PrefBlog

CDOs (Collaterallized Debt Obligations) were in the news today, as Bloomberg reported that Moody’s cut a batch of ratings. The Bloomberg story doesn’t mention some important context, presumably since that would make the story less interesting. According to the unexpurgated press release:

it has downgraded $33.4 billion of securities issued in 2006 backed by subprime first lien mortgages, representing 7.8% of the original dollar volume of such securities rated by Moody’s. Of the $33.4 billion downgraded securities, $3.8 billion remain on review for further downgrade. Moody’s also affirmed the ratings on $258.6 billion of Aaa-rated securities and $21.3 billion of Aa-rated securities, representing 74.7% and 52.0% of the original dollar volume of such securities rated in 2006, respectively.
…
The Aaa- and Aa-rated securities that have been placed on review for possible downgrade are generally not expected to move by more than three notches. The most heavily impacted securities were originally rated Ba, Baa, or A. Rating migrations have been much more severe for the more deeply subordinated tranches of 2006 subprime deals.

Accrued Interest, which has an excellent primer on CDOs, has made a rather breathtaking suggestion:

the ratings agencies simply shouldn’t rate CDOs at all.
…
Furthermore, the ratings agencies could still model CDO deals in their Monte Carlo simulators for a fee. Investors could then run the Monte Carlo themselves, inputting default and recovery rates, default patterns, and correlation as they see fit. Rather than getting one or two perspectives on what the default/recovery/correlation patterns should be, investors could impose their own stresses.

I’ve discussed the results of such simulations in the post Loan Default Correlation.

Sadly, Accrued Interest’s suggestion doesn’t have a chance of working. As I keep reiterating here, investors (as a group, with lots of exceptions) do not want to do any analysis. And they don’t want to spend any money on useless, profitless credit analysis, or any time understanding what it is they’re doing. They want to buy something that goes up because it’s good.

There are no possible regulations that will enforce this. Adding more rules will not make this a better world. All market regulators should have a form letter: “Yeah, you’re #$%^! bankrupt because you’re #$%^! stupid.” to be sent by the busload to complainers. They should also be much more willing to pull investment management licenses on the basis of incompetence.

This last thing is hard to do. If my investment theme is that demographics are going to cause a boom in granola, I tell all my clients this, they give me money and I promptly blow it all levering up granola futures 100:1: this doesn’t necessarily make me incompetent. Wrong, yes, but being wrong is simply part of the investment management game (which is why my other theme in this blog is the chaotic nature of financial markets). If, however, they inspect my records and find that my carefully estimated granola consumption growth rate was a little off because I used “15” as a factor rather than as a percentage … well, then I’m incompetent and should be civilly liable and should lose my license.

Investment managers should be held strictly accountable for adhering to the Prudent Man Rule. But you know something? I think a lot of investment funds are run in the same way as Greek pension plans:

Board members of Greek pension funds are appointed by the government, labor unions and employers, often on a part-time basis, without specific professional or educational qualifications. The country has about 200 pension funds with assets of more than $44 billion, according to finance ministry estimates.

Quis custodiet ipsos custodes? While specific professional or educational qualifications are nice to have, I’m not as impressed by them as the reporter seems to be … but they are, at least, an indicator. With respect to the particular Greek Tragedy reported, I agree with:

C. Kerry Fields, a professor of business law at the University of Southern California’s Marshall School of Business in Los Angeles, said JPMorgan appears to have acted lawfully in its handling of the sale to North Asset Management and bears no responsibility for what happened later.

“The foolish people are the buyers because they paid so much,” Fields said.

What’s needed on pension boards are people with the guts to ask questions, the intelligence to Think Useful Thoughts about the answers and the ruthlessness to fire those who don’t measure up. Those are the qualifications I like.

