PrefBlog

Menzie Chinn at Econbrowser has reviewed credit and term spreads: 

He notes:

It might appear that the two phenomena are unrelated. But the DB article argues that while banks pursued off-balance sheet activities such as “rating transformation” (transmuting assets of one credit default risk category to another category by financial engineering), they moved away from reliance on maturity transformation and taking on credit risk. With the end of the structured credit market, and reorienting of banks’ operations, credit spreads and term spreads will reappear.

Interestingly, as Chart 6 illustrates, term and credit spreads are not back to where they were pre-2005. However, in terms of the latter, they’re close. And, as time on goes on, one might very well expect further curve steepening.

It would certainly be a pleasure to see some actual curve steepening! Preferably a bull steepening (in which the steepening is effected by a decline in shorter-term rates), just to wipe the smug smile off the faces of those who claim to be avoiding risk by shortening term! Bloomberg notes, however, that steepness and fear of inflation are intertwined.

In somewhat related news:

JPMorgan Chase & Co. CEO Jamie Dimon said SIVs, whose assets have dwindled by at least $75 billion since July, will “go the way of the dinosaur.”

“SIVs don’t have a business purpose,” Dimon, 51, said at the Merrill Lynch conference today.

I consider this “somewhat related” because of the term spread; a SIV is nothing more nor less than an unregulated “country bank”, seeking to make money from the term spread (financing long-term assets with short paper) and the credit spread (enhancing the credit quality of its debt by subordination of its senior tranches with equity tranches). What we are seeing now is the unravelling of the business model due to:

• General loss of confidence (equivalent to a bank run)
• Bad quality on their asset side

… which are the same things that will do in any bank.

While I agree that SIVs qua SIVs are dead, I’m not so sure that they served no business purpose; and feel entirely confident that other vehicles – probably better capitalized and not so aggressive with their financing models – will arise to take their place. People want to lend short and borrow long. In the aggregate, short-term money is available for the long term. Banks, SIVs and ABCP conduits all serve the same business purpose in this respect … so I’m not sure what Dimon meant.

I mentioned possible downgrades of bond insurers on November 9. Accrued Interest has continued his educational campaign by analyzing some scenarios for ABS default, insurance and recovery that sheds quite a bit of light on the matter.

The CDOs are tricksy things! Fitch Ratings indulged in a mass downgrade yesterday:

Derivative Fitch–New York–12 November 2007: Derivative Fitch has downgraded $37.2 billion (U.S. dollar and U.S. dollar equivalent) and affirmed $6.9 billion of structured finance collateralized debt obligations (SF CDOs) across 84 transactions. Fitch’s rating actions follow the completion of a review of 55 U.S. and European SF CDOs executed on a synthetic basis, and 29 U.S. and Asian SF CDOs executed on a cash/hybrid basis. Ratings on 66 U.S. cash and hybrid SF CDOs remain on Rating Watch Negative pending resolution on or before Nov. 21, 2007.

A downgrade:affirm ratio in excess of 5:1 is big news, especially since many of the downgrades are multi-level:

more than $14 billion worth of transactions falling from the highest-rated AAA perch to speculative-grade, or junk, status.

The implications can be as scary as you want them to be. Naked Capitalism provides excellent links to some informed discussion. Just to make things even more interesting – for those of you who are bored by mere multi-billion writeoffs – Naked Capitalism also reports on a now somewhat dated (two weeks) judgement refusing foreclosure to Deutsche Bank:

Judge Christopher A. Boyko of the Eastern Ohio United States District Court, on October 31, 2007 dismissed 14 Deutsche Bank-filed foreclosures in a ruling based on lack of standing for not owning/holding the mortgage loan at the time the lawsuits were filed.

Whether this was an isolated SNAFU by Deutsche, or indicative of lack of paper trail maintenance by the various intermediaries, is something regarding which I do not care to speculate at this time.

