Monday, March 31, 2008

Credit Analysis of Financial Institutes as of 03 31 08

Based on 2007 10-k and 8-k 2008 financial statements Bear Stearns (total liability 383.6 bil, asset 395 bil, 143 bil financial instrments) 1.repo financing 102 bil, 26.6% of liabilities 2.long term 68.5 bil, 17.85% of liabilities 3.unencumbered collateral asset: 16.3 bil w a borrowing value of $14 bil (3.6%) 3.a unregulated unencumbered collateral asset: $5.1 bil (1%) and abs exposure 46 bil + 30 bil(VIE), 11.6% of total, 32% of financial instruements --> cash + unregulated unencumbered collateral asset = 17 bil + 5 bil = 22 bil (5.7%) Lehman (liab 668.6 bil, asset 691 bil, financial instrument 393 bil) 1.repo financing 181.7 bil, 27% 2.long term 123 bil,k 18.4% 3.unencumbered collateral asset: 193.6 bil (29%) 3.a unregulated unencumbered collater asset: $98.1 bil (14.7%) (including cash equivalent) no change until Feb 29th 2008 Exposure to Toxic Assets mortgage exposure 89 bil, out of assets 691 bil 13%, 22% of financial instrmenet in Q1. US mortgage exposure is $22 bil, CMBS $36.1 bil ($17 bil US) Appropriate Hedging: FI gross writedown in Q1 $4.7 bil ($3 residential mortgage, 1.1 CMBs, 0.7 bil leveraged loan), net write-down $1.8 bil (0.8 net RMBS, $0.7 bil CMBS, $0.3 leverage loan) (60% hedged) writedown forecast Morgage: 3 bil, CMBS 1.7 bil, Leveraged Loan 0.7 : net $2 bil captial: the company is planning to raise 3.7 bil convertible preferred stock. Together with eligible collater and liqudity pool (98 bil), it is well positioned. ---> cash + unregulated unencumbered collateral asset = 98.1 bil (14.7%) Comments: --Bear Stearns has far more liquidity issue than Lehman --Leh should weather the storm. But it will have further stumbles. The best time to buy Leh credit is the end of Q2.

Banks Regulatory Overhaul

``Our current regulatory regime is almost solely focusedabove ground at the tree level,'' Paulson said in remarks at theTreasury in Washington. ``The real threat to market stability isbelow ground, at the root level where the health of financialfirms is intertwined.'' ``We should and can have a structure that is designed for the world we live in, one that is more flexible, one that can better adapt to change, one that will allow us to moreeffectively deal with inevitable market disruptions, one thatwill better protect investors and consumers,'' Paulson said.

trading view: Icelandic banks

Glitnir Banki HF --A rating, CDS trading at nearly 1000 bps, stock trading at nearly 17.25, -20% down YTD --strategy: sell 5y cds or sell 5y CDS + short stocks --reasoning: a.even though it has 300 bil ISK bonds and loans due this year, it has enought funding to cushion liquidity: LT bonds increased 300 bill (ISK) in 2007; Customers deposits increased 300 bil (ISK) b.iceland economy is still holding up fine, unemployment rate 1%, 7 year low c.iceland authority will serve as the backstop of the bank

Prospects are uncertain for insurers

The Treasury Department's proposal to let insurers choose federal rather than state regulation would fulfill a long-held dream of some of the industry's major players. But many doubt that this piece of the financial-regulation overhaul plan will become reality any time soon. As part of its broad bid to change how financial firms are overseen, the Treasury Department wants the power to charter insurance companies at the federal level, if they prefer. Now, insurance is regulated by states, and big insurers have griped for years that they must deal with dozens of bureaucracies and sets of rules. Under Treasury's proposal, insurers would have the option of being regulated by the federal government, though they could also remain under state regulation. (Firms that chose federal regulation would still have to comply with state laws in some cases, under the proposal.) The proposal says that state regulation makes it "cumbersome and more costly" for insurers to develop products that they can sell nationally, and "creates increasing tensions" for U.S. insurers operating abroad and foreign insurers in the U.S. But the industry does not unanimously support the concept. "We don't believe you need a massive new bureaucracy," says Robert Rusbuldt, chief executive of the Independent Insurance Agents & Brokers of America, a trade group. One concern among smaller insurers is that the big firms will gain an advantage. Smaller insurers "would have less opportunity to switch" regulatory regimes because of the time and cost involved,

