January 30, 2008

OK, OK, OK. Let’s get this over with. The Fed cut 50bp to 3.00% and the yield curve steepened.

In news that I have not yet become completely fed up with, Fitch has cut the rating of FGIC, a monoline insurer:

Financial Guaranty, a unit of New York-based FGIC Corp., was cut two levels to AA, New York-based Fitch said today in a statement. The company had been AAA since at least 1991. Moody’s Investors Service and Standard & Poor’s are also reevaluating their ratings.

“This announcement is based on FGIC’s not yet raising new capital, or having executed other risk mitigation measures, to meet Fitch’s AAA capital guidelines within a timeframe consistent with Fitch’s expectations,” the ratings company said today.

Speaking of downgrades, how about them sub-primes, eh?

Standard & Poor’s said it cut or may reduce ratings on $534 billion of subprime-mortgage securities and collateralized debt obligations, the most sweeping action in response to rising home-loan defaults.

The downgrades may extend bank losses to more than $265 billion and have a “ripple impact” on the broader financial markets, S&P said in a statement today. The securities represent $270.1 billion, or 47 percent, of subprime mortgage bonds rated between January 2006 and June 2007.

Naked Capitalism has an update on monolines in general and the bail-out in particular and advocates more regulation:

While it’s probably a good idea to keep insurers away from risky instruments they have demonstrated they don’t understand, the remedy, closing a loophole dating from 1998, is a bit late in coming. The article focuses on how this bond insurers muscled their way into a business that it proving to be their undoing. Nevertheless, the regulators sound surprisingly timid, fearful of inhibiting innovation. Someone might point out that lobotomies and zeppelins were also innovations.

In other words, this would be a much better world, if only there were more rules.

Look – there has clearly been a screw-up. I must say, I’m not sure why bond insurers come under the purview of regulators, but let’s assume there’s a good reason … which is a hell of an assumption to make, but otherwise we’re left to mumbling libertarian slogans to each other. In the first place … just how is insuring a municipal bond different from writing a CDS? Not much, is the basic answer. There might be some legal differences in the bankruptcy games (mentioned in a recent update to the CDS Primer); credit risk is (almost certainly) greater; structural risk and analysis is (almost certainly) more complex. But what of it? Analysis of these elements and comfort-offering to potential investors who don’t want to do it, are what monolines do for a living.

If they didn’t do it very well, then they can go bankrupt. Just what, exactly, is the problem here? Which members of the unsophisticated public are we attempting to protect?

The only rational regulatory response I see is that of brokers and banks … and, quite frankly, I’m not 100% convinced about whether the brokers warrant a regulatory response. As I suggested on January 25, there may be cause to protect the banking system by reviewing the concentration rules for capital exposure … if the troubles of a single counterparty have the ability to bring down – or seriously wound – a bank, then the exposure should attract a charge against capital in excess of what the same bundle of risks would if it was spread around a little more …. just as if the counterparty was explicitly a hedge fund, rather than what may well be described as a hedge fund masquerading as a monoline.

There’s some interesting economic news that has added significance due to the precipituous decline in the Fed Funds rate: US GDP growth came in at a mere 0.6% annualized rate. Both the WSJ and Econbrowser pointed out that a chunk of the slowness was due to inventory reduction:

big surprise was a big drop in inventories. That means that production growth was not as strong as sales, and hence, reduces the estimate of GDP, though it may leave businesses in a little better position to weather any further drops in demand. Without the inventory correction, real final sales grew at a 1.8% annual rate in the fourth quarter, somewhat less alarming than the headline GDP numbers alone.

And, to make sure we’re all thoroughly confused regarding signals from the financial markets and economic reports, there is hope for tomorrow’s jobs number:

Nonfarm private employment surged by a seasonally adjusted 130,000 during the month, ADP said. Adding in 22,000 government jobs (the average gain over 12 months), total nonfarm payroll gains are estimated at 152,000 for the month. That’s more than double most economists’ estimates for Friday’s Labor Department report. It would also represent a huge rebound from the 18,000-job increase the government reported for December. (ADP revised its December number down to a gain of 37,000.)

Maybe some suddenly employed Americans will be able to afford some of the vacant housing!

