis.

I would not advocate formal liquidity guarantees. It’s too much central bank intervention in the economy … in times of stress, the private sector just ain’t gonna want to take long term debt onto its books, especially not if it’s esoteric. But liquidity could be measured and a capital penalty applied to instruments whose liquidity in times of stress was feared to be sub-normal. 

I’m not sure that I agree with Naked Capitalism‘s point about CDSs. They are sometimes more liquid, sure – it’s a lot easier to go long a CDS than it is to short a corporate bond, especially in size. But as I see it, the main attraction of CDSs has been that they make it a lot easier to lever up a portfolio, compared with taking a cash position (long or short) and (financing or borrowing it). That’s related to liquidity, but is not exactly liquidity.

The guts of the problem, however, is step 2 of Mr. Cox’s idea: and then develop some measure by which to sort them other than a credit rating.

Market prices won’t do it. I’ve posted elsewhere about market implied ratings and how dubious I am that such a system will prove to be a better indicator of credit quality than what we already have. The Fed is dubious too!

And, as noted, structural models such as Merton’s (equity implied ratings were briefly mentioned on October 18) (a) have a lot of problems, and (b) are pro-cyclical.

I’ve also noted that any quantitative system performs badly at trend changes … and it is at precisely the time of trend changes that stresses on the financial system become pronounced.

So what’s the Fed to do? The only answer is … if they want to come up with some way of defining credit risk, they’ll have to set up their own in-house credit rating service. Good luck with that!

Market Action

February 14, 2008

The bond insurance story is just getting bigger and bigger!

Accrued Interest points out:

According to data from Thomson Financial, only about 28% of municipal bonds issued in January carried insurance from a monoline insurer. That’s down from 46% in 2007. Meanwhile, according to Merrill Lynch, new insurance was dominated by FSA and to a lesser extent, Assured Guaranty. FSA insured $3.8 billion of new issues, about 70% of all new issue munis which carried insurance. Assured picked up most of the remainder ($1.3 billion or 23% of new insured issuers).
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The fact is that confidence in insurance has never been lower, and yet buyers continue to demand insurance at all tells you something. MBIA and Ambac may never be able to regain AAA levels of confidence, but municipal bond insurance as a concept will survive.

Yesterday‘s rumours that the New York insurance regulator would pursue a Good Insurer/Bad Insurer solution to the problem have been confirmed:

One part would operate the profitable municipal bond insurance business, while the other would handle so-called structured finance products, according to testimony prepared for Eric Dinallo, the New York State insurance superintendent. Dinallo is scheduled to address a U.S. congressional committee today.

“Our first priority will be to protect the municipal bondholders and issuers,” according to Dinallo’s testimony. “We cannot allow the millions of individual Americans who invested in what was a low-risk investment lose money because of subprime excesses. Nor should subprime problems cause taxpayers to unnecessarily pay more to borrow for essential capital projects.”

Naked Capitalism observes:

the priorities have been turned on their head. Before, the reason for a rescue was to prevent carnage on Wall Street. That objective has now been shunted aside as municipalities are hit by the seize-up in the auction rate securities market.

And yes, the Auction Rate Municipals market is getting worse by the day:

UBS AG won’t buy auction-rate securities that fail to attract enough bidders, joining a growing number of dealers stepping back from the $300 billion market, said a person with direct knowledge of the situation.
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As much as $20 billion of auctions didn’t attract enough buyers yesterday, an 80 percent failure rate, based on estimates from Bank of America Corp. and JPMorgan Chase & Co.

Merrill Lynch is also cutting back its support. Auction Rate Municipals were introduced to PrefBlog readers on February 6. From esoteric trivia to world crisis in eight days! I feel certain that, like the Canadian ABCP market, this is all the fault of the credit rating agencies. Did you know they get paid by the issuers?

There’s another interesting piece of trivia about the insurers … apparently many brokerages considered them such stellar credits that they didn’t have to put up collateral on their CDS exposure:

Goldman Sachs has made plenty of canny decisions in relation to the credit crunch. One of the smartest might have been its treatment of MBIA, the world’s biggest bond insurer.

While many rivals have in recent years been cheerfully using bond insurers to hedge their structured credit bets, Goldmans has refused to do so due to concern about counterparty risk.
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In taking $2bn and $3.1bn writedowns in hedges with insurers whose ability to honour those commitments is in doubt, CIBC and Merrill Lynch respectively have become the face of Wall Street’s nightmares.

It’s always the same thing, eh? Times are good and leverage increases, which only deepens the downturn when it finally arrives. Not just leverage, but also sector concentration of cowboys’ portfolios, witting or unwitting. The importance of correlation has been discussed before: briefly, for example, a husband and wife might each be in jobs that have a 10% chance of disappearing in any given year. A naive analysis (zero correlation) will assign a 1% chance to them both losing their jobs in a year … but if they both work for General Motors at a SUV plant, the chance of them both losing their jobs could be as high as the 10% risk they face individually.

Aleablog has noted in a post picked up and expanded by FT Alphaville that was linked by Naked Capitalism a story by Reuters [I love the Internet] that states:

Correlation on the five-year investment-grade Markit iTraxx Europe index — a measure of investor fears of a system-wide crash — reached new highs of 45 percent on Tuesday. Analysts said the figure had room to go higher still, but some said investors who are now trading based on high correlation could get burned if companies start to default.
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Over the past six months, the credit crisis and a low corporate default rate have pushed correlation up, which means the equity tranche has gained relative to the triple-A tranches.Analysts at UBS, in a recent note to investors, said one reason was that banks and financial entities such as conduits, which accumulated billions of dollars of triple-A tranches of CDOs, have needed to unwind or hedge against those tranches.
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“Now in a world where leverage has to come down, the pressure is on the piece that is the most leveraged, and that’s the super-senior tranches,” Charpin said.
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UBS analysts said the latest rise in correlation may have come also from hedge funds’ needs to raise cash. “If you are a cash-strained hedge fund, that may be a cheap trick to get quickly money back in your pocket,” the analysts wrote. “This is all the more relevant in the last weeks as prime brokers are clamping down on hedge funds’ funding.”

This is where smart analysis is worth money. A mechanism is at work that is pushing up the price of one analytical variable (correlation) without [necessarily] having anything to do with the the actual value of that variable. Therefore, a thorough analysis might show that shorting that variable is a smart thing to do – subject, of course, to a host of risk-control measures. In the preferred share market, for example, I might determine (with the use of HIMIPref™ that convexity is cheap. I might not be able to buy convexity directly, but the valuations of each investible instrument will be adjusted to reflect that view. And, perhaps, a portfolio with an increased convexity might then become cheap enough to the current portfolio that a trade is signalled. And … sometimes it works!