On another front, Naked Capitalism reviews the political pressure for a Fannie Mae / Freddie Mac bail-out. We can only hope that this pressure is successfully resisted – as has been argued by James Hamilton of Econbrowser:

it is equally clear to me that the correct instrument with which to achieve this goal is not the manipulation of short-term interest rates, but instead stronger regulatory supervision of the type sought by OFHEO Director James Lockhart, specifically, controlling the rate of growth of the GSEs’ assets and liabilities, and making sure the net equity is sufficient to ensure that it’s the owners, and not the rest of us, who are absorbing any risks.

Fannie Mae & Freddie Mac (the “GSEs” – Government Sponsored Enterprises) walk like banks and talk like banks … but they are not regulated like banks because grandstanding politicians such as Charles Schumer want to have all the fun of providing services to constituents without having to bother with trivial little details like paying for them (which in this case means, one way or the other, ensuring that the GSEs are capitalized like banks).

We have seen in recent months how a problem that’s relatively small (US Sub-prime mortgages) in the grand scheme of things (the world financial system) can act as a flashpoint for a major paradigm shift (if that metaphor makes any sense). Let’s not increase the potential for a major bankruptcy by allowing the GSEs to lever up even further beyond the bounds of prudence.

On a somewhat related note, I was amused to see the tone Bloomberg adopted when reporting the continued decline of American home ownership:

Homeownership in the U.S. dropped for a fourth consecutive quarter, the longest decline since at least 1981, suggesting more Americans will miss their best chance of building wealth.
…
“Owning a home in this country has been a principal source of wealth creation for low- and moderate-income people,” said Nicolas Retsinas, director of Harvard University’s Joint Center for Housing Studies in Cambridge, Massachusetts. “In the absence of home equity, families will inevitably spend less.”

Homeowners accumulate wealth faster than renters, with median net wealth for owners at $184,400 in 2004, compared with only $4,000 for renters, according to Federal Reserve figures.

Given the glee with which they regularly point out that everybody (except gullible investment managers) knew all along that housing was a bubble created by the Evil Credit Rating Agencies, the emphasis on these data is surprising! But they redeem themselves with an interesting factoid towards the end of the article:

Out of 297 townhouses in Springfield, Virginia, for sale last week, almost 80 were in the process of foreclosure or offered at a price lower than the mortgage balance, so-called short sales, said [Re-Max real estate agent Steve] Hawkins.

Two years ago there would have been about 50 such units offered in the same Washington suburb, with none in foreclosure, he said.

The long-term trend is clearly in homeowners’ favour – but, as the the WSJ reports, houses haven’t been doing too well lately:

 

On September 24 I noted that the US was testing pandemic preparedness, stressing the system with a simulated 49% absentee rate. The results are in and analysis is under way:

When asked “based on the lessons learned from the exercise, how effective are your organization’s business continuity plans for a pandemic,” 56% answered “moderately,” the next highest group was “minimally,” at 28%. Only 12% said their business continuity planning was very effective.

I have previously noted the various controversies about inflation measurement – but look at Argentina’s measurement problems:

Argentina’s benchmark inflation-linked bonds have tumbled 24 percent this year, making the country’s debt market the worst performer in the world, according to data compiled by JPMorgan Chase & Co. and Bloomberg.
…
Merrill Lynch & Co., the world’s biggest brokerage, estimates prices may be rising at a 17 percent annual pace, double the official rate.
…
Daniel Fazio, head of the employee union, said in February that a Kirchner political appointee had statisticians eliminate some details from the index and violate secrecy laws that prohibit the release of information during the data-gathering process. The union said federal prosecutor Carlos Stornelli is investigating the allegations. The prosecutor’s office has declined to comment.

I continued to work through the BoE Financial Stability report, but was sidetracked by a desire to investigate their “Box 2” further. What a great report that is! Crammed with information and references, but well written with a bias towards explaining the implications of important ideas from a policy perspective.