Sunday, March 30, 2008

Housing Woes Shake Bank in California

The financial crisis threatened to claim its first casualty in the U.S. banking industry, as federal and state regulators gave a rare directive to Fremont General Corp. to shore up its operations immediately. While the California lender's woes don't pose a threat to the broader financial system, its plight marks a new stage in the turmoil that began last summer. Regulators said the Brea, Calif., company, parent of a once highly active subprime lender called Fremont Investment & Loan, must raise new capital within the next 60 days or sell its banking subsidiary. Fremont disclosed Friday that the FDIC had issued a "prompt corrective action" order on Wednesday requiring it to raise capital or be sold, according to a filing with the Securities and Exchange Commission. "The financial condition of Fremont General Corporation, the company having ultimate control over the Bank, continues to deteriorate," the FDIC said in the order. Along with the California Department of Financial Institutions, the FDIC set a May 26 deadline to raise the capital. At the same time, the regulators said the bank can't seek capital by offering depositors higher interest rates than the rates prevailing in the California market. In addition, the bank won't be allowed to make capital payments to its parent or an affiliate, or pay bonuses to bank executives. Fremont doesn't appear likely to attract a federal rescue such as the one arranged for Bear Stearns Cos. Bear, a major Wall Street investment bank, had huge, complex exposure to other companies and creditors that could have provided a systemic shock to financial markets in the event of its collapse. Fremont's exposure is more isolated and contained. Fremont was one of the top 10 U.S. originators of subprime loans, thanks to practices that included loose underwriting and aggressive marketing to brokers. Fremont was hardly a household name. All of its 22 retail branches were in California, and it didn't advertise directly to consumers with TV ads or newspaper pitches. Yet from 2004 to 2006, Fremont made $81 billion in high-interest-rate loans, fourth-highest among U.S. lenders, according to a Wall Street Journal analysis of lending data filed with federal regulators. Nearly all of its home mortgages were subprime loans, which then were bundled into pools, sliced up and sold off to investors. In March 2007, the federal government forced Fremont to stop making subprime loans and to cease operating with management whose "policies and practices are detrimental." The company agreed to the order and sold its subprime division. Fremont was permitted to keep its commercial real-estate operations, but the FDIC required the bank to shore up this business line and improve risk management. In October, Massachusetts Attorney General Martha Coakley filed a suit against Fremont General and its banking unit, Fremont Investment & Loan, alleging that they were offering risky products such as 100% financing and "no documentation" loans that were unfair and deceptive. Fremont denies wrongdoing. In a court filing in November, it said that without access to its loans -- often requiring a lower standard of proof of income, assets and credit history than traditional lenders -- "many Massachusetts residents who are homeowners today would never have been able to purchase homes." Last month, a Massachusetts court issued a preliminary injunction saying Fremont couldn't foreclose on mortgages in the state without checking with the attorney general. Fremont was also a key player in Florida, one of the markets hardest hit in the real-estate slump. In 2005, at the housing boom's peak, Fremont made nearly 5,000 high-rate mortgages in the Miami/Miami Beach/Kendall metro area, making it the second-biggest subprime lender there. The company, which hasn't filed financial results since Sept. 30, has been seeking a buyer for months. It installed a new CEO and executive team in November and a new board in January. The FDIC has given "prompt corrective action" notices to only 13 other banks since it started releasing public data on these directives in 1993. Six of those banks failed, some within weeks of the notice. Such notices typically only come when a bank has very low capital levels or is at risk of failure. (Federal bank regulators often issue less-stringent public and private enforcement actions against banks.) There have only been five bank failures since July 2004. But federal regulators have warned of more potentially insolvent institutions, particularly banks with high exposures to risky commercial real-estate loans. After the savings-and-loan crisis of the late 1980s, Congress passed a law that required early intervention in problem banks -- known as "prompt corrective actions" -- to prevent troubled banks from digging themselves into a deeper hole. The 1991 legislation was called the Federal Deposit Insurance Corporation Improvement Act. The best hope for Fremont might be a federally engineered sale at a fire-sale price, or a deal structured in a way that cushions the buyer from some liabilities. For example, the 1983 purchase of Seafirst Corp. by BankAmerica Corp., a predecessor of Bank of America Corp., included new nonvoting preferred shares that left Seafirst shareholders bearing the financial risk of bad loans for five years. Also, Chemical New York Corp. -- now part of J.P. Morgan Chase & Co. -- was able to spin off problem energy and real-estate loans into a separate bank when it bought Texas Commerce Bancshares Inc. in 1987. Some larger lenders also are trying to bolster depleted capital levels. Washington Mutual Inc., the nation's largest savings-and-loan, and National City Corp., a Cleveland-based bank, have hired investment bankers to help them raise cash, say people familiar with the matter. National City is also exploring a possible sale of itself. The capital-raising efforts haven't been successful so far.

Saturday, March 29, 2008

Growing Gulf Divides China and Old Foe - NY Times

Across much of the Western world, the Dalai Lama is known as the beatific spiritual leader of a humble community of Buddhists, beloved in Hollywood, Congress and the White House, winner of the Nobel Peace Prize. Chinese leaders cast him in a different light. They call him a separatist and a terrorist, bent on killing innocent Han Chinese and “splitting the motherland.” That gap in perception, which has grown immeasurably wider in the two weeks since violent unrest rocked Tibet, is breeding pessimism that Chinese leaders are willing — or perhaps even able — to embark on a new approach to Tibet even as it threatens to cast a long shadow over their role as hosts of the Olympic Games this summer. Already, President Nicolas Sarkozy of France has suggested that he might consider using his presidency of the European Union this summer to organize a boycott of the opening ceremonies of the Olympics. An embarrassing protest at the lighting ceremony of the Olympic torch in Greece, and the cries of monks in Lhasa who disrupted a scripted tour of the Tibetan capital for foreign reporters on Thursday, portend a steady drum roll of criticism of China. The call for some kind of Chinese-Tibetan talks continues to mount. On Friday, the Dalai Lama, speaking in India, made his most extended comments on the violence, accusing China’s state-run media of trying to “sow the seeds of racial tension” there but calling for “meaningful dialogue” with Beijing about how to defuse tensions. China says that the riots killed about 20 people and were orchestrated by separatist followers of the Dalai Lama, the exiled Tibetan spiritual leader, and that the government responded with restraint.

Paulson's plan to overhaul regulatory system

Mr. Paulson is also expected to call for the Office of Thrift Supervision, which regulates federal thrifts, to be phased out within two years and merged with the Office of the Comptroller of the Currency, which regulates national banks. One reason is that there is very little difference these days between federal thrifts and national banks. A key part of the blueprint is aimed at fixing lapses in mortgage oversight. Mr. Paulson plans to call for the creation of a new entity, called the Mortgage Origination Commission, according to an outline of the Treasury Department's plan, which was first reported by the New York Times. This new entity would create licensing standards for state mortgage companies. This commission, which would include representatives from the Fed and other agencies, would scrutinize the way states oversee mortgage origination. Also related to mortgages, Mr. Paulson is expected to call for federal laws to be "clarified and enhanced," resolving any jurisdictional issues that exist between state or federal supervisors. Many of the problems in the housing market stemmed from loans offered by state-licensed companies. Federal regulators, too, were slow to create safeguards that could have banned some of these practices. A market stability regulator, which would likely be the Fed, would have broad powers over all three types of companies. A new regulator, called the Prudential Financial Regulatory Agency, would oversee the financial regulation of the insurance and federally insured banks. Another regulator, the Business Regulatory Agency, would oversee business conduct at all the companies.

Executive Summary of Paulson with Regard to Overhaul of Regulatorty System

The mission of the Department of the Treasury (“Treasury”) focuses on promoting economic growth and stability in the United States. Critical to this mission is a sound and competitive financial services industry grounded in robust consumer protection and stable and innovative markets. Financial institutions play an essential role in the U.S. economy by providing a means for consumers and businesses to save for the future, to protect and hedge against risks, and to access funding for consumption or organize capital for new investment opportunities. A number of different types of financial institutions provide financial services in the United States: commercial banks and other insured depository institutions, insurers, companies engaged in securities and futures transactions, finance companies, and specialized companies established by the government. Together, these institutions and the markets in which they act underpin economic activity through the intermediation of funds between providers and users of capital. This intermediation function is accomplished in a number of ways. For example, insured depository institutions provide a vehicle to allocate the savings of individuals. Similarly, securities companies facilitate the transfer of capital among all types of investors and investment opportunities. Insurers assist in the financial intermediation process by providinga means for individuals, companies, and other financial institutions to protect assets fromv arious types of losses. Overall, financial institutions serve a vitally important function in theU.S. economy by allowing capital to seek out its most productive uses in an efficient matter. Given the economic significance of the U.S. financial services sector, Treasury considers the structure of its regulation worthy of examination and reexamination.