Monoline woes are also spreading into the LBO market, as noted yesterday and on February 11. It seems that formerly reliable Negative Basis Trades are turning positive:

Banks’ exposures through bond insurers, or monolines, is far from limited to mortgage-related MBS and muni bonds. There’s a third big exposure – to leveraged buyout loans – that banks will have to deal with if monolines hit the rocks.

Negative basis trades have been around for a while. A bank buys a bond – say it’s AAA – and then it takes out a CDS against that bond with a monoline. Since spreads in the CDS market for such tranches have been typically much lower than in the cash market, the bank pockets the difference.

But as well as banks’ much-dissected CDO exposures, there have been two other big markets for that kind of trade: on infrastructure bonds and – most interestingly – in structured finance, on CLOs (collateralised loan obligations) – CLOs being the vehicle of choice in which to park massive buyout loans.

Monolines, of course, are no longer in a position to be writing new contracts for banks to use as one half of their negative basis trades. The consequence of that has been that banks have stopped buying AAA tranches of CLOs. Unable to sell those, CLOs have faltered and banks in turn, have found themselves with lots of big buyout loans stuck on their books. No new financing is available for private equity deals.

The monoline FGIC was downgraded by Moodys today, which won’t help things much. The last sentence of the quoted analysis might be of interest to BCE speculators! 

Meanwhile, with a continue plunge in US real-estate values, there are desperate pleas for a government bail-out:

One proposal, advanced by officials at Credit Suisse Group, would expand the scope of loans guaranteed by the Federal Housing Administration. The proposal would let the FHA guarantee mortgage refinancings by some delinquent borrowers….

The risk: If delinquent borrowers default on their refinanced loans, the federal government would have to absorb the loss…

*Yawn*. Speaking of bail-outs, the German government bailout of IKB was mentioned yesterday. Willem Buiter is not happy:

If ever a bank was sufficiently systemically insignificant and small enough to fail by any metric except for the political embarrassment metric, it is surely IKB, the German small and medium enterprise lending bank that got itself exposed fatally to the US subprime crisis through a conduit (wholly owned off-balance sheet entity) devoted to speculative ventures involving instruments it did not understand.
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I can think of no better way of encouraging more appropriate future behaviour towards risk by German banks than letting IKB go into insolvency now. The institution gambled recklessly and irresponsibly. It lost. Liquidation and sale of its assets would be the market-conform reward for its failures.

Light-ish trading again today, but holy smokes, this market is on FIRE! PerpetualDiscounts are up 2.84% month-to-date; I noticed yesterday that the S&P/TSX Preferred Share Index (as proxied by CPD) had erased its post-new-issue losses to return to the level immediately prior to the BNS new issue announcement. And more today. So there.

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 5.55% 5.58% 44,975 14.5 2 -0.6089% 1,074.1
Fixed-Floater 5.01% 5.65% 79,354 14.71 7 +0.3676% 1,023.8
Floater 4.92% 4.97% 74,607 15.51 3 +0.6897% 859.0
Op. Retract 4.80% 2.35% 79,212 2.59 15 +0.3751% 1,049.3
Split-Share 5.27% 5.41% 98,519 4.23 15 +0.2062% 1,044.7
Interest Bearing 6.23% 6.41% 59,486 3.58 4 -0.0248% 1,082.4
Perpetual-Premium 5.72% 4.53% 385,314 5.15 16 +0.0889% 1,029.8
Perpetual-Discount 5.36% 5.40% 289,567 14.81 52 +0.1013% 958.3
Major Price Changes
Issue Index Change Notes
BCE.PR.B Ratchet -1.4316% Closed at 23.41-15, 16×10, on zero volume. Nice, tight market, eh?
CM.PR.P PerpetualDiscount -1.3530% Now with a pre-tax bid-YTW of 5.71% based on a bid of 24.06 and a limitMaturity.
BNA.PR.C SplitShare +1.1663% Asset coverage of 3.3+:1 as of January 31, according to the company. Now with a pre-tax bid-YTW of 7.20% based on a bid of 19.95 and a hardMaturity 2019-1-10 at 25.00. Compare with BNA.PR.A (5.87% to 2010-9-30) and BNA.PR.B (7.27% to 2016-3-25).
ELF.PR.F PerpetualDiscount +1.2417% Now with a pre-tax bid-YTW of 5.87% based on a bid of 22.83 and a limitMaturity.
MFC.PR.C PerpetualDiscount +1.6173% Now with a pre-tax bid-YTW of 5.05% based on a bid of 22.62 and a limitMaturity.
BCE.PR.C FixFloat +1.6518%  
BAM.PR.G FixFloat +1.9155%  
ELF.PR.G PerpetualDiscount +2.0690% Now with a pre-tax bid-YTW of 5.80% based on a bid of 20.72 and a limitMaturity.
BAM.PR.I OpRet +2.8244% Now with a pre-tax bid-YTW of 2.57% based on a bid of 26.94 and a call 2009-7-30 at 25.75.
Volume Highlights
Issue Index Volume Notes
RY.PR.A PerpetualDiscount 60,915 RBC crossed 50,000 at 21.70 … finally able to find a block buyer to match his seller and make Assiduous Reader madequota a little happier! Now with a pre-tax bid-YTW of 5.14% based on a bid of 21.67 and a limitMaturity.
BNS.PR.O PerpetualPremium 59,975 Now with a pre-tax bid-YTW of 5.36% based on a bid of 25.55 and a call 2017-5-26 at 25.00.
SLF.PR.D PerpetualDiscount 52,232 Nesbitt crossed 50,000 at 22.14. Now with a pre-tax bid-YTW of 5.12% based on a bid of 22.01 and a limitMaturity.
TD.PR.Q PerpetualPremium 40,621 Now with a pre-tax bid-YTW of 5.33% based on a bid of 25.59 and a call 2017-3-2 at 25.00.
BAM.PR.N PerpetualDiscount 33,850 Now with a pre-tax bid-YTW of 6.44% based on a bid of 18.75 and a limitMaturity.

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

Interesting External Papers

Earth to Regulators: Keep Out!

Willem Buiter’s excellent blog, Maverecon, brings to my attention two reports prepared in the UK:

Willem Buiter is frequently mentioned in PrefBlog: he has, for example, prepared a very good summary of Lessons from the 2007 Financial Crisis. I sharply disagreed with his prescription for reform of the Credit Rating Agencies and also with his current statement:

The Report also mentions the need to improve the functioning of securitisation markets, including improvements in valuation and credit rating agencies but offers very little beef in these areas. It is clear that the credit rating agencies will have to be ‘unbundled’, and that the same legal entity should not be able to sell both ratings and advice on how to structure instruments to get a good rating. The conflict of interest is just too naked. Rating agencies will have to become single-product firms, selling just ratings.

