PrefBlog

Bobby Fischer, RIP. 

D. Byrne – R. Fischer

Rosenwald Memorial Tournament

New York City

October 17, 1956

17 … Be6!!

Naked Capitalism reviews the Credit Default Swaps market with an emphasis on the new two-ton gorilla in the room: counterparty risk. CIBC shareholders learnt all about counterparty risk on December 19; Merrill Lynch shareholders got a reminder more recently:

concerns ratcheted up when Merrill announced that $3.1 billion of its $16.7 writedown was due to the apparent worthlessness of hedges written by an obscure (to those not following credit guarantors) counterparty, ACA Financial Guaranty.

He also highlights the issue of insider trading, mentioned in the CDS Primer:

The Journal also mentions regulatory issues:

This market poses challenges for would-be regulators. It isn’t clear, for instance, how securities laws on fraud and insider trading would apply to credit-default swaps, because it’s not clear in what way they are even securities; they are private contracts.

Of all the regulatory concerns, fraud and insider trading are low on the list.

Mr. Smith does not explain his reporting of the ranking of fraud and insider trading. I will certainly grant that the question of regulatory capital requirements for “normal” transactions should be the number one concern [hint regarding my position: shorting a CDS and buying the notional amount of BAs is roughly the same exposure as an outright investment in the underlying corporate credit, for a term equal to the term of the contract], but fraud and insider trading are always concerns.

And the monolines continue to career down the road to oblivion:

Ambac Financial Group Inc. scrapped a plan to raise equity capital after the bond insurer’s shares plunged 70 percent in the past two days, putting its AAA credit rating in jeopardy.
…
MBIA raised $1 billion last week in the sale of surplus notes and last month entered a deal to sell $1 billion of equity to private-equity firm Warburg Pincus LLC. Both companies slashed their dividends and took out reinsurance on some securities to help shore up capital.

The surplus notes plunged as low as 70 cents on the dollar today, indicating a yield of about 25 percent, traders said. MBIA dropped $1.63, or 18 percent, to $7.59 on the New York Stock Exchange, extending its 56 percent decline this week.

And, as the market closed, Naked Capitalism republished news and commentary on the Fitch downgrade of Ambac.

More speculation in the press about the BCE / Teachers deal:

The Montreal-based company’s shares were down for the fifth consecutive trading day, losing 16 cents to $36.37 Friday.

The shares are down from a peak of $41.80 in July.

Crandall said the share price suggests many investors now believe there’s only a 50/50 chance the company will be sold to a group led by the Ontario Teachers’ Pension Plan. The group offered $42.75 per share in June for BCE and plans to finance the deal with up to $40 billion of debt.
…
Toronto Dominion Bank chief executive Ed Clark this week reinforced his bank’s commitment to provide $3.8 billion to the BCE deal.

“I know everyone stews and worries about it. I would like to tell you that I’m stewing and worrying, but I’m not,” he said at a conference of bank CEOs on Tuesday.
…
But Teachers spokeswoman Deborah Allan said the prospective buyers of Canada’s largest telecommunications won’t be distracted by “the noise that’s in the marketplace.”

“As far as this transaction is concerned, we have an agreement, we’re committed to it and we’re focusing on closing the deal,” she said in an interview.

Now, as PrefBlog’s Assiduous Readers will know, the way to read a press release is to see what it is that they DON’T say. Have a look at Deborah Allan’s remarks (as quoted by the CP reporter, Ross Marowits). Did she actually say anything at all meaningful? We know they have an agreement (it’s on SEDAR), we know they’re committed to it (they signed) and it’s not clear to me what “we’re focusing on closing the deal” means. We know that TD is happy about financing 10% of the price, but … where’s the other 90%?

Given everything that’s happened to the credit markets and to BCE over the past seven months, I suspect that a loss of a mere $1-billion break fee is a pretty cheap exit. But, I say again: what do I know? Either way it’s a speculation on basically zero information; I can have more fun playing blackjack.

As part of its continuing effort to prevent business from being done in Canada, Regulation Services has released Guidance on the Supervision of Algorithmic Trading, with the lovely little paragraph:

If a Participant has provided Dealer-Sponsored Access, commonly known as direct market access, to a client (“DSA Client”), the Participant, as part of its on-going supervision of client orders, must be aware of the origin of the orders entered by the DSA Client, including whether the DSA Client employs the use of algorithmic trading systems. The Participant must ensure the proper testing of any algorithmic trading system used by a DSA Client to enter orders on a marketplace by means of the Dealer-Sponsored Access provided by the Participant.

In other words, it’s not sufficient to take responsibility for your orders. Your process must be questioned, tested, validated and approved by Responsible Authorities. Assiduous Readers will remember that the purpose of rules only very rarely has anything to do with accomplishing anything … the purpose of rules is to give authorities their authority. Hail RS!

It is my understanding that a lot of proprietary traders (day traders who work for dealers) are finding out that their bonuses (and profits of the banks dealers) have not been due so much to their uncanny understanding of the market and brilliant exploitation of subtle shifts in supply and demand as they were to control of the order flow, better access to data and execution than their buy-side competitors and tick-sizes on prices of more than a penny.

Principal revenues earned from proprietary desks and market-making activities also succumbed to the market downturn. Equity trading revenues were off $209 million, a whopping 120 per cent lower than the previous quarter and off 123 per cent against the same period in 2006. For the quarter, equity trading resulted in a net loss of $35 million. This represents the first time since the third quarter of 2002, about the same time the TSX bottomed out from the tech market collapse, that the industry reported a net loss from their principal equity trading business.

