March 17, 2008

The big news today is the JPMorgan takeover of Bear Stearns, which has been the subject of so much commentary I’ll keep mine to a minimum. The interesting part is that the Fed is taking a first-loss position on the mortgage paper:

The steps were announced at the same time the Fed agreed to lend $30 billion to J.P. Morgan Chase & Co. to complete its acquisition of Bear Stearns & Co. The loans will be secured solely by difficult-to-value assets inherited from Bear Stearns. If the assets decline in value, the Fed — and thus, the U.S. taxpayer — will bear the cost.

The fact that this financing is non-recourse to JPM is confirmed by their investor presentation:

Special Fed lending facility in place; non-recourse facility to manage up to $30B +/- of illiquid assets, largely mortgage-related

The investor presentation is also remarkable for the coy nature of its disclosure of deal terms:

No material adverse change clause. JPM has customary protections

Huh? That’s it? One possibility that the deal is a stalking horse: JPM is backstopping an auction with a reserve price of $2 per share. In exchange, they’re getting a nice break fee and BSC is getting a “go shop” clause. But … Assiduous Readers who have heeded my advice that the first thing to examine in any commentary is what isn’t being said will note that no probability is assigned to this possibility!

The non-recourse provision is extraordinary and reinforces the arguments of the TSLF’s nay-sayers – such as interfluidity:

If you think, as I do, that the Fed would not force repayment as long as doing so would create hardship for important borrowers, then perhaps these “term loans” are best viewed not as debt, but as very cheap preferred equity.

The Federal Reserve is injecting equity into failing banks while calling it debt. Citibank is paying 11% to Abu Dhabi for ADIA’s small preferred equity stake, while the US Fed gets under 3% now for the “collateralized 28-day loans” it makes to Citi. Pace Accrued Interest (whom I much admire), I still think this all amounts to a gigantic bail-out. And that it is a brilliantly bad idea from which financial capitalism may have a hard time recovering. Like a well-meaning surgeon slicing up arteries to salvage the appendix, the Federal Reserve is only trying to help.

In an admirable discussion of the further implications of the TSLF, Econbrowser‘s James Hamilton pointed out:

One measure economists sometimes use for the liquidity of an asset is the bid-ask spread. By that definition, one might be justified in referring to the present problems as a problem of liquidity– the gap between the price at which owners would like to sell these assets and the price that counterparties are willing to pay is so big that the assets don’t move. That illiquidity itself has proven to be a paralyzing force on the financial system. By creating a value for these assets– the ability to pledge them as collateral for purposes of temporarily acquiring good funds– the Fed is creating a market where none existed, thereby tackling the problem of liquidity head on.

OK, but if we agree to use that framework to describe the current difficulties as a liquidity (as opposed to a solvency) problem, which is closer to the “true” valuation, the bid or the ask price?

Even in the worst possible outcome, the ultimate increase in outstanding Treasury debt would be substantially less than $400 billion, because the collateral is far from worthless. And I would trust the Fed to be taking a smaller risk on behalf of the Treasury than I would expect to be associated, for example, with congressionally mandated expansion of FHA insurance, or the unclear implicit Treasury liability that results from increasing the assets and guarantees from Fannie or Freddie. Nevertheless, the doubters seem to me to be correct that the risks currently being absorbed by the Federal Reserve are substantially greater than zero.

You don’t get something for nothing.

Accrued Interest provides an entertaining analysis of the knock-on effects of the BSC/JPM deal:

Nothing, nothing, would surprise me today. Down 500? Up 200? Who knows? What we have is a tug of war. Traders betting on things getting worse. The Fed and Treasury are trying to draw a line in the sand, telling the market they won’t let either banks nor primary dealers fail as long as they still have decent assets to pledge as collateral.