There’s a fascinating report that the credit rating agencies are being investigated for corrupt practices:

[Connecticut Attorney General Richard] Blumenthal’s office is investigating complaints that the ratings companies rank debt against issuers’ wishes, then demand payment, he said today. The state also is probing whether the companies threaten to downgrade debt unless they win a contract to rate all the issuer’s securities, as well as the practice of offering ratings discounts in return for exclusive contracts.

Quite the laundry list of charges! ‘Ranking debt against the issuers’ wishes’ is hardly a problem; ‘Demanding payment’ is not a problem [hint: say ‘No’]; ‘offering ratings discounts in return for exclusive contracts’ is not a problem; the only allegation that, if proven, is actually a Bad Thing is the threat to downgrade if they don’t get a contract for the entire issued portfolio.

I find the idea a little hard to swallow, frankly. Transition matrices are holy and I don’t think the agencies would put them at risk in order to make an extra nickel or two. It might possibly be a deliberate mis-interpretation (either by the rating agency salesman or the issuer) of a threat to downgrade unless more information is made available to the agency … but we will see. It’s worthwhile to note the recent General Electric / DBRS kerfuffle, reported on the DBRS site as:

Given the level of investor interest, DBRS believes it is important to provide clarity as to its decision to withdraw the ratings on General Electric Company (GE), GE Capital Canada Funding Company (GE Capital Canada), Heller Financial Canada and Heller Financial, Inc.

DBRS had recently been in discussions with GE to ensure that DBRS would continue to receive adequate resources, including time and attention, from GE to support DBRS’s ratings and that there would be no issue with DBRS assigning ratings to GE Capital Corporation (GECC), the guarantor of GE Capital Canada.

Ultimately, GE decided that it was not fully supportive of adding a third rating agency for GECC, and GE formally requested that DBRS withdraw all ratings related to GE.

It’s easy to see how a bad relationship could quickly get worse given worst-case interpretations of such negotiations. But we’ll see!

In technical news that some (wierdos) might find of interest, the NYSE is eliminating rule 80A, which was enacted as part of the volatility damping package deemed necessary after the crash of 1987:

Rule 80A (a) and (b) require that, for any component stock of the S&P 500 Stock Price IndexSM, whenever the NYSE Composite Index® (“NYA”) advances or declines by a predetermined value from its previous day’s closing value, all index arbitrage orders to buy or sell (depending on the direction of the move in the NYA) must be entered as either “buy minus” or “sell plus”.
…
The Exchange is making this change since it does not appear that the approach to market volatility envisioned by the use of these “collars” is as meaningful today as when the Rule was formalized in the late 1980s. Rule 80A addresses only one type of trading strategy, namely index arbitrage, whereas the number and types of strategies have increased markedly in the last 20 years and may as well contribute to the increase in or lack of volatility.

The rule has been applied 15 times on 13 days this year; the peak was 1998, with 366 occurances on 227 days.

And, holy smokes, I almost let an entire post go by without mentions SIVs! Naked Capitalism provides a round-up and some commentary; still quite convinced (perhaps correctly – who knows?) that Super-Conduit is a nefarious plot of some kind that is unlikely to attract investors.

The TD New Issue announced October 9 now has an estimated fair value of $23.76. It will not be a happy opening!

By one definition, Great-West and SunLife Financial are now distressed companies: GWO.PR.I closed at 19.90-98, 12×3 on volume of 47,085; SLF.PR.E closed at 19.92-18, 4×3, on volume of 11,750. I wonder what the Globe will have to say about this tomorrow?

Month-to-date, the PerpetualDiscount index is down 4.93% (on the week, it’s down 2.18%) and has gained on only two of nineteen trading days. On the other hand, the PerpetualPremium index has managed to grovel back over its 6/30 starting figure of 1,000.00, and is down only 1.89% on the month. On the other hand, there’s some very strange things going on in that index. What the HELL is CU.PR.B doing, being bid at 26.12 for a pre-tax bid-YTW of 5.17, when PWF.PR.I has the same coupon and a redemption schedule that differs by one month and one day, AND has a one-notch higher credit rating (DBRS) to put it into widows-and-orphans grade … and is bid at 25.31 to yield 5.71%?