Friday, March 28, 2008

It is time to put financial institutions within the purview of the Fed

Treasury Secretary Henry Paulson hinted Wednesday that he wants the country's patchwork financial regulatory system overhauled. It is a good time to do so. The Federal Reserve is now lending money to investment banks, traditionally supervised by the Securities and Exchange Commission. And the Fed helped rescue Bear Stearns because, in today's interconnected markets, the firm's problems threatened the deposit-taking banks the Fed does regulate. With real levers to deploy, the Fed is well-placed to lead a simpler, more coherent regulatory effort that encompasses all of Wall Street. It isn't a secret that the current regime is a mess. It puts different financial institutions -- or their different parts -- within the purview of the Fed, the Federal Deposit Insurance Corp., the SEC, the Office of the Comptroller of the Currency and a host of others. The United Kingdom long ago folded multiple supervisors into one entity, the Financial Services Authority. The FSA is fallible. On Wednesday, it admitted shortcomings in its supervision of mortgage lender Northern Rock. But at least it can take a holistic view across financial markets. The Fed already trades with the investment banks on its 20-strong list of primary dealers, so it knows them well. That relationship and the Fed's balance sheet give it real muscle. The Fed has traditionally used its power and influence to encourage prudence and pre-empt problems at banks. That is arguably of broader importance than the SEC's more retrospective compliance and enforcement mindset, although that has its place, too. The Fed's monetary-policy role also meshes comfortably with a financial-stability remit, as the feedback loop between the mortgage meltdown and the economy has shown. Of course, the Fed isn't perfect. Some argue, for instance, that its moves to save Bear came too late. But the financial experts at the Fed's New York branch look relatively smart so far. While the U.S. system needs more than just an extension of the Fed's oversight to the rest of Wall Street, it could be a good start.

Ten Days That Changed Capitalism

The past 10 days will be remembered as the time the U.S. government discarded a half-century of rules to save American financial capitalism from collapse. On the Richter scale of government activism, the government's recent actions don't (yet) register at FDR levels. They are shrouded in technicalities and buried in a pile of new acronyms. But something big just happened. It happened without an explicit vote by Congress. And, though the Treasury hasn't cut any checks for housing or Wall Street rescues, billions of dollars of taxpayer money were put at risk. A Republican administration, not eager to be viewed as the second coming of the Hoover administration, showed it no longer believes the market can sort out the mess. "The Government of Last Resort is working with the Lender of Last Resort to shore up the housing and credit markets to avoid Great Depression II," economist Ed Yardeni wrote to clients. First, over St. Patrick's Day weekend, the Fed (aka the Lender of Last Resort) and the Treasury forced the sale of Bear Stearns, the fifth-largest U.S. investment bank, to J.P. Morgan Chase at a price so low that a shareholder rebellion prompted J.P. Morgan to raise the price. To induce J.P. Morgan to do the deal, the Fed agreed to take losses or gains, if any, on up to $29 billion of securities in Bear Stearns's portfolio. The outcome will influence the sum the Fed turns over to the Treasury, so this is taxpayer money; that's why the Fed sought Treasury Secretary Henry Paulson's OK. 1 DISCUSSION Has the U.S. government done enough to save American financial capitalism, or has it crossed a line? Join a discussion 2. Then the Fed lent directly to Wall Street securities firms for the first time. Until now, the Fed has lent directly only to Main Street banks, those that take deposits from ordinary folks. That's because banks were viewed as playing a unique economic role and, supposedly, were more closely regulated than other types of lenders. In the first three days of this new era, securities firms borrowed an average of $31.3 billion a day from the Fed. That's not small change, and it's why Mr. Paulson, after the fact, is endorsing changes to give the Fed more access to these firms' books. Increased Leverage In the days that followed, the Republican Treasury secretary leaned on two shareholder-owned, though government-chartered, companies -- Fannie Mae and Freddie Mac -- to raise capital that their boards didn't want to raise. In exchange, their government regulator allowed them to increase their leverage so they can buy about $200 billion more in mortgage-backed securities. So Fannie and Freddie will get bigger, a welcome development when mortgage markets are in trouble. Already, they have regained lost market share. They accounted for 76% of new mortgages in the fourth quarter of last year, up from 46% in the second quarter, Mr. Paulson said Wednesday. But everyone knows that if Fannie or Freddie stumble, taxpayers will get stuck with the tab. And then, the federal regulator of the low-profile Federal Home Loan Banks, which are even less well capitalized than Fannie and Freddie, said they could buy twice as many Fannie and Freddie-blessed mortgage-backed securities as previously permitted -- more than $100 billion worth. Was this necessary? It's messy, uncomfortable and undoubtedly flawed in many details. Like firefighters rushing to a five-alarm fire, policy makers are making mistakes that will be apparent only in retrospect. Too Great to Ignore But, regardless of how we got here, the clear and present danger that the virus in the housing, mortgage and credit markets is infecting the overall economy is too great to ignore. The Great Depression was worsened because the initial government reaction was wrong-headed. Federal Reserve Chairman Ben Bernanke spent an academic career learning how to avoid repeating those mistakes. Is it working? It is helping. One key measure is the gap between interest rates on mortgages and safe Treasury securities. A wide gap means high mortgage rates, which hurt an already sickly housing market. A lot of recent activity, including Wednesday's previously planned auction in which the Fed is trading Treasurys for mortgage-backed securities, is aimed at increasing demand for those securities to drive down mortgage rates. The gap remains enormous by historical standards, but has narrowed. On March 6, according to FTN Financial, 30-year fixed-rate mortgages were trading at 2.92 percentage points above the relevant Treasury rates; Wednesday the gap was down to 2.22. Normal is about 1.5 percentage points. Money markets are still under stress, as banks and others hoard cash and super-safe short-term Treasurys. Is it enough? Probably not. Although it's hard to know, the downward tug on the overall economy from falling house prices persists. The next step, if one proves necessary, is almost sure to require the explicit use of taxpayer money. Cushion the Blow The case for doing more is twofold. One is to cushion the blow to families and communities, even if some are culpable. The other is to disrupt a dangerous downward spiral in which falling prices of houses and mortgage-backed securities lead lenders to pull back, hurting the economy and dragging asset prices down further, and so on. In ordinary times, a capitalist economy lets prices -- such as those of homes, mortgage-backed securities and stocks -- fall to the point where the big-bucks crowd rushes in, hoping to make a killing. But if the big money remains on the sidelines, unpersuaded that a bottom is near, the wait for bargain hunters to take the plunge could be very long and very painful. So the next step, no matter how it is dressed up, is likely to involve the government's moving in ways that put a floor under prices, hoping that will limit the downside risks enough so more Americans are willing to buy homes and deeper-pocketed investors are willing, in effect, to lend them the money to do so.