Naked Capitalism also takes issue with Countrywide funding its operations with Certificates of Deposit, but I can’t see any problem with that … provided that FDIC and Fed is supervising the bank properly and it’s solvent. Otherwise, of course, it would be a Bad Thing. I’m much more concerned about the back-door guarantees via the Federal Home Loan Banks, as I noted on October 30.

I noted yesterday that Legg Mason was bailing one of its MMFs out of SIV paper – now it appears that Sun Trust is doing the same thing along with Bank of America and at least two others. This is a very worrisome development for the investment industry as a whole … I am currently trying to finish an article on the topic, but there’s a lot going on in the market just now! In an overdue development:

The 10 largest managers of U.S. money funds have about $50 billion in short term debt of SIVs, some issued by vehicles such as Cheyne Finance Plc that defaulted as investors shunned the funds on concerns about losses from securities linked to subprime mortgages, according to reports from the companies.
…
BlackRock, the largest U.S. publicly traded asset manager, has been in contact with the Treasury, Fink said. BlackRock will raise “multibillion dollars” to invest in distressed securities that are resulting from the “chaos” in the market, Fink said, while declining to elaborate on fund details.

Well, whether Superconduit = Vulture or not, there’s at least one major player stepping up!

If today’s news has been too cheery for you: consider deadly bird flu!

Good volume, poor returns in the preferred share market today.

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

A quiet day, with bond markets closed for Rememberance Day.

There is speculation the Fed will move to explicit inflation targetting … but the WSJ can’t make up its mind. At a Bank of Canada conference in 2006, Alan Blinder, a former Fed Vice Chairman, commented on evolution of Bernanke’s thinking on the subject to that date.

There are some heavy-weight predictions of a US slowdown floating around, linked by both Naked Capitalism and WSJ. Willem Buiter points out that the banks are feeling some strain:

At the end of October 2007, the net worth of commercial banks in the US (as reported by the Fed) stood at just under $ 1.1 trillion (against assets of $10.7 trillion). Tier 1 capital stood approximately at $964 bn. While quite a significant share of the mortgage-related losses will be born by financial institutions other than commercial banks, such as investment banks, commercial banks’ capital will take a significant hit.
…
The combination of losses and unintended asset accumulation may depress the banks’ capital ratios to the point that dividends and share repurchases are threatened and even rights issues may have to be contemplated. All that does not do much for their willingness to engage in new lending, including to the real economy.
…
The single best thing that could happen would be for the true magnitude of the losses suffered by banks and other exposed parties to be revealed and put in the P&L. Until what happens, fear of getting stuck with the hot potato makes banks unnaturally unwilling to extend credit against the kind of collateral that they would not have thought about twice accepting at the beginning of the year.

Noriel Roubini, while acknowledging the banks’ problems, considers the wealth effect and increased difficulty of Home Equity Withdrawal to be more important.

Naked Capitalism points out that there is mass confusion over Super-Conduit, what it is supposed to be doing and whether there is economic reason to expect it to work … but quite frankly, I can’t be bothered to discuss the situation much any more. There’s no information – merely rumours. I’ll talk about it when there’s something to talk about.

But there is some related news illustrating the problem. Readers with exceptional memories may remember Ottimo Funding, briefly mentioned here on August 21:

Mortgage companies without any sub-prime on their books, such as Ottimo Funding LLC, are experiencing financing difficulties.

Well, it’s gone bust:

Ottimo Funding Ltd., whose name is Italian for “excellent,” started selling its $2.8 billion of mortgage bonds this week after being unable to raise debt financing in the commercial paper market, according to three people with knowledge of the sale.

The securities being auctioned are rated AAA and backed by Alt-A mortgages, a credit class above subprime, according to Standard & Poor’s. The sale probably won’t generate enough cash to fully repay investors who bought short-term debt from the fund, the ratings firm said last week.

As far as I can make out from S&P ratings reports, Ottimo was one of several Extendible asset-backed commercial paper (ABCP) conduits with no or partial third-party liquidity support – in other words, it was like a Canadian ABCP issuer, relying on credit enhancement and extendability to avoid liquidity squeezes.