Don’t expect much squawking from the street on this one.

After yesterday’s fall, the preferred share market took a little breather today – volume was way down and, overall, losses were minor. All eyes are on equities at this point … the Monday back from a weekend of worrying and second-guessing can often be rather exciting. What effect the US holiday will have on this process is something that I’m afraid even to contemplate!

There were eleven other index-included $25.00-equivalent issues trading over 10,000 shares today.

Prof. Hamilton’s use of the unadjusted 10-year Nominal/TIpS spread, mentioned here yesterday, attracted some criticism in the comments to his post. The Cleveland Fed adjusts the raw data for (a) the inflation risk premium, and (b) liquidity premium.

The naive method of pricing real return bonds is:

Nominal Yield = Real Yield + Inflation Expectations (Wrong!)

If this were the actual equation, there would be no incentive for the issuers to issue the bonds; they would just go with nominals. However, the correct equation:

Nominal Yield = Real Yield + Inflation Expectations + Inflation Risk Premium (Right!)

adds a term. A buyer of nominals must not only forecast inflation, but (if he’s prudent) add a little bit extra just in case his expectations are wrong. By issuing real return bonds, the issuer can capture that Inflation Risk Premium for itself.

The liquidity premium doesn’t need a lot of explanation – especially in this environment, where the liquidity premium on some issues – especially US financials – is enormous. When you buy treasuries – or Canadas, to a lesser extent – you can trade a boatload of them without moving the price. Want a quote on 10-years, $50-million a side? The quote will come back at you with a ten cent spread. Why not? The dealer’s ‘phone is always ringing, he can keep turning over his inventory and earning the spread with ease, and he can alter the directional bias of his trades by shading his quote a few pennies one way or the other.

This is – ahem! – not the case with instruments of lesser liquidity. Therefore, you are willing to pay less for instruments of low liquidity (which increases the yield required) to compensate for the risk that you’re going to want to – or have to – sell them prior to maturity anyway and be subject to the tender mercies of the dealers and their book of inventory.

I have added a link to the Cleveland Fed’s calculations at the sidebar. Curious readers will see that the adjusted series is volatile and has been sharply increasing in recent months.

The implosion of the weaker monolines, Ambac and MBIA, continued today.

Michael Woodford of Columbia University wrote an interesting piece on the ideal methodology of central bank communication with investors:

All of the big-3 central banks (the Fed, Bank of Japan and the ECB) have experimented over recent years with more explicit forward guidance through their official communications. Generally it is through the use of “code words,” such as removal of policy accommodation at a “measured pace,” or the exercise of “strong vigilance” toward inflation risks.
…
I suspect that other central banks are becoming more cautious as well about the use of code words that are taken to directly indicate future interest-rate decisions, under the current rapidly changeable conditions in financial markets.

He suggests that the use of fan charts would be preferable. To my chagrin I have been unable to find a linkable example of a fan chart, but the name should be self explanatory. Draw your projection of … whatever … into the future. Draw in confidence limits at, say, 50%, 75% and 95% confidence. Colour them in. Voila! See, for example, Chart#3 in the Norges Bank 2006-03 Inflation Report.

At a 2006 Bank of Canada conference, such fan charts were lauded:

The Reserve Bank of New Zealand is the pioneer not only in inflation targeting but also in introducing and publishing explicit instrument-rate paths that can be interpreted as optimal instrument-rate plans. The bank has done so since 1998 (Archer 2004, 2005; Svensson 2001a). The Reserve Bank has for many years been alone in taking this bold step. However, Norges Bank, an enthusiastic and competent newcomer to the inflation-targeting camp, has recently started to publish explicitly optimal instrument-rate paths with uncertainty bands, together with criteria for optimal inflation and output-gap projections and other innovations in transparent monetary policy (Norges Bank 2005; Qvigstad 2005). This should be an example to other central banks.

There was a bit more speculation about BCE today:

Shares of BCE Inc. Canada’s biggest telecom company, continue to trade well below the offer price in its $34.8-billion buyout as investors remain worried the deal may be repriced, abandoned or face further delays.

The buyer group, which includes the Ontario Teachers’ Pension Plan, Providence Equity Partners, Madison Dearborn Partners and Merrill Lynch Global Private Equity, has offered $42.75 a share to take the company private.

However, its shares were at $36, down $1.01, on the Toronto Stock Exchange on Thursday afternoon, despite repeated assurances from both BCE and Teachers’ that the deal remains on track.

A BCE spokesman said on Thursday the company is still “looking forward to closing the deal” in the second quarter.

A Teachers’ spokeswoman was not immediately available for comment.

My guess is that the Teachers’ spokeswoman was in the Ladies’, throwing up. But what do I know?

Today’s response in the preferred market to the new BNS 5.60% Perpetual certainly makes my “frothy” correspondent of January 7 and January 8 look like a genius! The correspondent now feels that (a) long-term, prefs are a buy; (b) short term, it might be better to wait; and (c) if another issue comes out before the new issue settles, take the day off and buy a bottle of something tasty. 

Volume, rather surprisingly, was good, but by no means heavy. Make of that what you will.

There were thirty-two other index-included $25.00-equivalent issues trading over 10,000 shares today.