I will say that I wouldn’t be a buyer of protection against any of the big banks or brokerages here. The Fed just delivered a big middle finger to people who bet against Bear Stearns. If you want to bet against brokerages, the stock is a much smarter bet. The Fed doesn’t give a fuck if a stock falls 50%. They have basically unlimited power to prevent a bankruptcy.

The problems brokerages are facing today have nothing to do with the normal financial ratio-type analysis that the ratings agencies do. In fact, for a guy like me who likes to pour over financial statements when making an investment decision, analyzing credits now is next to impossible.

Lehman and Goldman’s earnings reports tomorrow are probably the most important earnings reports for the broad economy of my career.

Naked Capitalism points out that we are currently engaged in a monstrous game of prisoner’s dilemma:

[Eugene Linden observes] The problem facing the credit markets right now is yet another iteration of the “prisoner’s dilemma” from game theory, at least in the sense that participants know that if everybody takes the stance of “every man for himself” the markets will crater, but they also know that if they rush for the exits there’s a chance that they will get out the door relatively unscathed. Studies of the problem suggest that the more anonymous the context, the more likely that players will adopt “every man for himself,” and, of course there’s nothing more anonymous than markets.

[Naked Capitalism reader Lune argues] We’ve already seen the law of unintended consequences so far:

1) Congress raises conforming limits on Fannie/Freddie to help unfreeze the mortgage market. Result: agency spreads skyrocket, bringing down Bear and a host of hedge funds. Mortgage markets still remain frozen.

2) Fed opens TSLF to unfreeze mortgage market. Result: Carlyle goes bankrupt as people rapidly arbitrage the difference between holding MBS in firms that can and can’t access the new credit facility. Mortgage markets remain frozen.

Now we have 3) Fed opens TSLF to broker-dealers.

[Also “Lune”] I’m wondering: if the demise of Carlyle and BSC was hastened because they were firms that couldn’t access Fed money and thus were foreclosed by firms that could, what will happen Monday? I’m thinking hedge funds, unable to access the Fed directly, will be eaten alive by the IBs.

Meanwhile, in a Financial Times piece dissed by Naked Capitalism as self-serving, Greenspan has pointed out the vulnerabilities of quantitative models:

The most credible explanation of why risk management based on state-of-the-art statistical models can perform so poorly is that the underlying data used to estimate a model’s structure are drawn generally from both periods of euphoria and periods of fear, that is, from regimes with importantly different dynamics.

The contraction phase of credit and business cycles, driven by fear, have historically been far shorter and far more abrupt than the expansion phase, which is driven by a slow but cumulative build-up of euphoria. Over the past half-century, the American economy was in contraction only one-seventh of the time. But it is the onset of that one-seventh for which risk management must be most prepared. Negative correlations among asset classes, so evident during an expansion, can collapse as all asset prices fall together, undermining the strategy of improving risk/reward trade-offs through diversification.

If we could adequately model each phase of the cycle separately and divine the signals that tell us when the shift in regimes is about to occur, risk management systems would be improved significantly. One difficult problem is that much of the dubious financial-market behaviour that chronically emerges during the expansion phase is the result not of ignorance of badly underpriced risk, but of the concern that unless firms participate in a current euphoria, they will irretrievably lose market share.

Paradigm-shift is indeed a problem in quantitative modeling – such models, including all the ones I’ve ever worked on, tend to perform poorly during trend changes, and not at their best when a definite trend exists. All you can do is manage diversification – ‘I can compare equities, and I can compare bonds, but I can’t compare bonds to equities’.

The key phrase in these remarks is: If we could … divine the signals that tell us when the shift in regimes is about to occur, risk management systems would be improved significantly. Can’t be done! The world is chaotic and every bad result has its own unique set of circumstances. So diversify! I am in complete agreement with Mr. Greenspan’s conclusion:

In the current crisis, as in past crises, we can learn much, and policy in the future will be informed by these lessons. But we cannot hope to anticipate the specifics of future crises with any degree of confidence. Thus it is important, indeed crucial, that any reforms in, and adjustments to, the structure of markets and regulation not inhibit our most reliable and effective safeguards against cumulative economic failure: market flexibility and open competition.