In a fascinating report, the Asset Management firm Legg Mason has disclosed it is bailing one of its MMFs out of ABCP trouble:

Legg Mason Inc. invested $100 million in one of its money-market funds and arranged $238 million in credit for two others as a cushion against potential losses on commercial paper linked to subprime mortgages.

In related problems, E-Trade is in trouble:

Chief Executive Officer Mitchell Caplan’s strategy of building E*Trade’s bank by tripling loans outstanding backfired as borrowers fell behind on payments and U.S. home prices declined.
…
Bhatia estimated that E*Trade will post a loss in the fourth quarter after setting aside $500 million in extra money for bad loans and writedowns. Clients in the company’s brokerage unit may shift their accounts to rivals, while deposits at the bank could erode, said Bhatia, who cut his rating on the stock to “sell” from “hold.”

Citigroup is downgrading E*Trade “based on the higher probability of a run on the bank,” Bhatia said.

But let’s keep things in perspective. While there is lots of pain, while some people are losing their jobs, others their houses and an overall slowdown in forecast by some … Wall Street is still on track for a great year. They take risks and when it works against them the numbers are huge … but when they work out – as, by and large, they did in the first half of the year – the numbers are even bigger.

At least one Wallaby Street player is doing pretty well too:

Macquarie Group Ltd., Australia’s biggest securities firm, said first-half profit climbed 45 percent to a record on higher trading income and increased fees from mergers and acquisitions.

Net income rose to a record A$1.06 billion ($931 million), or A$4.02 a share, in the six months to Sept. 30, from A$730 million, or A$3.01 a share, a year earlier, the Sydney-based bank said in statement today. That beat the $1.03 billion median estimate of four analysts surveyed by Bloomberg.

It was a quiet day for prefs with relatively light volume … not only were the bond markets closed, but all eyes were on stocks and currencies! It was good to see BAM.PR.N among the volume leaders … but a continuing puzzle to see it among the loss leaders as well!

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

Well, there’s a day and a half!

US T-Bill yields plunged again and Fed Funds futures are now showing certainty of a cut to 4.25% in January, down from the current 4.5%. In what may be assumed to be related news, the Bank of Canada intervened to boost the overnight rate – presumably, there’s a lot of cash-equivalent money looking for a home.

There are alarming reports of gloomy consumers, but the direct catalyst is, as usual, more bad news from the banks. CIBC, ‘bank most likely to walk into a sharp object’, is taking a $463-million CDO/RMBS writedown, which offsets their gains from the VISA restructuring (TD has managed to hang on to its profit). Rumours that Barclays is looking at a big write-off triggered a temporary collapse of their share price, but they staggered back to more usual levels by the end of London’s trading day – Barclays’ CEO has stated “his refusal to comment on subprime writedowns indicates there is no truth to speculation about losses that wiped 29 percent off the bank’s market value in the past month”. Wachovia has disclosed $1.7-billion mark-to-market losses in October alone. Nouriel Roubini somewhat gleefully forecasts a total of $500-billion on a mark-to-market basis.

It’s almost a relief to see news of the first CDO liquidation:

Carina is the first CDO to begin unwinding after a slump in the credit worthiness of the underlying assets, S&P said. Thirteen others have informed S&P of an event of default, a precursor to liquidation. A widespread fire sale by CDOs, which package asset-backed securities and resell them in pieces, may further exacerbate declines in subprime-mortgage securities.

As these structures unwind it will become easier to sort out the winners from the losers … and easier for investors to price the assets!

On November 7 I made the comment:

Even worse, Citigroup has increased its exposure to CDO-issued CP, which has had the effect of ballooning the amount of Level 3 ‘Mark-to-Make-Believe’ assets. Citigroup’s cost of borrowing, as proxied through Credit Default Swaps, is skyrocketting.