Auction rate Securities hurt Tech Companies

The $330 billion market for the securities -- long-term instruments with rates that reset frequently at auction -- has seized up, making it difficult for holders to convert them to cash. Dallas telecom company MetroPCS Communications Inc. recently took an $83 million charge related to auction-rate securities, the arcane debt instruments -- once thought to be as safe as cash -- that are now nearly impossible to sell in today's jittery markets. in MetroPCS 10-k 2007, auction rate securiteis are disclosed under short investments The Company holds investments of $133.9 million in certain auction rate securities some of which are secured by collateralized debt obligations with a portion of the underlying collateral being mortgage securities or related to mortgage securities. Consistent with the Company’s investment policy guidelines, the auction rate securities investments held by the Company all had AAA credit ratings at the time of purchase. With the liquidity issues experienced in global credit and capital markets, the auction rate securities held by the Company at December 31, 2007 have experienced multiple failed auctions as the amount of securities submitted for sale in the auctions has exceeded the amount of purchase orders. In addition, three auction rate securities held by the Company have been placed on credit watch. However, as of January 31, 2008, all of the auction rate securities held by the Company still retain a AAA/Aaa rating as reported by Standard and Poors and Moody’s Investors Service. The estimated market value of the Company’s auction rate security holdings at December 31, 2007 was approximately $36.1 million, which reflects a $97.8 million adjustment to the principal value of $133.9 million. Although the auction rate securities continue to pay interest according to their stated terms, based on statements received from the Company’s broker and an analysis of other-than-temporary impairment factors, the Company has recorded an impairment charge of $97.8 million during the year ended December 31, 2007, reflecting the portion of auction rate security holdings that the Company has concluded have an other-than-temporary decline in value.

First Auction of Term Security Lending Facility Shows Less Desperation

Top-notch banks and brokerages on Wall Street appear less desperate than feared for super-safe Treasurys, if the soft demand for the first auction of the Federal Reserve's security lending facility is any guide. At the same time, cash borrowings at the Fed's primary dealer facility increased modestly from a week earlier, averaging a daily $32.9 billion in the latest week to Wednesday. In the first Treasurys swap, dealers put in a mere $86.1 billion in bids for the $75 billion in Treasury securities on offer, according to the New York Fed. The Fed accepted a broad range of hard-to-trade mortgage debt as collateral for its loans of super-safe government debt. Mr. Franzese said people had expected dealers to submit as much as $100 billion for the auction. The lower-than-expected bids suggested dealers "aren't dying for the money." As a result, the low-risk Treasurys markets saw a knee-jerk sell-off after the auction results were announced. Short-dated Treasurys, such as three-month T-bills and two-year notes, erased early gains, while the five-, 10- and 30-year sectors were down further following the auction results. The benchmark 10-year note ended down 11/32 point, or $3.4375 for every $1,000 invested, to yield 3.534%. That's up from 3.494% Wednesday. Yields rise when prices fall. Tony Crescenzi, chief bond-market strategist at Miller Tabak & Co. in New York, said dealers did not show signs of "being desperate" to get their hands on Treasurys much beyond what was available, given the 1.15 bid-to-cover ratio. Bid-to-cover is a gauge of demand used in auctions that measures the ratio of the amount on offer and the amount of bids submitted.

Streamline Derivative Trading Process

Credit-derivative traders usually agree to the terms of a trade over the phone. After that, a dealer typically records the trade and sends an email or electronic message to the client to confirm the trade. In other instances, a firm on one side of a swap may ask another dealer to take its position, in a process called "novation." That requires the approval of the firm's original trading partner, and such requests are also commonly sent via email. When such requests surge, dealers have to sort through hundreds of emails. In their letter to the Fed, market participants said one of their goals is to make better use of electronic platforms to handle these novation requests and confirmations. A few years ago, regulators became aware that some traders were scribbling down details of derivative trades on scraps of paper and leaving the trades unconfirmed for weeks or months on end. Concerned that markets might malfunction if some companies failed and firms didn't have a good grip on their exposures to others, the Fed in 2005 pushed large dealers to clean up their large backlogs of derivatives trades and outstanding confirmations. That effort was largely successful, but recent market events have shown that more needs to be done.

Wednesday, March 26, 2008

What is the main dispute of Clear Channel deal

The main dispute centers on the syndicate's demand that the private-equity firms replace a long-term financing package of at least six years in the original agreement with a short-term, three-year bridge-financing agreement. Such a change would constrain the ability of a highly leveraged company to deploy capital and operate its business. In addition, the financial firms asked that the buyers not use a revolving credit facility or Clear Channel's cash flow to pay down about $3.8 billion in short-term debt securities, according a person familiar with the talks.

Clear Channell Deal Collapse

Banks financing the $19.5 billionuyout of Clear Channel Communications Inc. stand to lose about3 billion on the transaction because loan prices have tumbled. The banks committed to lend as much as $22 billion to fund the deal, $18 billion of it as senior secured loans. They have the most to lose if the deal goes ahead. The continuing crisis in the market for leveraged debt means they would have to mark down the value of their Clear Channel loans as soon as the deal closes and book the losses. Such debt has typically been marked down 15%, meaning the banks could lose $2.7 billion the moment they close the deal. Still, the commitment letters the banks signed when the deal was cut in May make it almost impossible for them to back out of their commitments. Banks led by Citigroup Inc. and Deutsche Bank AG agreed inApril to provide $22.1 billion for the purchase by private-equity firms Thomas H. Lee Partners LP and Bain Capital PartnersLLC. Since then, losses on subprime-mortgage securities spreadthroughout credit markets and loan prices for similar LBOs fellto as low as 85 cents on the dollar. Negotiations are stuck on details of the credit agreement,the Wall Street Journal reported, citing unidentified peoplefamiliar with the matter. The banks asked for more cash upfrontand stricter payment terms, the New York Times reportedyesterday, citing people briefed on the discussions. Thomas H. Lee and Bain, both based in Boston, agreed to pay$39.20 a share after raising their bid to $37.60 and givinginvestors a 30 percent equity stake in the company. Shareholdersapproved the deal in September. While lenders typically commit to financing when buyouts are announced, the final terms are worked out just before thedeal closes. A collapse may force the private-equity firms to pay asmuch as $600 million in breakup fees. Banks may be better off offering to pay the penalty on behalf of the firms rather than completing the deal, said Mark Patterson, chairman and co-founder of MatlinPatterson Global Advisers LLC, which invests inbankrupt and distressed companies. ``It's cheaper for the banks to pay breakup fees and getthe loan off their books than try and syndicate these loans at95 to 85 cents on the dollar,'' Patterson said. Clear Channel debt rallied in anticipation that thecompany's chance of default would be reduced without the burdenof the LBO debt. The cost to protect Clear Channel's existing debt fromdefault fell for a second day, indicating investors are lessconcerned about the debt. Credit-default swaps tied to thecompany's bonds narrowed 11 basis points to 637 basis points,according to CMA Datavision in London. That means it would cost$637,000 to protect $10 million in debt for five years.