A horrible, horrible day for the preferred share market, particularly the PerpetualDiscounts, on light volume. The guy who sold a whack of RY.PR.F at 20.45 last week is starting to look a lot smarter!

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 5.43% 5.45% 31,440 14.73 2 +0.2043% 1,094.4
Fixed-Floater 4.77% 5.54% 62,144 14.80 8 -0.5464% 1,041.4
Floater 4.74% 4.74% 79,386 15.99 2 -0.3329% 876.6
Op. Retract 4.86% 3.37% 74,166 3.35 15 -0.1296% 1,043.1
Split-Share 5.44% 6.30% 95,093 4.13 14 -0.9753% 1,012.3
Interest Bearing 6.21% 6.69% 66,911 4.24 3 +0.1906% 1,084.8
Perpetual-Premium 5.80% 5.63% 267,788 10.77 17 -0.4796% 1,016.8
Perpetual-Discount 5.56% 5.62% 303,164 14.45 52 -0.8133% 927.2
Major Price Changes
Issue Index Change Notes
WFS.PR.A SplitShare -4.6344% Asset coverage of 1.7+:1 as of March 6, according to Mulvihill. Now with a pre-tax bid-YTW of 7.83% based on a bid of 9.26 and a hardMaturity 2011-6-30 at 10.00.
BMO.PR.J PerpetualDiscount -2.5173% Now with a pre-tax bid-YTW of 5.76% based on a bid of 19.75 and a limitMaturity.
LFE.PR.A SplitShare -2.4728% Asset coverage of just under 2.4:1 as of February 29, according to the company. Now with a pre-tax bid-YTW of 5.67% based on a bid of 9.86 and a hardMaturity 2012-12-1 at 10.00.
BNA.PR.C SplitShare -2.2785% Asset coverage of 3.3+:1 as of January 31, according the company. Now with a pre-tax bid-YTW of 7.52% based on a bid of 19.30 and a hardMaturity 2019-1-10 at 25.00. Compare with BNA.PR.A (5.93 to hardMaturity 2010-9-30) and BNA.PR.B (8.50% to hardMaturity 2016-3-25).
NA.PR.L PerpetualDiscount -2.2243% Now with a pre-tax bid-YTW of 5.82% based on a bid of 21.10 and a limitMaturity.
RY.PR.B PerpetualDiscount -2.2222% Now with a pre-tax bid-YTW of 5.40% based on a bid of 22.00 and a limitMaturity.
GWO.PR.H PerpetualDiscount -2.1978% Now with a pre-tax bid-YTW of 5.70% based on a bid of 21.36 and a limitMaturity.
PWF.PR.I PerpetualDiscount -2.1127% Now with a pre-tax bid-YTW of 6.08% based on a bid of 25.02 and a limitMaturity.
TD.PR.P PerpetualDiscount -2.0945% Now with a pre-tax bid-YTW of 5.58% based on a bid of 23.84 and a limitMaturity.
CM.PR.R OpRet -2.0650% Now with a pre-tax bid-YTW of 4.69% based on a bid of 25.61 and a softMaturity 2013-4-29 at 25.00.
BNS.R.M PerpetualDiscount -1.9886% Now with a pre-tax bid-YTW of 5.52% based on a bid of 20.70 and a limitMaturity.
RY.PR.F PerpetualDiscount -1.9750% Now with a pre-tax bid-YTW of 5.53% based on a bid of 20.35 and a limitMaturity.
BNS.PR.J PerpetualDiscount -1.5663% Now with a pre-tax bid-YTW of 5.35% based on a bid of 24.51 and a limitMaturity.
BAM.PR.N PerpetualDiscount -1.5303% Now with a pre-tax bid-YTW of 6.40% based on a bid of 18.66 and a limitMaturity.
RY.PR.D PerpetualDiscount -1.5094% Now with a pre-tax bid-YTW of 5.45% based on a bid of 20.88 and a limitMaturity.