I should make this more clear; banking & investment strategy is sometimes a little more complicated than can be summarized in a couple of casual sentences – particularly when discussing an institution that has more capital in the business than the Canadian Big Five-and-a-Half put together. It is not necessarily a Bad Thing for Citigroup to accumulate CDO paper and Level 3 assets. Panic has hit the markets and panics are the perfect time for an organization that has already done its homework to make an absolute killing taking unwanted assets off other people’s hands.

However, there are knock-on effects. If this same panic causes their borrowing costs (as proxied by CDS levels) to increase beyond the expected winnings, then the strategy becomes defunct. No matter how stupid the market is being in increasing the funding costs of such an investor. Blind fear in the marketplace can paralyze even a well-prepared investor.

What’s needed is for “real money” investors (those who will be perfectly happy holding on to the paper until maturity, like pension funds, retail investors and such, since they’re not completely at the mercy of mark-to-market; as opposed to “hot money” investors who want to flip it next week) to step up and buy the stuff. I suspect, however, that any pension fund manager who suggests such a plan at this stage of the game to an ordinary, unsophisticated pension board will get a blank stare and a chuckle instead of a mandate.

But at least one major player has gone bottom-fishing in the bond-insurers market:

MGIC Investment Corp. and PMI Group Inc., the two largest U.S. mortgage insurers, rose in New York trading after insurer Old Republic International Corp. disclosed it became the biggest investor in each company.

More news on the bond insurers’ front, as well. Fitch is reviewing the bond insurance industry, which may need to raise capital at one of the worst possible times to do so (typical!). Josef Ackerman, CEO of Deutsche, warns of a very strong impact on financial assets if a downgrade comes to pass, as has been previously stated by Accrued Interest. Naked Capitalism passes on the report that Fitch is outraged by the Financial Times misuse of technical terms in reporting the concerns … in times like this, when a misplaced comma in a Bernanke speech could cost billions, the technical guys want precision above all else! Two major municipal refinancings have been delayed due to market instability.

Naked Capitalism has a very good piece about Cuomo’s investigation of WaMu regarding possibly deliberately inflated appraisals of properties. I didn’t discuss it at the time, thinking it was just minor league grandstanding, but it seems more serious – especially since it appears Cuomo knows little about the business – or is disingenuously overstating his case. Lockhart’s letter, linked by Naked Capitalism, is priceless; Accrued Interest translates the refined prose into more every-day language.

However, I must take issue with Naked Capitalism’s characterization of the GSEs::

Cuomo astoundingly called the GSEs investment banks, and as the article points out, raises doubts about the value of their even though they are government backed. Huh? That is likely the basis for Lockhart’s “you may not understand remark.”

The last thing the securities market needs is doubts being cast on the creditworthiness of Freddie’s and Fannies’ paper.

GSEs are not, in fact, government backed. There is certainly a market perception that they are government backed … but if push comes to shove, Congress can let them rot. There is a very dangerous ambiguity in Fannie & Freddie’s status that should be clarified; they walk like banks, talk like banks and write cheques like banks – they should be regulated like banks. I often link to James Hamilton’s presentation to the Jackson Hole conference which addressed the issue: now I’ll link to it again. Speaking of Fannie Mae, they too aren’t doing too well in the current environment:

Fannie Mae, the biggest source of money for U.S. home loans, said its third-quarter loss more than doubled to $1.39 billion as a deepening housing slump increased mortgage delinquencies.

The net loss was caused by a $2.24 billion decline in the value of derivative contracts and $1.2 billion in credit losses among the $2.7 trillion of mortgage assets Fannie Mae owns or guarantees, the Washington-based company said today in a U.S. Securities and Exchange Commission filing.

Fannie Mae has a minimum capital requirement of $30-billion and maintains a 30% surplus over this figure. So say they’ve got twice the capital of Royal Bank (Fannie Mae is far more highly leveraged, due to the inadequacies of the legislation) … can you imagine the consternation if Royal Bank lost $700-million in a quarter?

A relatively calm day for preferreds, with good volume.

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