There’s an interesting essay by John Dizard (hat tip: Naked Capitalism) that argues that disintermediation – referred to by its mechanism, securitization – will become more prevalent in the future, and that this is a secular change rather than a mere transient reaction to market forces. The trouble is, the essay makes sweeping statements regarding ‘what central bankers believe’ and I don’t know on what basis the author makes these claims. I have referenced an academic paper that presents evidence that banks’ balance sheets balloon in times of stress, as the madding crowd runs to familiar, regulated entities … but eventually the crisis passes and investors wonder why they’re letting the bank take a spread on their investment. So, until I see a little more meat on the bones of Mr. Dizard’s argument, I’ll remain very skeptical that a fundamental paradigm shift has occurred.

Accrued Interest has finally returned from his vacation and offers an endorsement of junk bonds at current spreads:

If we do have a recession in 2008, high-yield default rates will certainly increase. But at today’s valuation levels, high-yield already has a recession priced in. Given that there is good reason to believe credit losses will be no worse, or perhaps even better than the last two recessions, high-yield looks fundamentally attractive.

I’m not sure about this and a large chunk of my skepticism is based on the new developments in the CDS market, which can create players who have both negative exposure to the firms AND a seat at the creditors’ table (by going long the actual bonds, but even longer on Credit Default Swaps). These players take such positions because they can actively create a lower return for the class of securities they own, contrary to all expectations and procedures in bankruptcy.

The more I think about this development, the less convinced I am that the CDS market has a future. Who will sell CDS protection in such an environment? But a lot will depend on the precise wording of the individual CDS contracts – when does the cash settlement price get calculated? In this counter-intuitive scenario, it is best for the hedge fund to delay calculation until some point during the bankruptcy process, rather than at entry.

So anyway … until somebody shows me different, my attitude is … spreads, schmeads. With holders like those, junk bonds become even more risky than usual.

The continued preoccupation with Jerome Kerviel’s back office background continues. I expressed concern about this on January 25 and I’m going to do so again, in light of an emphasized quote in a Bloomberg story:

Jean-Pierre Mustier, the head of investment banking at Societe Generale, has said Kerviel didn’t take the “usual path to the trading floor.” The bank normally hires traders straight from university with degrees in math or finance, Mustier said on a Jan. 27 conference call with reporters.

Kerviel was promoted from the back office in recognition of his “excellent” work, Mustier said.

This is just another attempt to keep barrow boys out of the club.

Mustier is an example of the type of talent Societe Generale normally grooms.

He took classes at Ecole Polytechnique, a French engineering school that has produced prominent French executives such as BNP Paribas SA Chairman Michel Pebereau, before transferring to Ecole des Mines, which focuses on science and technology.

The system you ran didn’t work very well, did it, M. Mustier? How did it really happen? The triggerman himself has an idea:

I can’t believe that my superiors were not aware of the amounts I was committing, it’s impossible to generate such profits with small positions, which leads me to say that when I’m in the black, my superiors close their eyes about the methods and volumes committed.

A good strong day in the preferred market, but there was some very sloppy trading in the Ratchet / FixFloat / Floater sectors … doubtless people are rather nervous, not just about BCE (common down $0.44 today to $34.00).