… but for now I’ll let that go. In this post I will discuss the Official Position.

Section 2.61 of the Financial Stability report states:

The Authorities believe that the preferred approach to tackling such issues is through market action, and where appropriate through changes to the IOSCO Code of Conduct on Credit Rating Agencies. However, it is important to recognise that prudential credit ratings are a regulatory tool, in that supervision within the CRD/Basel II framework places reliance on the use of rating opinions to determine risk weightings for capital purposes. Therefore regulators have a strong interest in ensuring that ratings are viewed as reliable and that the information content of ratings is sufficient. If the issues summarised above are not adequately addressed by the markets, alternative measures to remedy these issues should be considered.

… while Section 2.62 continues:

Investors also need to learn lessons from recent events. In particular, investors need to develop a more sophisticated use of ratings. Market participants that consider investing in new asset classes, such as structured products, should not use ratings as a substitute for appropriate levels of due diligence, nor draw – potentially misplaced – inferences from ratings that the behaviour of structured securities share the same characteristics, including liquidity characteristics, as more familiar comparably-rated corporate securities. Recent losses and illiquidity in such asset classes have ensured these issues are in the forefront of investors’ minds, and market practice is already adapting rapidly in response. There will be a role for coordinating bodies – such as industry groups and international fora – in clarifying and codifying new practice.

And, finally, I note that the authorities are requesting, inter alia, the following feedback:

2.6) Have the Authorities correctly identified the issues on which international work on credit rating agencies should focus?

2.7) Do you agree with the Authorities’ proposals to improve the information content of credit ratings?

2.8) Do you agree with the Authorities that the preferred approach to restoring confidence in ratings of structured products is through market action and, where appropriate, changes to the IOSCO Code of Conduct on Credit Rating Agencies?

First, let’s look at a little history. Remember the Panic of 1825? I will remind Assiduous But Sometimes Forgetful Readers of the bailout of the banking house of Sir Peter Pole, as related and analyzed by Larry Neal, professor of economics at the University of Illinois at Urbana-Champaign:

The first mention of the crisis occurs on December 8, 1825, when “The Governor [Cornelius Buller] acquainted the Court that he had with the concurrence of the Deputy Governor [John Baker Richards] and several of the Committee of Treasury afforded assistance to the banking house of Sir Peter Pole, etc.”44 This episode is described in vivid detail by the sister of Henry Thornton Jr., the active partner of Pole, Thornton & Co. at the time. On the previous Saturday, the governor and deputy governor counted out £400,000 in bills personally to Henry Thornton, Jr., at the Bank without any clerks present.45 All this was done to keep it secret so that other large London banks would not press their claims as well. A responsible lender of last resort would have publicized the cash infusion to reassure the public in general. Instead, the run on Pole & Thornton continued unabated, causing the company to fail by the end of the week. Then the deluge of demands for advances by other banks overwhelmed the Bank’s Drawing Office.

The analysis makes perfect sense to me. The lender of last resort should enjoy the utmost confidence of the investing public, with an unparalleled reputation for probity and bottomless pockets.

However, the Treasury Committee report on Northern Rock referenced above provides extensive detail about the urge of the lender of last resort to provide covert assistance only and why it was finally decided that any support had to be made public (paragraphs 123-142, inclusive). Paragraph 165 states as a conclusion of the committee:

We accept that the consequences of an announcement of the Bank of England’s support operation for Northern Rock were unpredictable. There was a reasonable prospect that the announcement would have reassured depositors rather than having the opposite effect, particularly prior to the premature disclosure of the operation. However, after the premature disclosure of the support, and against the background of the market reaction to Barclays use of lending a fortnight earlier, it seems surprising that the issues were not urgently revisited. It is unacceptable, that the terms of the guarantee to depositors had not been agreed in advance in order to allow a timely announcement in the event of an adverse reaction to the Bank of England support facility.

In this case it was the announcement that the Lender of Last Resort had been called upon that actually caused the run.

I will also note the acknowledgement of Prof. Buiter in Paragraph 164:

Professor Buiter took a rather different view:

If [the Tripartite authorities] were not quite convinced that the public would believe them—and in these days you cannot be sure of that—then the immediate creation of a deposit insurance scheme that actually works and is credible would have been desirable. To wait three days was again an unnecessary delay.

In other words, there is good agreement that the authorities have squandered the trust of the public. The quote seems to have been lost in a revision, but I recall reading at the time that one woman queuing up for her money at a Northern Rock branch told a reporter at the time – who was puzzled as to why she was concerned – that ‘they lied to us about Iraq. Why shouldn’t they lie to us now?’

My thesis can be stated very simply: given that distrust of regulatory and other official bodies is so deeply ingrained into the public psyche, how can there be any contemplation of the idea that increased regulation and official oversight of the Credit Rating Agencies will improve public trust in the ratings?

The proponents of increased regulation also appear to be completely unable to provide any evidence that a credit rating analyst required to fill in forms and tick off boxes will provide estimates and advice that are any better than he would have produced without filling in forms and ticking off boxes.

Sadly however, those investment advisors, both licensed and unlicenced, who persuaded clients/employers/investors that the ability to write a big cheque equated to investment management skill desperately need someone to blame, now that their delusions have blown up in their clients faces. There is also pressure from subscription-based agencies for the regulators to get them more clients. And, of course, the supreme test of one’s ability as a regulator is total faith in the proposition that everything be regulated by a wise regulator.

So … there’ll be changes, for sure. Mostly cosmetic, assuredly costly, definitely useless. But after all, nobody must ever lose money on an investment, or take responsibility for their own actions, right?

And, sadly, once any plan is implemented it will meet its unstated purpose of creating a well-defined scapegoat for any blow-up. As Scotia is proving in the course of its battle with David Berry: if you want to get somebody, and are prepared to spend enough money on enough lawyers to check through things carefully enough, you can “get” anybody … and pretend to be shocked at what you’ve found.

Market Action

February 13, 2008

MGIC, the US Mortgage Insurer, announced a huge loss today and is seeking capital:

MGIC Investment Corp., the largest U.S. mortgage insurer, fell the most in a month after posting a record quarterly loss of $1.47 billion and said it hired an adviser to raise capital.

MGIC’s fourth-quarter net loss was $18.17 a share, compared with a profit of $122 million, or $1.47, a year earlier, the Milwaukee-based company said in a statement today. Excluding investment losses, the insurer lost $18.09 a share, worse than the $8.13 average loss estimate of seven analysts compiled by Bloomberg.

They’ll have to pay up for capital in this environment!

Buffet’s municipal bond re-insurance offer, mentioned yesterday, attracted some comment at Naked Capitalism amid rumours that it is merely a stalking horse for regulatory action:

This seems to be a misguided application of the “good bank-bad bank” approach used in the saving & loan workouts.