Feb Durable Goods Order

--It provides solid clues that consumers, especially corporations, are less willing to invest. It is a red flag, indicating that economy will further weaken. --New orders droped 1.7%, reflecting less demand for druable goods --Capital Goods, especially non-defense cap good, an important item reflecting corporations' invesment spending, dropped -4.3%, most since Aug 2007

China Policy Helped Fuel Bubble

The 40% decline since October in the Shanghai Stock Exchange's composite index of Chinese-listed shares has coincided neatly with the global financial-market rout. For a government worried about what would happen when the country's 100 million speculators found their portfolios suddenly plunging, this probably is a relief. Beijing can, after all, point the finger at all those subprime mortgages in Florida. That isn't to say the credit crunch hasn't contributed to China's stock-market decline. Its newbie class of equity investors sees many of the same headlines as the rest of the world's punters. And they know the country's sovereign wealth fund, China Investment Corp., has been called upon to bail out ailing financial institutions on Wall Street. Still, global market sentiment isn't the only force at work. China tightly restricts the flow of foreign capital into the Shanghai and Shenzhen stock markets. To blame the recent slide solely on hedge funds and international investors dumping their holdings of Chinese stocks, as Zhou Xiaochuan, governor of People's Bank of China, did this month, is a stretch. The government's own policies surely helped inflate the bubble, which saw the Shanghai Composite index rocket more than 400% in two years. In addition to limiting foreign investment, the government caps the flow of domestic money destined for international stocks. Moreover, the lack of capital gains or inheritance taxes, with only a nominal stamp duty imposed on stock investments, arguably helped fuel share-price inflation. The bubble's deflation has, not surprisingly, damped the erstwhile ebullience of the Chinese market. But rising inflation is a more fundamental threat. Producer prices last month rose 6.6% from a year earlier. Chinese companies will need to pass these higher costs on to their customers if they want to keep profit margins intact. That is a tall order. The Beijing government is alarmed by the rise in consumer prices -- which hit a near 9% annual pace last month. That may not sound scary with the economy growing at an 11% clip. But because the average Chinese household spends a third or more of its wages on food, the worry is that rising consumer prices will fuel social unrest. The headline-grabbing protests in Tibet might be a harbinger of what could happen elsewhere. With the Olympic Games coming to Beijing and the world watching, the government may take more extreme measures to combat inflation. Already it has forced banks to put aside more reserves, which it hopes will reduce lending. It has done this repeatedly in recent years, to little effect. Among other options are further price controls. These might damp food prices, but as the U.S.'s Nixon administration learned in 1971, controls often just make goods disappear from shelves. Either way, companies would bear the brunt of restrictions on their ability to pass on higher costs to consumers. More radical measures could include allowing the Chinese currency to revalue at a faster pace. That would help curb inflation by making imported goods -- including energy, raw materials, grains and meat -- cheaper. It also would slam the export sector. Higher dollar prices for goods at the very moment big clients like Wal-Mart Stores are seeing customers tightening their belts could lead many manufacturers to close shop. Of course, there are companies in China whose businesses can withstand inflation. Morgan Stanley points to infrastructure plays like Jiangsu Expressway; airports; telecom operator China Mobile, and coal-miner China Shenhua Energy as potentially safer havens. And a year or two of clipped earnings might seem a small price to pay if it enables the government to prevent upheaval among China's 1.3 billion people. But Chinese investors thinking their portfolios have been hit by nothing more than subprime fallout should prepare for worse to come.

Bank of China Cuts Subprime Exposure

Bank of China Ltd., which has been the most heavily invested in U.S. subprime securities among Asia's financial institutions, said it halved that exposure by the end of last year and posted better-than-expected profit for 2007. Separately, Industrial & Commercial Bank of China Ltd., China's biggest lender by assets, said its 2007 net profit rose 65%. Bank of China started investing in subprime assets in 2002, and by the end of 2006 it had some $10 billion of such assets in its portfolio, it said in a statement Tuesday. The bank has been paring down those investments, either by writing them off or selling them at reduced values. On Tuesday, it said it had reduced its subprime exposure to $4.99 billion -- half the portfolio's original value when the bank first made such details public in August 2007. The lender also has booked an impairment allowance of $1.3 billion to cover potential losses, it said in its statement. Analysts are likely to spend the next few days trying to figure out exactly how much the bank has lost on its subprime investments. The lender said in its statement that it "disposed" of a portion of the higher-risk U.S. subprime-asset-backed securities and all of its subprime-mortgage-related collateralized debt obligations in the fourth quarter. CDOs are among the most volatile of subprime investments, and getting rid of all of them has significantly reduced the bank's risks, analysts say. Yet it still isn't clear exactly how much the bank has lost from its subprime portfolio. Wang Zhaowen, the bank's spokesman, declined to answer any questions. International banks in general have lost between 30% and half of the value of their subprime investments. Analysts suggest that the subprime losses probably haven't pressured net earnings because of the way the bank has done the accounting. Some of the losses could have been booked to shareholder equity rather than recorded as a profit-and-loss number. If so, the government -- which owns about 70% of the bank -- would have taken the lion's share of the hit, rather than foreign and domestic investors. Such an accounting method is legal, analysts say. Meanwhile, Industrial & Commercial Bank of China said its 2007 net profit rose to 81.52 billion yuan from 49.26 billion yuan amid higher interest income and growth in its fee-based services, such as bank cards and wealth management. The bank said it booked a charge of US$400 million for its exposure to U.S. subprime-mortgage-related investments valued at US$1.226 billion. It said the provisions are enough to cover any potential losses from the investments.

Tuesday, March 25, 2008

JPM Deal will go through

JP nows has 39.5% stake On March 24, 2008, JPMorgan Chase and Bear Stearns, in connection withentering into the Amendment, entered into a Share Exchange Agreement, underwhich JPMorgan Chase will purchase 95 million newly issued shares of BearStearns common stock, or 39.5% of the outstanding Bear Stearns common stock after giving effect to the issuance, in exchange for the issuance of 20,665,350shares of JPMorgan Chase common stock to Bear Stearns and the entry by JPMorganChase into the Amended and Restated Guaranty Agreement and the Fed GuarantyAgreement (each as described below). NYSE makes an exception for the stock excange While the rules of the New York StockExchange (the "NYSE") generally require shareholder approval prior to theissuance of securities constituting 20% or more of the outstanding shares of alisted company, the NYSE's Shareholder Approval Policy provides an exception incases where the delay involved in securing shareholder approval for the issuancewould seriously jeopardize the financial viability of the listed company. Inaccordance with the NYSE's rule providing that exception, the Audit Committee ofBear Stearns's Board of Directors has expressly approved, and the full Board ofDirectors has unanimously concurred with, Bear Stearns's use of the exception.