However, as a participant on Financial Webring said today:

No, it’s because the market is an ass. Preferreds are retail driven with about half of the purchasers not even aware what they’re buying. We see it on this board all the time. They got lumped into the whole subprime/ABCP mess in my opinion by boneheads who think they have a connection to it. Down goes the price…………

Ah, Grasshopper, when you can take the pebble from my hand, it will be time for you to trade.

The market will normalize eventually. It always does. But DAMN, the waiting can be aggravating – and it probably wouldn’t irritate me so much if HIMIPref™ hadn’t indicated valuations were severely out of whack a little too early!

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

A bit more news came out regarding the Aastra lawsuit mentioned yesterday. In a Globe story:

Mr. Del Sorbo was an investment adviser to Aastra for about seven years, according to the lawsuit. During May and June, rising interest rates caused paper losses in the company’s bond and preferred share holdings. As a result, the company told Mr. Del Sorbo in June “that it wished to invest only in conservative, short-term, liquid securities with no exposure to interest rates and very low default risks,” the suit said.

As the portfolio was being reassessed, Mr. Del Sorbo talked about non-bank asset-backed commercial paper, “which he described as primarily baskets of residential mortgages with limited car loans and credit card debt, bundled together to produce a high-quality short-term investment product,” the suit said.

In July, Aastra put $8.5-million into an ABCP trust called Structured Investment Trust III, which was priced to yield 4.62 per cent.

That’s one of the issuers whose business was frozen under the Montreal Accord.

As it turns out, the underlying assets were about 94 per cent credit default swaps on long-term bonds, the lawsuit said. The claims have not been proven in court.

John Tobia, Aastra’s general counsel, would only say that “from our perspective, the pleadings speak for themselves.”

Finding Structured Investment Trust III on the DBRS website is a little tricky (they’re not exactly unique keywords, are they?), but one can quickly find the May 11 Press Release:

The Trust is a vehicle that is designed to purchase structured securities including CDOs.

The press release also states that Coventree is the sponsor, and a quick trip to Coventree’s site yields the conduit’s page which has links to the full rating report and the Information Memorandum. Coventree’s site also has Monthly Conduit Reports which are password protected; I can’t be bothered to get a password because, well, because I’m not putting $8.5-million into the thing. However, the Information Memorandum states:

The Financial Agent prepares a monthly Investor Report and makes this report available on-line to purchasers of Notes on a password-protected basis at http://www.nereusfinancial.com/. The Investor Reports contain information about the specific Purchased Securities held by SIT from time to time. Purchased Securities are obtained by SIT from Originators in major international credit default, CDO and associated markets. In order to secure optimum execution and terms, in accordance with prevailing practice in these markets, the identities of Originators are shared with the Rating Agency but are otherwise kept confidential by the Financial Agent.

It’s right there, in the summary, page 4, under the heading “Investor Information”. If anybody didn’t know what was in the thing, it’s because they couldn’t be bothered to find out.

Aastra’s counsel is quoted as stating that “from our perspective, the pleadings speak for themselves.”, but oddly, I don’t see the pleadings disclosed on their website; I guess they don’t really have a lot to say. Or maybe it’s just an oversight. Or something.

Speculation is building regarding next week’s Fed meeting, with a cut of 25bp being forecast by some. The November Fed Funds contract implies that this forecast has some general acceptance; trading at 95.54 today implying a projected effective rate of 4.46%. The actual trading rates for this month have been choppy, but it appears that the current 4.75% target is holding and being defended.

Meanwhile, the credit crunch continues, with another SIV indicating it is having difficulty financing:

MBIA Inc., owner of the world’s largest bond insurer, said a $1.8 billion structured investment vehicle it runs through its asset management business is having trouble raising money and is seeking funding alternatives.