But consider the differences: the dead S&L’s landed in the FDIC’s lap. They had to figure out what to do with them, and they wanted to make a recovery on the payments they made in deposit insurance. So the Resolution Trust Corporation was set up. Note that a big issue was that the Federal government had to continue to fund the S&L’s working capital and also pay to keep some staffing going. That cost was considerable and controversial, and led the RTC to sell assets faster than it would have if it had wanted to maximize value.

The reason for segregating assets was simple: there were two different types of investors who might want to acquire them: banks that hadn’t been too badly damaged were interested in the “good bank” assets; distressed players and wealthy individuals went after the “bad bank” assets. The bad bank assets were going sufficiently on the cheap that even parties that had never dabbled in that sort of deal like Ron Perlman made acquisitions and did very well.

But what does a segregation achieve here? No one but an AAA rated party would make sense as a buyer/reinsurer of the muni portfolio. Buffett already having decided to enter the business on a de novo basis means the only interest another insurer is likely to have is reinsurance.
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And who would buy the rest? The parties who best understand the CDO/CDS exposures and have reason to do a deal are already at the table. You aren’t going to have new parties materialize out of the blue. Private equity investors like TPG and Bain Capital predictably said no thank you, we don’t understand this stuff.
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So a simple runoff of the portfolios would make the most sense. Any other activity appears to be for the benefit of lawyers and Perella Weinberg, not the policyholders.

As corporate spreads widen, there are fears that Fed cuts are pushing on a rope:

Companies are paying more to borrow now than before the Fed reduced its benchmark rate by 1.25 percentage point over nine days in January, based on data compiled by Merrill Lynch & Co. Rates on so-called jumbo mortgages, those above $417,000, have increased in the past month, making it tougher to sell properties and risking further price declines.

“It’s the clogging up of the credit markets that worries me most,” Harvard University economist Martin Feldstein said in an interview in New York. “The Fed has done a lot of cutting, the question is whether it’s going to get the traction that it did in the past.”

One example of this is the recent spate of Auction Rate Municipal auction failure. These auctions were last discussed – and explained! – on February 6. Another example is the market for Leveraged Buy-Out loans. Naked Capitalism provides an update to the commentary that was discussed February 11. Incidentally, there’s a new issue of CLO being touted:

Goldman Sachs Group Inc. and Carlyle Group plan to sell a 2 billion-euro ($2.9 billion) collateralized loan obligation and invest their own funds in the riskiest portion, according to a person with direct knowledge.
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The CLO will mostly hold loans used to finance European leveraged buyouts, purchasing directly from the managers of the transactions as well as loans traded in the market, the person said. Goldman is handling the CLO sale and Carlyle will manage the investments.
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CELF Partnership Loan Funding 2008-1

Class Size Rating Reinvestment Initial terms

(euros) (M/SP)** Period (years)

A 1.47 bln Aaa/AAA 2 150 bp* B 85 mln Aa2/AA 2 350 bp* C 90 mln A3/A- 2 525 bp* D 70 mln Baa3/BBB- 2 750 bp* E 50 mln Ba3/BB- 2 1100 bp* F 80 mln B3/B- 2 1500 bp* Pref 55 mln 20 percent Sub 100 mln

* in basis points over Euribor ** Ratings are Moody’s Investors Service and Standard & Poor’s

However, when I look at two Fed H.15 releases, for Feb. 11, 2008, and Feb. 12, 2007, I see that 30-year interest rate swaps are now at 4.83% to receive 3.20% LIBOR, vs. the year ago figures of 5.42% to receive 5.36% LIBOR. In Canada, long corporates hit 5.8%+ around the end of September and have been relatively stable since … and when we make a selection from the Fed’s easily accessible data, we see that the October 1 rates were 5.42% to receive 5.30% LIBOR. Note that Swaps were discussed briefly on PrefBlog in the context of synthesizing floating rate preferreds.

So maybe things are being transmitted quite as quickly as some might hope, but it certainly appears to me that there has been a bull steepening … at least as far as the swaps market is concerned! To the extent that arbitrage still exists – and friction has increased a lot in the last six months! – that should filter through to the cash bond market in the course of time.

It should also be noted that in Canada, long corporates and long Canadas are down (in price) roughly the same amount Year-to-Date, so all this fancy-pants Swap-Rate stuff should be taken with a grain of salt – at least as far as Canadian prospects are concerned.

Meanwhile, Treasury Secretary Paulson, fresh from his successes with the Hope Now Alliance and Super-SIV/MLEC is proposing new rules for securitization.

U.S. financial regulators will propose changes in the rules for packaging loans into bonds in the aftermath of the subprime credit collapse.

Paulson said it will be “a number of months” before the Presidential Working Group on Financial Markets announces its recommendations and that easing credit strains is the first “priority.”

In not entirely unrelated news, Moody’s has requested comment on the question “Should Moody’s Consider Differentiating Structured Finance and Corporate Ratings?”. There’s a survey! Log in RIGHT NOW and tell them that cosmetic differences are relevant solely to cosmeticians and bullshit artists!

The German government has bailed out IKB:

Germany will provide 1 billion euros in capital to the Dusseldorf-based lender, government officials told reporters in Berlin today. The country’s banks should help pay for the rest and talks on how to raise the remaining 500 million euros are continuing, the officials said.
…
An agreement on the bailout was necessary because IKB needed 500 million euros immediately to have sufficient capital to fulfill demands by German financial regulator BaFin to avoid insolvency, Scheel said. BaFin President Jochen Sanio threatened to close the bank last week if it didn’t quickly receive new capital, Handelsblatt newspaper reported.

I have been extremely annoyed about the emphasis on SocGen scapegoat Kerviel’s background as a back-office employee, most recently on January 30. My fears of a decline in career mobility appear to be justified:

Kerviel’s unauthorized trading at Societe Generale SA ruined the chances of French bank clerks getting promoted to the trading floor, headhunters say.

Kerviel, 31, became a trader at Societe Generale in 2005 after spending five years in the compliance and control section of the bank’s so-called middle office. Last month, the Paris- based bank blamed him for trading losses of 4.9 billion euros ($7.2 billion).

“The middle office won’t be a springboard to become a trader anymore,” said Gael de Roquefeuil, an adviser for financial industry headhunting at Korn/Ferry International in Paris. “Career bridges were already difficult and at least for the short term they are completely over.”

Great. So, especially in France, one of the primary qualifications in gaining promotion to a management position in trading is not having a clue about operations; such clues are gained only through experience. Expect more blow-ups over the next twenty years as competence and knowledge becomes even further divorced from authority than is already the case in financial services. Not to mention reduced profits even in the absence of problems if the major dealers wilfully reduce the size of their talent pool.