Home Loand Banks May More Mortgage Securities

The agency that regulates the Federal Home Loan Banks has given them more scope to acquire mortgage-backed securities, marking the latest attempt by the U.S. government to restore confidence in the country's housing market. Under rules announced Monday by regulators at the Federal Housing Finance Board, the 12 regional banks will be able to increase their holdings of mortgage securities issued by Fannie Mae and Freddie Mac by more than $100 billion. Though created by Congress and federally regulated, the home-loan banks are owned by more than 8,000 banks, thrifts, credit unions and insurance companies. The home-loan banks' main role is to provide loans, known as "advances," to their owners, which are called "members." Because investors assume that the government would bail out the home-loan banks in a crisis, they can borrow cheaply in the international bond markets. Countrywide Financial Corp. and other ailing mortgage lenders have relied heavily in recent months on advances from the home-loan banks as other sources of credit dried up. 6 times leverage The home-loan banks previously could have holdings of mortgage securities of no more than three times their capital. Effective immediately, the regulator is raising that to six times capital for the next two years. At the end of 2007, the banks had combined capital of about $54 billion, and they held $136 billion of mortgage-backed securities as of Sept. 30, the latest data available. But the regulator said the banks must submit a plan to manage the risks of additional holdings before they embark on purchases that would take them over the old limit. In theory, the new rules would allow the banks to increase their holdings of the securities by a maximum of around $160 billion, but they are considered very unlikely to bump up against the limits, a spokesman for the regulator said. In the past, critics at the regulator and in government sometimes argued that the home-loan banks held too many mortgage securities and that such holdings did little to support the banks' "mission" of providing funds for housing. The critics argued that there were plenty of other investors willing to buy mortgage securities and that the home-loan banks should focus on providing advances to local banks. Today, such criticism has vanished as regulators search for ways to ensure a steady flow of money into mortgage securities.