MBIA has invested $15.8 million in the capital notes of Hudson-Thames Capital Ltd. and said it has no obligation to provide the SIV with liquidity support or guarantees. MBIA today reported its first quarterly loss ever after marking down the value of mortgage-related debt it guarantees by $342.1 million.

In what may or may not be interpreted as a positive sign (depending on what answer you want) US ABCP outstanding declined by only USD 4.6-billion in the past week – practically a rounding error. November could be interesting, however: there are persistent, if unofficial and unconfirmed reports that there will be a big whack of MTN paper maturing, that may well be very difficult to roll.

One of the more entertaining things I’ve read recently is an ‘I toldja so’ puff-piece by Nouriel Roubini – for instance:

In March, when this author wrote a long (30 pages), serious semi-academic research analysis – with Christian Menegatti – of why the housing recession had not bottomed out and why home prices would sharply fall further, this scholarly analysis was summarily and cheaply dismissed in the most crass terms (“the paper is really just a longer-than-usual blog”) by a popular blogger who had barely bothered even to read it. At least Daniel Gross – a very smart blogger – had the decency to literally eat pages of his own writings – as he had promised he would – when one [of] his financial predictions failed.

Cassandra’s Revenge!

I’ve updated the post regarding the BoE Financial Stability Report and will add more as I work through it. It’s good stuff, it really is; beautifully researched. If I made a special note of everything it contains that is interesting, my post would be longer than the report itself; those with an interest in this sort of thing are strongly encouraged to read the full publication.

As far as preferreds are concerned … PerpetualDiscounts continued to decline, much to my chagrin. One participant on Financial Webring Forum noted today:

I suppose this may have answered my question I had been pondering for some time about the recent MAPF sectoral allocation shift toward discount issues. The low coupon discounts seem like a bit of a trap to me, and although I hadn’t ruled out that you’d simply lost your mind, I suspect you know what you’re doing……………….

Well, it’s nice to know he presumed I had a mind to start with! As it is, I fear that results for the fund for this month will be summed up as “Too Soon”. As has been noted here in the past, sectoral shifts within the fund do not reflect an attempt at market timing; merely an analysis of the curve that shows that one sector has gotten out of whack with another. Over time, this works quite well; but not this time.

HPF.PR.B was down over 7% today, presumably due to yesterday’s downgrade. I suppose there are some non-PrefBlog-reading investors out there who considered the downgrade a surprise.

Good volume today, which is certainly meaningful. Just precisely what it means changes every time, of course, but in a month or so the technical analysts will be pleased to tell us what we obviously should have done.

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

Well … there won’t be much today!

All my non-preferred-trading-and-carnage-watching time today was spent puzzling over Capital Tax … some bond investments are subject to capital tax and some other bond investments are not subject to capital tax. The difference is, ostensibly, to avoid double taxation; I suspect that the real goal is to

• raise money in a manner that will be invisible to Joe Lunchbucket
• provide employment for retired politicians

Friend Flaherty is, of course, too busy grandstanding with ATM fees, National Securities Regulators and the price of eggs & milk in Buffalo … no, scratch that, the price of eggs and milk in Buffalo SHOULD be cheaper than in Toronto, because otherwise farmers with quota might have to work for a living … the price of Harry Potter books in Buffalo to be worried about doing something useful. Like eliminating busy-work taxes that have economically negative effects.

Some readers might surmise that I’m not in the best of tempers. Some readers might win a kewpie doll if they can do it three times running.

So … just time for one snippet of interesting financial news … there’s an ABCP lawsuit announced:

A potential flood of lawsuits over asset-backed commercial paper could hit courts in the coming weeks after Aastra Technologies Ltd. (TSX: AAH.TO) became the first to launch a legal action against adviser HSBC Securities for exposing the IT company to the troubled investment vehicle.