A very strong day for preferreds, with returns well-distributed within each asset class.

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% 5.54% 46,030 14.61 2 -0.1837% 1,080.7
Fixed-Floater 5.03% 5.67% 79,948 14.70 7 +0.0300% 1,020.0
Floater 4.96% 5.01% 76,259 15.45 3 +0.5653% 853.1
Op. Retract 4.82% 3.17% 80,397 2.68 15 +0.1978% 1,045.4
Split-Share 5.28% 5.45% 98,451 4.22 15 +0.3168% 1,042.6
Interest Bearing 6.23% 6.40% 60,247 3.58 4 +0.2275% 1,082.7
Perpetual-Premium 5.73% 4.39% 387,693 5.20 16 +0.1448% 1,028.8
Perpetual-Discount 5.36% 5.40% 291,501 14.80 52 +0.4638% 957.4
Major Price Changes
Issue Index Change Notes
BCE.PR.C FixFloat -1.6250%  
MFC.PR.C PerpetualDiscount -1.1984% Now with a pre-tax bid-YTW of 5.13% based on a bid of 22.26 and a limitMaturity. 
RY.PR.B PerpetualDiscount +1.0200% Now with a pre-tax bid-YTW of 5.18% based on a bid of 22.78 and a limitMaturity.
SLF.PR.B PerpetualDiscount +1.0927 Now with a pre-tax bid-YTW of 5.25% based on a bid of 23.13 and a limitMaturity.
SLF.PR.C PerpetualDiscount +1.1029% Now with a pre-tax bid-YTW of 5.12% based on a bid of 22.00 and a limitMaturity.
ELF.PR.F PerpetualDiscount +1.1211% Now with a pre-tax bid-YTW of 5.94% based on a bid of 22.55 and a limitMaturity.
BNS.PR.M PerpetualDiscount +1.1899% Now with a pre-tax bid-YTW of 5.13% based on a bid of 22.11 and a limitMaturity.
SLF.PR.D PerpetualDiscount +1.2414 Now with a pre-tax bid-YTW of 5.12% based on a bid of 22.02 and a limitMaturity.
TD.PR.O PerpetualDiscount +1.2414% Now with a pre-tax bid-YTW of 5.16% based on a bid of 23.63 and a limitMaturity.
GWO.PR.I PerpetualDiscount +1.2582% Now with a pre-tax bid-YTW of 5.23% based on a bid of 21.73 and a limitMaturity.
RY.PR.W PerpetualDiscount +1.4031 Now with a pre-tax bid-YTW of 5.15% based on a bid of 23.85 and a limitMaturity.
BAM.PR.K Floater +1.4870%  
W.PR.H PerpetualDiscount +1.5063% Now with a pre-tax bid-YTW of 5.67% based on a bid of 24.26 and a limitMaturity.
RY.PR.E PerpetualDiscount +1.5661% Now with a pre-tax bid-YTW of 5.12% based on a bid of 22.05 and a limitMaturity.
SLF.PR.E PerpetualDiscount +1.7471% Now with a pre-tax bid-YTW of 5.15% based on a bid of 22.13 and a limitMaturity.
BAM.PR.I OpRet +1.7476% Now with a pre-tax bid-YTW of 4.51% based on a bid of 26.20 and a call 2010-7-30 at 25.50. Compare with BAM.PR.J (5.32% to softMaturity 2018-3-30).
Volume Highlights
Issue Index Volume Notes
PWF.PR.K PerpetualDiscount 121,885 RBC crossed 110,000 at 23.15. Now with a pre-tax bid-YTW of 5.38% based on a bid of 23.15 and a limitMaturity.
GWO.PR.E OpRet 106,741 Now with a pre-tax bid-YTW of 3.72% based on a bid of 25.89 and a call 2011-4-30 at 25.00.
MFC.PR.C PerpetualDiscount 83,815 RBC crossed 31,200 at 22.64. Now with a pre-tax bid-YTW of 5.13% based on a bid of 22.26 and a limitMaturity.
TD.PR.Q PerpetualPremium 78,680 Now with a pre-tax bid-YTW of 5.41% based on a bid of 25.45 and a limitMaturity.
CM.PR.I PerpetualDiscount 64,575 National Bank crossed 38,900 at 20.90. Now with a pre-tax bid-YTW of 5.69% based on a bid of 20.86 and a limitMaturity.

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

Spreads to Bonds

Recent Bond/Preferred Performance

Assiduous Reader madequota has asked on another post:

OK, one more question that’s easy to ask, and hard to answer:

In very general terms, I’ve always believed that prefs (of the so-called perp variety especially) should behave, more or less, in sync with the 30 year bond. I’m aware of the variety of specific differences between the two vehicles, but at the end of the day, these two investments are very similar in that the occurances of the daily market should have identical impact on both of them. Hence they should, at the very least, move in the same direction.

Assuming my generalization is correct, why then do these things trade so often in opposite directions? For example, the US retail number came out today, and because it was marginally “better than analyst’s expectations”, bonds got punished both in the US and Canada. But the prefs had a great day in Canada.

Specifically then, why is the long bond getting creamed over the past week, while at the same time, thirst for perp prefs seems to be unquenchable?

madequota

I am on the verge of doing serious work on spreads … though what I am calling “serious work” is what I would normally term as a product of the “Look, Mummy, I got a spreadsheet!” school of security analysis.

One more month and I should have the HIMIPref™ indices up to date, which will give the data I require to draw long term spread graphs. PerpetualDiscounts SHOULD trade like long corporates (NOT long Canadas!), PerpetualPremiums, Retractibles & OpRets SHOULD trade like short corporates – the first of these with a little slippage due to negative convexity.

All I can really say is: spreads are volatile. And without some hot institutional money (even lukewarm institutional would be a help) to arbitrage corporates/prefs, they’re going to stay volatile.

Note that long corporates are down about 2.52% YTD, while perpetualDiscounts are up about 2.67%. So go figure.

Better Communication, Please!

Sunlife Financial Dividend Not Yet Declared

The headline says it all! There’s nothing on their website and a VERY EXPENSIVE data inquiry to TSX Market Data returns no declarations in the last three months.

Data have been estimated as:

  • ExDate: 2008-2-19
  • Record Date 2008-2-21
  • Pay Date 2008-3-31

… which is consistent with both the last dividend (ex-date 11/19) and last year’s 1Q dividend (ex-date 2/19) but is still just a guess.

Sunlife directors! Get with the programme! Surely preferred share dividends can be declared a month in advance of the ex-date and posted on your website! Surely a notice of expected dividends, “if, as and when”, could be posted in your investor relations section!