Monday, March 24, 2008

Negative Repo Rates in 2003

Contrary to popular belief, interest rates can drop below zero. From early August to mid-November of 2003, negative rates occurred on certain U.S. Treasury security repurchase agreements. An examination of the market conditions behind this development reveals why market participants are sometimes willing to pay interest on money lent. Short-term interest rates fell to their lowest level in forty-five years in 2003. The low rates, coupled with a sharp increase in intermediate-term yields during the summer, gave rise to significant settlement problems in the ten-year Treasury note issued in May. To ease those problems, market participants lent money at attractive rates on investment contracts that provided the note as collateral. From early August through mid-November, such repurchase agreements ("repos" or "RPs") were sometimes arranged at negative interest rates. This episode of negative interest rates is interesting for several reasons. For one, it refutes the popular assumption that interest rates cannot go below zero because a lender would prefer to hold on to its money and receive no return rather than pay someone to borrow the money. This may be true for uncollateralized loans, but a lender may be willing to pay interest if the securities offered as collateral on a loan allow it to meet a delivery obligation. Researchers (D'Avolio 2002; Jones and Lamont 2002) have reported cases of negative interest rates when equity securities are offered as collateral. The events of 2003 show that negative rates can also occur when Treasury securities are offered as collateral. The 2003 episode is also interesting because of the specific circumstances that led to negative interest rates. The option of Treasury market participants to fail on, or postpone, delivery obligations with no explicit penalty usually puts a floor of zero on repo rates. In 2003, however, ancillary costs of failing increased as settlement problems in the May ten-year note persisted. The increased costs ultimately led some participants to agree to negative interest rates on RPs that provided the May note as collateral. Finally, the episode of negative interest rates is interesting because it illustrates how market participants adapt old contract forms to satisfy new needs as economic conditions evolve. In particular, market participants devised "guaranteed-delivery" RPs that allowed for negative interest rates without unduly penalizing a lender of money if a borrower failed to deliver collateral as promised. This edition of Current Issues explores the recent episode of negative interest rates in detail. We begin with a brief review of repurchase agreements. We then describe how market conditions led to an extraordinary volume of settlement fails in the May ten-year note. Finally, we explain how the fails problem became so severe that some market participants chose to lend money at negative rates in order to borrow the note. Repurchase Agreements Repurchase agreements play a crucial role in the efficient allocation of capital in financial markets. They are widely used by dealers to finance their market-making and risk management activities, and they provide a safe and low-cost way for institutional investors to lend funds or securities. The importance of the repo market is suggested by its immense size: dealers with a trading relationship with the Federal Reserve Bank of New York—so-called primary dealers—reported financing $2.41 trillion of fixed-income securities with RPs in August 2003.1 An RP is a sale of securities coupled with an agreement to repurchase the same securities on a later date and is broadly similar to a collateralized loan. As shown in Figure 1, a dealer can borrow $10 million overnight from a corporate treasurer at an interest rate of 3 percent per annum by selling Treasury notes valued at $10,000,000 and simultaneously agreeing to repurchase the same notes the following day for $10,000,833. The payment from the initial sale is the principal amount of the loan; the excess of the repurchase price over the sale price ($833) is the interest on the loan. As with a collateralized loan, the corporate treasurer has possession of the dealer's securities and can sell them if the dealer defaults on its repurchase obligation. General Collateral Repurchase Agreements A general collateral RP is a repurchase agreement in which the lender of funds is willing to accept any of a variety of Treasury and other related securities as collateral. The class of acceptable collateral commonly includes all Treasury securities, but it might be limited to Treasury securities maturing in less than ten years or it might extend to agency issues as well as Treasury securities. The lender is concerned primarily with earning interest on its money and having possession of assets that can be sold quickly in the event of a default by the borrower. Interest rates on overnight general collateral RPs on Treasury securities are usually quite close to rates on overnight loans in the federal funds market. This reflects the essential character of a general collateral RP as a device for borrowing and lending money. Special Collateral Repurchase Agreements A special collateral RP is a repurchase agreement in which the lender of funds designates a particular security as the only acceptable collateral.2 Dealers and others lend money on special collateral RPs in order to borrow specific securities needed to deliver against short sales. A short sale is a sale of securities that the seller does not own and that it has to borrow to make delivery. Dealers sell Treasury securities short in the expectation that prices will be lower in the future, to hedge the risk of other fixed-income securities, and to accommodate customer purchase interests. The interest rate on a special collateral RP is commonly called a "specials" rate. The owner of a Treasury security that a dealer wants to borrow may not have any particular interest in borrowing money, but can nevertheless be induced to lend the security if it is offered an opportunity to borrow money at a specials rate less than the general collateral rate. For example, if the rate on a special collateral RP is 2 percent and the general collateral rate is 3 percent, then—as shown in Figure 2—an investor can earn a 100 basis point spread by borrowing money on the special collateral RP and relending the money on a general collateral RP. The difference between the general collateral rate and the specials rate for a security is a measure of the "specialness" of the security. If the demand to borrow the security is modest relative to the supply available for lending, a dealer borrowing the security will usually be able to lend its money at a rate no lower than about 15 to 25 basis points below the general collateral rate. If the demand to borrow is strong, or if the supply is limited, the specials rate for the security may be materially below the general collateral rate and the specialness spread correspondingly large.3 A Lower Bound on Special Collateral Repo Rates? Interest rates on special collateral RPs nearly always stay above zero because, instead of lending money at a negative interest rate to borrow a particularly scarce issue, a short seller can choose to fail on its delivery obligation. In a "fail," a seller does not deliver the securities it promised to a buyer on the scheduled settlement date and, consequently, does not receive payment for the securities. The convention in the Treasury market is to reschedule delivery for the next day at an unchanged price.4 As detailed in Box 1, the cost of failing is about the same as the cost of borrowing a security on a special collateral RP at an interest rate of zero. It follows that failing is usually preferable to borrowing a security at a negative specials rate. The zero lower bound on specials rates depends on the absence of any costs or penalties for failing other than a delay in the receipt of the invoice price. However, the events of 2003 show that fails can sometimes have significant ancillary costs and that those costs can lead to negative interest rates on special collateral RPs.5 Short Sales and Settlement Fails in the Summer of 2003 Intermediate-term Treasury yields rose sharply during the summer of 2003. Yields on ten-year notes rose from about 3.15 percent in mid-June to 3.50 percent at the end of June and to 4.50 percent in mid-August. The rise led to an extraordinary volume of short sales of the on-the-run (or most recently issued) ten-year note (the 3 5/8 percent note maturing in May 2013) as holders of fixed-income securities sold the note short to hedge against the possibility of further rate increases.6 Demand to borrow the note (to deliver against short sales) expanded commensurately. With the general collateral rate at about 1 1/4 percent until late June, and subsequently at about 1 percent, the specials rate for the ten-year note did not have far to fall before it hit zero. Demand to borrow the note drove the specials rate to within a few basis points of zero by June 23 (Chart 1). The rate hit zero on July 10, after which additional borrowing demand spilled over into settlement fails.7 In the absence of any evidence that interest rates had stopped rising, hedgers maintained their short positions through July. Demand to borrow the ten-year note remained strong and the specials rate for the note remained at zero. The persistence of the specials rate at zero left sellers with little economic incentive to borrow the note to cure their settlement fails. In late July, one market participant commented, "the issue . . . has totally stopped clearing."8 Strategic Fails The fails situation worsened when some market participants realized that they could acquire a free (or nearly free) option to speculate against an increase in the specials rate for the ten-year note by contracting to lend the note against borrowing money at a zero (or near zero) rate of interest for a term of several days or weeks and then intentionallyor strategically—failing to deliver the note. Understanding the nature of this option requires an appreciation of the consequences of failing to settle the starting leg of a repurchase agreement. Market convention holds that if a collateral lender fails to deliver securities on the scheduled starting date of an RP and thus fails to receive funds from its counterparty, it nevertheless owes the counterparty interest on the principal amount of the borrowing for the full term of the RP. The full amount of interest is owed regardless of whether the collateral lender delivers the securities late or not at all. (The repo contract terminates on the originally scheduled closing date even if the securities are delivered late.) Among other things, this convention provides an incentive for the collateral lender to deliver the securities on the scheduled starting date. Consider, however, a trader who does not own the ten-year note but who nevertheless agrees to lend the note over the interval from July 15 to July 29, 2003, against borrowing $10 million at a zero rate of interest. Suppose the trader fails to deliver the note on the scheduled starting date. Regardless of whether the trader delivers the note late or not at all, the trader will not owe its counterparty any interest because the interest rate on the repo contract is zero. Suppose also that the specials rate on the ten-year note for RPs ending July 29 rises to 0.50 percent on July 22. The trader can then borrow the note from July 22 to July 29 against lending $10 million—thereby earning $972 interest [$972 = (7/360) x 5 0.50 percent of $10 million]—and deliver the borrowed note against its original repo contract—thereby borrowing $10 million at a zero rate of interest for the seven days remaining on that contract. The $10 million borrowing funds the trader’s loan of $10 million and the trader makes a net profit of $972. A similar analysis applies if the specials rate is positive but small. For example, if the fourteen-day specials rate for the ten-year note is 0.05 percent, a trader would pay only $194 for the implicit option described in the preceding paragraph [$194 = (14/360) x 5 0.05 percent of $10,000,000]. Ancillary Costs of Fails By early August, dealers were beginning to incur substantial ancillary costs as a result of their fails. Opportunity costs stemming from regulatory capital requirements are one example. The net capital rule of the Securities and Exchange Commission provides that dealers have to maintain additional capital—that is, assets in excess of liabilities—for fails to deliver more than five business days old and for fails to receive more than thirty calendar days old. Additional capital is required because "aged" fails are a source of credit risk. If two parties agree to a securities transaction and the buyer becomes insolvent prior to settlement, the seller will incur a loss if the price of the security has fallen and it has to find a replacement buyer at a lower price. The buyer will incur a loss if the price of the security increases after the trade is negotiated and the seller subsequently becomes insolvent. Capital charges for aged fails soak up capital that would otherwise be available to support profitable risk-taking activities; in this way, they impose opportunity costs on dealers.9 By early August, dealers were also experiencing increased labor costs and deteriorating customer relations. Labor costs rose because dealers were forced to divert back-office personnel from their usual assignments to efforts aimed at reducing the backlog of unsettled trades.10 Customers became unhappy when they did not receive the securities they had purchased, even after long delays. This left them in the position of involuntarily financing dealer short positions and meant that they themselves had nothing to deliver in the event they decided to sell. Negative Specials Rates In the strained environment of early August, some dealers became willing to pay interest on money lent to borrow the ten-year note. They concluded that it would be less expensive to pay interest to borrow the notes needed to remedy their settlement fails than to continue to incur the capital charges, labor costs, and customer dissatisfaction associated with the fails. Loan Fees in the Federal Reserve's Securities Loan Auctions The first indication that the specials market for the ten-year note was undergoing a major change came in the Federal Reserve's securities loan auctions. As described in Box 2, the Fed offers to lend securities that it owns on a daily basis. Dealers who borrow securities from the Fed pay a fee, expressed in percent per annum, which is equivalent to the difference between the rate paid for borrowing money in the general collateral market and the rate earned on lending money in the specials market. When transactions are settling normally, the loan fee that dealers are willing to pay the Fed to borrow a security will not rise above the general collateral rate because the specials rate for the security will not go below zero.11 The average auction loan fee for the ten-year note rose materially above the general collateral rate for the first time on August 5 when it hit 1.25 percent (Chart 2). The general collateral rate was 0.95 percent that day so the implied specials rate for the note was -30 basis points (Chart 3). On August 11, 12, and 13, the loan fee exceeded 1.20 percent and the implied specials rate was less than -20 basis points. Thus, the Fed's loan auctions in the first half of August gave a clear indication of unusual stress in the market for borrowing the ten-year note. That stress eased a bit following issuance of a new ten-year note (the 4 1/4 percent note maturing in August 2013) on August 15. Average auction loan fees for the 3 5/8 percent note moderated to about 1 percent and the implied specials rate rose to about zero. However, at 11 a.m. on September 8, the Treasury Department announced that it would reopen the 4 1/4 percent ten-year note in an auction on September 11. This quashed any hope that it might reopen the 3 5/8 percent note in order to alleviate the fails situation in that note.12 On the same day, the loan fee for the 3 5/8 percent note moved back above the general collateral rate and the implied specials rate fell to -11 basis points. The implied specials rate stayed well below zero through the beginning of October, reaching a low of -146 basis points on September 26. Specials Rates for the 3 5/8 Percent Note Comparing Charts 1 and 3 raises the question of why the specials rate for the 3 5/8 percent note remained at zero when the implied specials rate for the same note in the Fed's loan auctions was well below zero. Part of the answer lies in the difference between the certainty that the Fed will deliver securities following an auction and the likelihood that a private collateral lender would deliver on a loan of the notes. Dealers were willing to pay a premium to borrow from the Fed because the Fed never fails to deliver securities. (As noted in Box 2, the Fed only auctions securities that are actually in its account at the time of an auction.) In contrast, a private collateral lender may fail to deliver securities on a special collateral RP just as a private seller may fail to deliver securities on an outright sale. This was a material risk in the case of the 3 5/8 percent note because, as explained earlier, specials rates at or near zero created an incentive for market participants who did not already own the note to agree to lend it and then intentionally fail to deliver. The absence of any widely accepted convention for how interest payments would be treated in the event of a settlement fail also contributed to the difference between the zero specials rate in the private collateral loan market and the negative implied specials rate in the Fed's collateral auctions. Guaranteed-Delivery Special Collateral RPs with Negative Interest RatesIn mid-September, some dealers began to enter into "guaranteed-delivery" repo contracts for the 3 5/8 percent note at interest rates as low as -3 percent.13 The guarantee of delivery on these contracts was weaker than a contractual commitment that the collateral lender would bear the costs of any damages caused by its failure to make delivery, but it was stronger than the obligation to deliver collateral against a conventional repo contract. Participants in the guaranteed-delivery market had a common understanding that an offering for guaranteed delivery would be made only if the notes were already in the lender's possession and available for settlement. Participants also had a common understanding that a negative rate contract would be canceled if the collateral lender failed to deliver the notes on the scheduled starting date. This precluded the use of guaranteed-delivery contracts as vehicles for speculating against an increase in the specials rate for the notes. Negative rate RPs did not make financing a short position in the 3 5/8 percent notes more expensive than it had been; they merely converted the implicit ancillary costs of failing—including incremental capital charges, higher labor costs, and customer dissatisfaction—into the explicit cost of lending money at a negative rate of interest in order to cure an outstanding fail. Moreover, the negative rates likely provided some additional incentive for holders of the notes to lend their securities. After mid-October 2003, market stresses in the 3 5/8 percent ten-year note gradually eased and dealers began to make progress in reducing their outstanding fails through industry efforts to identify and net offsetting fails among multiple counterparties.14 Bids and offers for the note in guaranteed-delivery RPs at negative interest rates disappeared and the frequency with which the Fed's auction loan fee for the note exceeded the general collateral rate declined. Conclusion From early August to mid-November of 2003, some market participants lent money at negative interest rates to borrow a particular Treasury note. The episode is instructive because it refutes the popular assumption that interest rates cannot go below zero and demonstrates how the collateral value of a security can lead to negative interest rates. The episode also shows that the ancillary costs of failing on an obligation to deliver Treasury securities can sometimes be significant. Finally, the episode shows that market participants will modify old contract forms to meet new needs—demonstrated in this case by the appearance of guaranteed-delivery repo contracts—as economic conditions evolve. comments: --high demand for collateral - Treasury, such as short-sell, can lead to low, even negative, repo rate