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% 5.51% 53,983 14.67 2 +0.9967% 1,076.3
Fixed-Floater 5.14% 5.72% 75,674 14.62 9 -1.1646% 1,003.8
Floater 4.89% 4.93% 82,724 15.61 3 +0.5549% 864.4
Op. Retract 4.82% 1.46% 84,583 2.61 15 +0.0852% 1,046.1
Split-Share 5.32% 5.58% 102,068 4.24 15 +0.2588% 1,033.0
Interest Bearing 6.27% 6.49% 61,976 3.61 4 +0.5913% 1,075.7
Perpetual-Premium 5.80% 5.56% 64,959 6.98 12 +0.0631% 1,018.3
Perpetual-Discount 5.52% 5.55% 305,999 14.36 54 +0.2945% 930.8
Major Price Changes
Issue Index Change Notes
BCE.PR.T FixFloat -2.9374%  
BCE.PR.Z FixFloat -2.6531%  
BMO.PR.K PerpetualDiscount -2.2941% Now with a pre-tax bid-YTW of 5.65% based on a bid of 23.85 and a limitMaturity.
BAM.PR.G FixFloat -2.0697%  
BCE.PR.R FixFloat -1.3395%  
FTN.PR.A SplitShare -1.2821% Asset coverage of just under 2.3:1 according to the company. Now with a pre-tax bid-YTW of 4.99% based on a bid of 10.01 and a hardMaturity 2008-12-1 at 10.00.
BCE.PR.C FixFloat -1.0525%  
BAM.PR.K Floater +1.0417%  
BCE.PR.B Ratchet +1.0638%  
BAM.PR.M PerpetualDiscount +1.0747% Now with a pre-tax bid-YTW of 6.40% based on a bid of 18.81 and a limitMaturity.
HSB.PR.C PerpetualDiscount +1.1515% Now with a pre-tax bid-YTW of 5.64% based on a bid of 22.84 and a limitMaturity.
BNA.PR.B SplitShare +1.2207% Asset coverage of 3.6+:1 as of December 31, according to the company. Now with a pre-tax bid-YTW of 7.40% based on a bid of 21.56 and a hardMaturity 2016-3-25 at 25.00. Compare with BNA.PR.A (5.92% TO 2010-9-30) and BNA.PR.C (7.91% to 2019-1-10).
GWO.PR.G PerpetualDiscount +1.3141% Now with a pre-tax bid-YTW of 5.49% based on a bid of 23.90 and a limitMaturity.
POW.PR.B PerpetualDiscount +1.5605% Now with a pre-tax bid-YTW of 5.59% based on a bid of 24.08 and a limitMaturity.
POW.PR.D PerpetualDiscount +1.6466% Now with a pre-tax bid-YTW of 5.52% based on a bid of 22.84 and a limitMaturity.
BSD.PR.D InterestBearing +1.7989% Asset coverage of just under 1.6:1 according to Brookfield Funds. Now with a pre-tax bid-YTW of 6.87% (mostly as interest) based on a bid of 9.62 and a hardMaturity 2015-3-31 at 10.00.
CIU.PR.A PerpetualDiscount +1.8824% Now with a pre-tax bid-YTW of 5.39% based on a bid of 21.65 and a limitMaturity.
BNA.PR.C SplitShare +2.0076% See BNA.PR.B, above. Now with a pre-tax bid-YTW of 7.91% based on a bid of 18.80 and a hardMaturity 2019-1-10 at 25.00.
PWF.PR.K PerpetualDiscount +2.0665% Now with a pre-tax bid-YTW of 5.47% based on a bid of 22.72 and a limitMaturity.
IAG.PR.A PerpetualDiscount +2.4248% Now with a pre-tax bid-YTW of 5.51% based on a bid of 21.12 and a limitMaturity.
Volume Highlights
Issue Index Volume Notes
WN.PR.B Scraps (would be OpRet but there are credit concerns) 145,550 Now with a pre-tax bid-YTW of 4.66% based on a bid of 25.28 and a softMaturity 2009-6-30 at 25.00.
CM.PR.I PerpetualDiscount 130,977 Nesbitt crossed 48,300 at 20.52. Now with a pre-tax bid-YTW of 5.79% based on a bid of 20.46 and a limitMaturity.
PIC.PR.A SplitShare 117,351 Asset coverage of 1.5+:1 as of January 24, according to Mulvihill. Now with a pre-tax bid-YTW of 6.11% based on a bid of 14.88 and a hardMaturity 2010-11-1 at 15.00.
CM.PR.E PerpetualDiscount 73,725 Now with a pre-tax bid-YTW of 5.82% based on a bid of 24.18 and a limitMaturity.
BAM.PR.N PerpetualDiscount 50,615 Now with a pre-tax bid-YTW of 6.44% based on a bid of 18.71 and a limitMaturity.
SLF.PR.B PerpetualDiscount 44,800 Now with a pre-tax bid-YTW of 5.42% based on a bid of 22.40 and a limitMaturity.