Market Action

February 12, 2008

The Street was alive today with news that Warren Buffet, out of the kindness of his heart, is willing to fix the monoline crisis:

Billionaire investor Warren Buffett said he offered to assume responsibility for $800 billion of municipal bonds guaranteed by MBIA Inc., Ambac Financial Group Inc. and FGIC Corp.
…
“The Buffett plan basically cherry picks out the only worthwhile parts of the portfolio,” said David Havens, a credit analyst at UBS AG in Stamford, Connecticut. “It leaves them with a terrible mix of business.”

Berkshire would put up $5 billion as capital for the plan and is offering to insure the municipal debt for 1.5 times the premium charged by the bond insurers to take on the guarantee. The insurers could accept the offer and back out within 30 days for a fee, Buffett said.

The secret of Buffet’s success? Do business only with those who are stupid and desperate.

AIG’s woes with Credit Default Swaps, which were mentioned yesterday, continued to attract attention today. AIG issued a press release:

AIG continues to believe that the mark-to-market unrealized losses on the super senior credit default swap portfolio of AIG Financial Products Corp. (AIGFP) are not indicative of the losses AIGFP may realize over time. Based upon its most current analyses, AIG believes that any losses AIGFP may realize over time as a result of meeting its obligations under these derivatives will not be material to AIG.

… and so did Fitch:

Fitch Ratings has placed American International Group, Inc.’s (NYSE: AIG) Issuer Default Rating (IDR), holding company ratings and subsidiary debt ratings including International Lease Finance and American General Finance on Rating Watch Negative.
…
AIG has relatively large exposure to the current U.S. residential mortgage crisis. Fitch believes the area of AIG most exposed to further deterioration in this market is the credit derivative portfolio within AIG FP, with its large net notional exposure of $505 billion at Sep. 30, 2007. Included in this total is $62.4 billion of collateralized debt obligations backed by structured finance (SF CDOs) collateral, mainly subprime U.S. residential mortgage-backed securities (RMBS).

Fitch has stated that it believes AIG will not be immune to potential losses from U.S. residential mortgage crisis, although at the present time the agency believes these losses should be absorbed by the existing capital base and future earnings stream. Today’s announcement brings additional uncertainty to the potential impact on the financial statements.

The actual SEC Filing states:

As disclosed in AIG’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007 (the “Form 10-Q”), AIGFP values its super senior credit default swaps using internal methodologies that utilize available market observable information and incorporate management estimates and judgments when information is not available. In doing so, it employs a modified Binomial Expansion Technique (“BET”) model that currently utilizes, among other data inputs, market prices obtained from independent sources, from which it derives credit spreads for the securities constituting the collateral pools underlying the related CDOs. The modified BET model derives default probabilities and expected losses from market prices, not credit ratings. The initial implementation of the BET model did not adequately quantify, and thus did not give effect to, the benefit of certain structural mitigants, such as triggers that accelerate amortization of the more senior CDO tranches.

As disclosed in the Form 10-Q, AIG did not give effect to these structural mitigants (“cash flow diversion features”) in determining the fair value of AIGFP’s super senior credit default swap portfolio for the three months ended September 30, 2007. Similarly, these features were not taken into account in the estimate of the decline in fair value of the super senior credit default swap portfolio through October 31, 2007 that was also included in the Form 10-Q because AIG was not able to reliably estimate the value of these features at that time. Subsequent to the filing of the Form 10-Q, through development and use of a second implementation of the BET model using Monte Carlo simulation, AIGFP was able to reliably estimate the value of these features. Therefore, AIG gave effect to the benefit of these features in determining the cumulative decline in the fair value of AIGFP’s super senior credit default swap portfolio for the period from September 30, 2007 to November 30, 2007 that was disclosed in AIG’s Current Report on Form 8-K/A, dated December 5, 2007 (the “Form 8-K/A”) filed after AIG’s December 5, 2007 Investor Conference.

In addition, during AIG’s December 5 Investor Conference, representatives of AIGFP indicated that the estimate of the decline in fair value of AIGFP’s super senior credit default swap portfolio during November was then being determined on the basis of cash bond prices for securities in the underlying collateral pools, with valuation adjustments made not only for the cash flow diversion features referred to above but also for “negative basis”, to reflect the amount attributable to the difference (the “spread differential”) between spreads implied from cash CDO prices and credit spreads implied from the pricing of credit default swaps on the CDOs.

So … as far as I can make out, this is more of a mark-to-market problem than an actual credit problem, but I’d have to do a lot more work before I bet a nickel on that scenario. The trouble is that AIG has shareholders equity of $104-billion and notional exposure of $505-billion. So just on this notional bond portfolio – of credit quality that I’m not looking at right now – they’ve levered up the company 5:1, on top of whatever leverage is implicit in their regular insurance operations.

There is a rather amusing section in their most recent 10Q:

As of October 31, 2007, AIG is aware that estimates made by certain AIGFP counterparties with respect to the fair value of certain AIGFP super senior credit default swaps and the collateral required in connection with such instruments differ significantly from AIGFP’s estimates.

Yeah, I’ll just bet!

Quite frankly, I don’t understand their investment strategy … or, I should say, I don’t understand how it makes sense. Why would an operating company seek to make money simply by levering up to hell-and-gone? I can certainly see them having a trading portfolio, and I can certainly see them having a greater value of tradeable instruments on the books than the value of their capital … but these CDSs were not – and, importantly, are not – tradeable … not in the same way regular bonds are tradeable, anyway, since you’ve got counterparty risk in there that cannot – usually – be transferred. CDSs are not fungible.

I am all in favour of big financial institutions providing liquidity – as dealer normally do, by keeping positions on their books for as long as it take to find somebody who wants to take the other side – but AIG was not, strictly speaking, providing liquidity except in the most general and useless sense.

Well, it’s easy to be wise after the event! But given the oppobrium in which large brokerage houses (and their stock prices) are now held, it will be most interesting to see whether any of the big-big-big public ones go private in the near future in a reversal of recent trends:

The private partnerships that once dominated Wall Street guarded their capital, used less leverage and limited their risk to trading blocks of stock for clients and shares of companies in mergers, said Roy Smith, a finance professor at New York University’s Stern School of Business and a former partner at Goldman Sachs Group Inc. Since raising money from the public, many of the biggest firms have abandoned that caution.

There was TAF auction today, which at least one news source thinks is new money. In fact, this auction, which resulted in a stop-out rate of 3.01%, simply rolls over the loans from the January 14 auction. It is interesting to compare this with the Fed Funds Rate of 3.00% … the next FOMC meeting is March 18, which is after the maturity of these loans. It would appear that:

  • No intra-meeting activity is anticipated
  • there is no term premium being paid on this money

Pedants may wish to point out that this is not necessarily the case, since these two effects might be equal and opposite; I will apply sophisticated quantitative analysis in my rejoinder: So’s your old man! Ray Stone of Stone & McCarthy Research Associates notes:

“The TAF program was an ingenious approach to solving a serious problem” of strained money markets, Mr. Stone says in a note to clients. “That said, it is not clear that the TAF program should be employed except in the extraordinary circumstances that have prevailed in recent months.” The TAF credit weakens the Fed’s balance sheet because the collateral offered at auction is inferior to the Fed’s other holdings, he says. And the result of the two January auctions — with interest rates below the federal funds target — “raises a philosophical issue as to whether the Fed’s provision of reserves at a rate below the target debases the role of the FOMC,” he says.