Aastra’s press release states:

Finally, as previously announced during the quarter, the Company currently holds $13.7 million of non-bank owned asset-backed commercial papers for which, currently, there is no active market. Of these investments, $8.5 million is invested in Structured Investment Trust III and was not repaid to the Company when it became due on October 10th while $5.2 million invested in Lafayette Structured Credit Trust is not yet due until October 30th of this year.

As a result of the developments above, Aastra commenced legal proceedings today against its investment advisor, HSBC Securities (Canada) Inc. and one of its employees, in the Ontario Superior Court of Justice seeking damages relating to investment advice provided with respect to Aastra’s purchase of the Structured Investment Trust III asset-backed commercial paper.

On August 23, they stated:

As of August 23, 2007, Aastra had $13.7 million, or approximately 11% of its cash and short-term investment balances, invested in asset-backed commercial paper.

So … a couple of observations … most of which are really queries:

• HSBC Securities? So it’s a stockbroker they’re blaming? What was his Money-Market track record? I wonder how much due diligence they did before hiring him.
• Frankly, 11% of a money market portfolio in ABCP doesn’t sound all that actionable to me. It’s aggressive, sure, but it doesn’t sound all that reckless.
• Every time the market goes down a nickel, the OSC gets bagfulls of complaints. The favourite story I’ve heard is of a guy who got angry with his advisor during the Tech Boom (not the Wreck … the Boom). He had a portfolio and received a total of sixteen (if memory serves) recommendations. Fifteen of them made money. One of them lost a little bit. His portfolio did quite well. The client went completely berserk over the one unfortunate recommendation and made life miserable for everybody, for literally years, with complaints.
• Is Aastra serious about the lawsuit, or just grandstanding for their shareholders? If they’re serious, they’ll post all the court documents on their website; if they’re grandstanding, they’ll just send out the occasional press release.

Prefhound commented on yesterday’s post regarding current market conditions and – to my gratification – did not cast aspersions on my observation that perpetual/retractible spreads were starting to look awfully juicy! I had hoped to comment further on these spreads today, but as it is, I will set some homework for the blog’s readers (BOTH of them! That means you, too, Dad!).

In my article How Long is Forever?, I compared a perpetual with a retractible by:

• Calculating the total return of the retractible to the Retraction Date
• Determining what price the perpetual would be on that date to provide the same total return
• Determining what yield would give rise to that price
• Laughing

Recent events have increased yields of the retractibles to the point where they’re not completely stupid any more … and increased the term to their presumed retraction/redemption date to the point where meaningful comparisons can be made (if the YTW is just six months off, you’re basically comparing the perp to cash, which is silly). There’s even enough that we can choose pairs for which credit quality will cancel – or, at least, cancel as much as one can for a perp.

So, here’s your homework: What will be the perps’ yield on the retractibles’ end-date in order for the two total returns to the end-date to be equal?

I’ll try to get to this … but maybe somebody else will get there first! Just for fun, I’ll do a really quick back-of-the-envelope calculation for the PWF.PR.J / PWF.PR.L pair:

• L gets about 1.4% more yield annually than J
• For six years
• Total 8.4% more return
• Therefore can withstand 8.4% capital loss and still break even
• Current bid price of L is 21.67
• Less 8.4% is 19.94
• Dividend is $1.275
• Therefore, yield on 2013-7-30 can be 1.275 / 19.94 = 6.39% and still break even

Now, I’m not going to suggest that this calculation automatically shows that PWF.PR.L is a screaming buy for everybody. Hell, they were down 4.58% today! But I do wonder how many people have actually performed the calculation and decided they want the safety of the retractible anyway!

Total carnage for preferreds today – I can only imagine that people saw the Merrill Lynch downgrade and decided that

• All financials were at risk
• The preferreds as much as the common

The PerpetualDiscount index hit a new 18-month low and now has a total return of about negative nine percent for the 15-odd months since 2006-6-30. And, for the first time, the PerpetualPremium index has gone below the 1,000.00 starting figure. I should have stood in bed.

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