GWO.PR.G PerpetualDiscount -1.4571% Now with a pre-tax bid-YTW of 5.50% based on a bid of 23.67 and a limitMaturity.
BNS.PR.K PerpetualDiscount -1.4423% Now with a pre-tax bid-YTW of 5.40% based on a bid of 22.55 and a limitMaturity.
BCE.PR.A FixFloat -1.4344%  
FBS.PR.B SplitShare -1.3830% Asset coverage of just under 1.6:1 as of March 13, according to TD Securities. Now with a pre-tax bid-YTW of 7.05% based on a bid of 9.27 and a hardMaturity 2011-12-15 at 10.00.
BNS.PR.L PerpetualDiscount -1.3333% Now with a pre-tax bid-YTW of 5.52% based on a bid of 20.72 and a limitMaturity.
RY.PR.G PerpetualDiscount -1.3208% Now with a pre-tax bid-YTW of 5.44% based on a bid of 20.92 and a limitMaturity.
CM.PR.P PerpetualDiscount -1.3102% Now with a pre-tax bid-YTW of 5.94% based on a bid of 23.35 and a limitMaturity.
HSB.PR.D PerpetualDiscount -1.2576% Now with a pre-tax bid-YTW of 5.50% based on a bid of 22.77 and a limitMaturity.
W.PR.H PerpetualDiscount -1.2500% Now with a pre-tax bid-YTW of 5.86% based on a bid of 23.70 and a limitMaturity.
BCE.PR.R FixFloat -1.2371%  
BCE.PR.I FixFloat -1.2245%  
FFN.PR.A SplitShare -1.2232% Asset coverage of just under 2.0:1 as of February 29, according to the company. Now with a pre-tax bid-YTW of 5.90% based on a bid of 9.69 and a hardMaturity 2014-12-1 at 10.00.
GWO.PR.I PerpetualDiscount -1.2077% Now with a pre-tax bid-YTW of 5.52% based on a bid of 20.45 and a limitMaturity.
CM.PR.J PerpetualDiscount -1.1599% Now with a pre-tax bid-YTW of 5.84% based on a bid of 19.60 and a limitMaturity.
CM.PR.H PerpetualDiscount -1.0900% Now with a pre-tax bid-YTW of 5.85% based on a bid of 20.87 and a limitMaturity.
FIG.PR.A InterestBearing +1.1625% Asset coverage of 2.2+:1 as of March 14 according to the company”. Now with a pre-tax bid-YTW of 6.33% (mostly as interest) based on a bid of 9.96 and a hardMaturity 2014-12-31 at 10.00.
BAM.PR.J OpRet +1.2826% Now with a pre-tax bid-YTW of 5.27% based on a bid of 25.27 and a softMaturity 2018-3-30 at 25.00.
BAM.PR.B Floater +1.3333%  
Volume Highlights
Issue Index Volume Notes
TD.PR.R PerpetualDiscount 52,240 Recent new issue. Now with a pre-tax bid-YTW of 5.69% based on a bid of 24.73 and a limitMaturity.
BMO.PR.J PerpetualDiscount 22,215 Now with a pre-tax bid-YTW of 5.76% based on a bid of 19.75 and a limitMaturity.
BNS.PR.O PerpetualPremium (for now!) 21,545 Now with a pre-tax bid-YTW of 5.71% based on a bid of 24.87 and a limitMaturity.
TD.PR.Q PerpetualPremium (for now!) 21,420 Now with a pre-tax bid-YTW of 5.69% based on a bid of 24.95 and a limitMaturity.
BAM.PR.N PerpetualDiscount 18,300 Now with a pre-tax bid-YTW 6.40% based on a bid of 18.66 and a limitMaturity.

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

Leave a Reply

You must be logged in to post a comment.