Note, however, that Bernanke has stated:

Based on our initial experience, it appears that the TAF may have overcome the two drawbacks of the discount window, in that there appears to have been little if any stigma associated with participation in the auction, and–because the Fed was able to set the amounts to be auctioned in advance–the open market desk faced minimal uncertainty about the effects of the operation on bank reserves. The TAF may thus become a useful permanent addition to the Fed’s toolbox.* TAF auctions will continue as long as necessary to address elevated pressures in short-term funding markets, and we will continue to work closely and cooperatively with other central banks to address market strains that could hamper the achievement of our broader economic objectives.
…
*With the footnote: “Before making the TAF permanent, however, we would seek public comment on its design and utility.”

The Fed Funds Futures are projecting a massive easing at the March meeting, to hit 2.5% in April before bouncing back (although the later contracts are low-volume). You know something? This is all very strange.

Not the most interesting of days. Volume was light and there wasn’t much price movement.

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 5.50% 5.52% 45,706 14.60 2 -0.2207% 1,082.7
Fixed-Floater 5.03% 5.67% 80,956 14.70 7 +0.2877% 1,019.7
Floater 4.98% 5.04% 77,262 15.41 3 -0.4226% 848.3
Op. Retract 4.82% 3.36% 80,726 2.91 15 +0.0521% 1,043.4
Split-Share 5.29% 5.51% 99,718 4.22 15 +0.1142% 1,039.3
Interest Bearing 6.25% 6.44% 60,582 3.37 4 +0.0254% 1,080.3
Perpetual-Premium 5.73% 4.70% 391,027 5.20 16 +0.1306% 1,027.4
Perpetual-Discount 5.39% 5.43% 292,994 14.76 52 -0.0019% 953.0
Major Price Changes
Issue Index Change Notes
TOC.PR.B Floater -1.2987%  
ELF.PR.F PerpetualDiscount +1.0879% Now with a pre-tax bid-YTW of 6.01% based on a bid of 22.30 and a limitMaturity.
BNA.PR.C SplitShare +1.8220% Asset coverage of 3.6+:1 as of December 31, 2007, according to the company. Now with a pre-tax bid-YTW of 7.45% based on a bid of 19.56 and a hardMaturity 2019-1-10 at 25.00. Compare with BNA.PR.A (6.07% to 2010-9-30) and BNA.PR.B (7.45% to 2016-3-25).
BCE.PR.G FixFloat +2.5918 On zero volume!
Volume Highlights
Issue Index Volume Notes
MFC.PR.C PerpetualDiscount 303,710 RBC bought 57,200 from Nesbitt in three tranches at 22.63. Now with a pre-tax bid-YTW of 5.07% based on a bid of 22.53 and a limitMaturity.
BNS.PR.O PerpetualPremium 41,690 Now with a pre-tax bid-YTW of 5.45% based on a bid of 25.38 and a call 2017-5-26 at 25.00.
RY.PR.D PerpetualDiscount 26,200 Now with a pre-tax bid-YTW of 5.20% based on a bid of 21.65 and a limitMaturity. 
CM.PR.I PerpetualDiscount 24,047 Now with a pre-tax bid-YTW of 5.67% based on a bid of 20.92 and a limitMaturity.
BAM.PR.B Floater 21,400  

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

Miscellaneous News

David Berry Catfight Spreads

The OSC has announced it:

will hold a hearing to consider the Application made by David Berry for a review of a Market Regulations Services Inc. decision dated November 8, 2007.

The hearing will be held on March 6, 2008 at 10:00 a.m. on the 17th floor of the Commission’s offices located at 20 Queen Street West, Toronto.

There are ten elements to the application; I find the most interesting one to be the first, which asks for, among other things, better disclosure of the “materials relating to settlement negotiations between RS Staff and each of Marc McQuillen (‘McQuillen’) and Scota Capital Inc.”

The David Berry Saga was last reported at PrefBlog on December 12. Readers will remember that I am not impressed by Scotia’s business practices or by Regulation Service’s eagerness to be used as a negotiating tool.

Issue Comments

WN.PR.A WN.PR.B WN.PR.C WN.PR.D WN.PR.E Downgraded by DBRS

DBRS has announced that it:

today downgraded the long- and short-term ratings of George Weston Limited (Weston or the Company). The Notes & Debentures have been downgraded to BBB from BBB (high), the Exchangeable Debentures to BBB (low) from BBB and the Preferred Shares to Pfd-3 from Pfd-3 (high), all with a Stable trend. At the same time, DBRS has downgraded Weston’s Commercial Paper rating to R-2 (high) from R-1 (low), also with a Stable trend.

This action removes Weston’s ratings from Under Review with Negative Implications, where they were placed on November 16, 2007 along with Loblaw Companies Ltd.’s (Loblaw).

Although management of Loblaw and Weston are separate, and there is no cross-default or cross-collateralization covenants on the respective debt, Weston’s ratings reflect the investment in Loblaw, as it is a significant portion of the group’s consolidated operations. DBRS’s approach in considering Weston’s debt ratings includes: 1) the implied rating for Weston’s wholly-owned operating businesses; and 2) the support of the Loblaw rating.

Last week, Loblaw’s long-term rating was downgraded to BBB (high) from A (low), while the short-term rating was downgraded to R-2 (high) from R-1 (low). The trend is Negative for the long-term ratings and Stable for the short-term rating. (See separate Loblaw Press Release dated February 7, 2008 for details.)

DBRS has completed its review of Weston and confirmed that the stand-alone businesses are well placed in the BBB rating category. The view reflects Weston’s above average operating efficiency, strong brands, and reasonable financial profile for companies within the bakery sector. The Stable trend reflects the fact that Weston has been successful at passing on price increases and maintaining its market position in a rising cost environment. With regards to the short-term rating, Weston’s liquidity profile is commensurate with the R-2 (high) category based on its long-term rating, the dividend income received from Loblaw, reasonably stable cash flow, a high level of cash and marketable investments and manageable debt levels.

With the downgrade of Loblaw’s ratings to BBB (high) and R-2 (high), the ratings for Weston at BBB and R-2 (high) reflect more its operating businesses and less the support from the Loblaw rating. As such, if there is any further deterioration in Loblaw’s long-term rating, it will not necessarily affect the long-term rating of Weston.