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

5 Responses to “January 30, 2008”

  1. madequota says:

    Good morning! . . . With the markets opening lower by 150+ Toronto and New York, I am delighted [and quite surprised] that BNS and TD’s recent 5.6% prefs started trading today . . . at a premium . . . only a couple of pennies above par, but this would mark the first time that a Canadian based preferred share opened above par in recent history. Perhaps the trough really has been reached! (symbols are BNS.PR.O, and TD.PR.Q)

    A message to the braintrust at Scotia and TD: take a look at the current discount level in the market . . . before you issue new paper at this kind of discount . . . I would say that they could have gotten away with 5.35 or 5.4% on these issues, based on the trading levels of the 5.3′s that were at par when these new ones were announced. As well, BMO’s got massive bids at par on both of these right now, so the “institutional” appetite appears to be unfullfilled at this point.

    With yesterday’s Fed cut of an additional 50 pts, I’m really starting to wonder about the talent levels at some Canadian banks.

    madequota

  2. jiHymas says:

    I think you’re being a little harsh.

    Scotia just issued some Tier 2B sub-debt which priced to yield 5.30%.

    According to the prospectus:

    The Debentures offered by this short form prospectus will be dated January 31, 2008 and will mature on January 31, 2018. Interest on such Debentures at the rate of 5.30% per annum will be payable in equal semi-annual payments in arrears on January 31 and July 31 in each year, commencing July 31, 2008 and continuing until January 31, 2013. From January 31, 2013 until maturity on January 31, 2018 interest on such Debentures will be payable at an annual rate equal to the 90-day Bankers’ Acceptance Rate, as herein defined, plus 1.90% payable quarterly in arrears on the last day of each of April, July, October and January in each year, commencing April 30, 2013. Reference is made to ‘‘Details of the Offering—Interest’’.

    So the step-up implies that the market expects this to be 5-year money and it will trade like 5-year money … and, of course, it’s senior to preferreds. It’s by no means a rich coupon … a similar RY issue is trading at Canada 5-year +140.

    Given that, 5.6% for perpetual – Tier 1 – money doesn’t look ludicrous.

  3. madequota says:

    Good Morning!

    I hear what you’re saying with the logic, but from a pure market acceptance standpoint, it still does not quite jive for me.

    Remember last fall, all of the current gen perps were trading in the high $22′s, low $23′s price range . . . I’m referring to prefs such as BNS.PR.L, BMO.PR.J, CM.PR.J.

    Suddenly three banks flooded the market with the 5.3% issues, and within minutes . . . literally . . . all the existing issues dropped into the mid $21′s range.

    The only reason why this did not happen upon the issue of the 5.6′s, I believe, was because they erroneously priced the issues too low . . . not to mention that the existing prefs have really not yet enjoyed any serious recovery to the pre-5.3′s level.

    The net result that these banks should be concerned with is the possibility that their logic in pricing prefs could cause lack of confidence with investors, resulting in the market losing credibility, and hence, impairing their ability to sell future issues.

    Remember what happened with SLF.PR.D? . . . a failed IPO at $25 . . . and two weeks later, they do a secondary tranche at $24 . . . how does that make the original investors feel about investing in this kind of vehicle?

    One must just remember that 2 or 3 tenths of a percentage point in yield can translate into $1 or $2 in the share price very quickly, and this is a very slippery slope when long term acceptance is a factor. I believe it’s the main reason why the pref market is still so far off the levels it should be at.

    madequota

  4. jiHymas says:

    Well … maybe the banks did price these new 5.6%s too low … as I noted at the time, the BNS issue had a curve price of about $26.00, based on the curve at the close immediately prior to the announcement. You’ll rarely here any complaints from me about new issues being priced too low, though!

    SLF.PR.D? I don’t think they sold much at $25.00 … I posted about it at the time … SLF.PR.C was virtually identical and trading at $24.50 at the time.

    As to how the original investors at $25 feel about the situation … well, if they want to do well in the preferred share market, they should get professional advice. Not from a regular stockbroker, but from a preferred share specialist. I may have a slight conflict of interest in making this recommendation.

    I, personally, LOVE the market the way it is now. Tons of mispricing, lots of trading opportunities.

  5. [...] I am unable to determine whether Eric Cordelle went to a good school, or if he’s just another disposable barrow-boy. [...]

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