The November 16 Credit Watch has been previously reported. S&P has not yet made any changes from their P-3(high)/Watch Negative level.

Market Action

February 11, 2008

I mentioned the increasing nervousness of the Treasury market on February 8 and now Accrued Interest has opined:

Treasury yields at current levels can only be supported if the Fed holds interest rates low for an extended period of time and inflation doesn’t become a problem. Traders know this is a very fine line to walk, and confidence in Bernanke’s ability to walk that line is, well, not as strong as it could be. It will probably take a pretty stiff recession to keep inflation low despite highly accomodative monetary policy. Tuesday’s ISM report supported the idea that we are already in a recession, and therefore supported rates at their current levels. But if it turns out we aren’t in a recession, the Fed will have to make a rapid reversal of policy to combat inflation. If so, long rates will be the big loser.

Place yer bets, gents, place yer bets! Never mind Bernanke, I have serious doubts about anyone’s ability to walk the line demanded by current long rates.

In news that may be of interest to BCE Takeover Speculators, Naked Capitalism has exerpted articles regarding the current weakness of the Collateralized Loan Obligation (CLO) market:

Investment banks are sitting on sizable unsold inventories that are declining in value, thus sure to lead to further writedowns. And ironically, the Fed’s interest rate cuts are only making matters worse. These instruments are floating-rate, priced off the short end of the yield curve, so rate cuts lower their interest payments, making them less attractive to investors.

The Journal article adds some useful information: UBS and Wachovia are set to auction $700 million of loans believed to underlie some collateralized loan obligations (instruments made from pools of leveraged loans) adding to further pressure to the market.
…

Readers who have become heartily sick of seeing the word “monoline” in this blog will be gratified to learn that a multi-line insurer has now gotten in trouble over a CDS portfolio:

American International Group Inc., the world’s largest insurer by assets, fell the most in 20 years in New York trading after auditors found faulty accounting may have understated losses on some holdings.

So-called credit-default swaps issued by AIG lost $4.88 billion in value in October and November, four times more than previously disclosed, the company said today in a filing with the U.S. Securities and Exchange Commission. AIG’s auditors found “material weakness” in its accounting for the contracts, according to the filing. The insurer said it has no yearend price estimate for the obligations.

Similarly, SocGen is looking for €5.5-billion. Meanwhile, a group of US banks is seeking to avoid foreclosures:

Bank of America Corp., Citigroup Inc. and four other lenders will announce new steps tomorrow to help borrowers in danger of default stay in their homes, according to three people familiar with the plans.

The banks will start “Project Lifeline,” offering, on a case-by-case basis, a 30-day freeze on foreclosures while loan modifications are considered, two people said on condition of anonymity. The companies met with Treasury officials over the past week to discuss ways to encourage homeowners to get in touch with their mortgage servicers, one person familiar with the deliberations said.

Translation (courtesy of PrefBlogs Spin/English dictionary [patent pending]): “Please don’t make us buy all these damn houses.”

On February 6 I noted some news reports about Auction Rate Municipals auctions failing … now they have been joined by some Student Loan securities:

College Loan Corp., a San Diego- based lender, said some bonds it issued with rates determined through periodic auctions failed to attract enough bids.

The company wouldn’t say which specific issues failed or identify the banks that managed the auctions.

Demand for bonds in the $360 billion auction-rate securities market is waning on investor concern that dealers who collect fees for managing the bidding on the bonds won’t commit their own capital to prevent failures. Reduced appetite for auction-rate debt in the municipal market also reflects expectations that the credit strength of insurers backing the securities may deteriorate.

A quiet day, of overall good performance. To my regret, I am unable to update the indices at this time. I regret this because it proves I’m an idiot. Never mind the story … you don’t want to know.

Major Price Changes
Issue Index Change Notes
BAM.PR.K Floater -1.6745%  
BCE.PR.G FixFloat -1.0684%  
PWF.PR.J OpRet -1.0663% Now with a pre-tax bid-YTW of 3.83% based on a bid of 25.98 and a call 2010-5-30 at 25.50.
BAM.PR.B Floater +1.0128%  
BNS.PR.M PerpetualDiscount +1.0176% Now with a pre-tax bid-YTW of 5.19% based on a bid of 21.84 and a limitMaturity.
MFC.PR.B PerpetualDiscount +1.2270% Now with a pre-tax bid-YTW of 5.10% based on a bid o 23.10 and a limitMaturity.
ELF.PR.G PerpetualDiscount +1.2500% Now with a pre-tax bid-YTW of 5.94% based on a bid of 20.25 and a limitMaturity.
RY.PR.C PerpetualDiscount +1.5625% Now with a pre-tax bid-YTW of 5.22% based on a bid of 22.10 and a limitMaturity.
Volume Highlights
Issue Index Volume Notes
BCE.PR.A FixFloat 87,900  Scotia crossed 50,000 shares at 23.97, then another 36,500 shares at 24.00. Closed at 23.96-03, 4×4.
RY.PR.E PerpetualDiscount 78,600 RBC crossed 75,000 at 21.70. Now with a pre-tax bid-YTW of 5.18% based on a bid of 21.71 and a limitMaturity.
TD.PR.Q PerpetualPremium 73,375 Nesbitt bought 50,000 shares from National Bank at 25.38. Now with a pre-tax bid-YTW of 5.45% based on a bid of 25.37 and a call 2017-3-2 at 25.00.
RY.PR.W PerpetualDiscount 57,200 Now with a pre-tax bid-YTW of 5.21% based on a bid of 23.59 and a limitMaturity.
POW.PR.D PerpetualDiscount 53,650 Nesbitt crossed 50,000 at 23.45. Now with a pre-tax bid-YTW of 5.43% based on a bid of 23.26 and a limitMaturity.

There were twelve other index-included $25-equivalent issues that traded over 10,000 shares today.

Update, 2008-2-12: Finally! The indices!

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 5.49% 5.51% 46,485 14.5 2 +0.1225% 1,085.1
Fixed-Floater 5.04% 5.69% 81,551 14.7 7 -0.1823% 1,016.8
Floater 4.96% 5.01% 75,380 15.45 3 -0.2017% 851.9
Op. Retract 4.83% 3.45% 81,514 3.12 15 -0.1416% 1,042.8
Split-Share 5.30% 5.51% 99,286 4.21 15 +0.1638% 1,038.1
Interest Bearing 6.25% 6.40% 60,112 3.37 4 +0.0759% 1,080.0
Perpetual-Premium 5.74% 4.98% 398,475 5.21 16 +0.0188% 1,026.0
Perpetual-Discount 5.39% 5.42% 295,773 14.76 52 +0.1540% 953.0