Strain in Repo market signal the high demand for Treasury

Rate markets have been so consistently abnormal for so long," said William O'Donnell, rates strategist at UBS Securities in Stamford, Conn., it will take more than liquidity boosters to restore confidence and to put the economy back on track. Last week, rates to borrow Treasurys in the securities repurchase market -- essential to the smooth functioning of the financial system -- turned negative and Treasury bill yields plunged to levels not seen in more than 50 years, signaling strong demand for government debt. Bond prices rise when yields fall. Fails in the repo markets have also risen as it has become uneconomical for investors to return loaned Treasurys. At one point on Thursday, the three-month T-bill repo rate was quoted at -0.2%, and bills to December were seeing bids of -0.25%. These rates typically hover around the target fed-funds rate, which is at 2.25%. Fixed-income markets were closed Friday for the Easter holidays. Given the massive demand for Treasurys, and investors' tight grip on government debt once they've snatched it up, "the Fed adding to the supply mix should help," said Kevin Flanagan, fixed-income strategist at Morgan Stanley Individual Investor Group. At a minimum, the Fed's lending facility should nudge repo market rates higher this week and slow the frenzied buying of T-bills. The facility complements another effort by the Fed to get more liquidity to dealer banks -- the primary dealer credit facility. That allows securities firms to borrow at the discount window, a privilege normally accorded only to regulated financial institutions that take deposits. Also this week, the Fed will conduct March's second Term Auction Facility sale, which auctions funds to banks that take deposits. The auction Tuesday will be the Fed's eighth sale under the program, which was created late last year to address liquidity pressures after banks proved reluctant to tap into the discount window for emergency borrowings. The auction sizes have increased steadily, with the Fed this month offering $100 billion in two auctions. All this liquidity comes as quarter-end -- typically a volatile time for markets -- looms. Investors are normally unwilling to have riskier loans on their books this time of year and hoard the safest possible securities.

Mortgage Rescue Options

Pressure is growing in Washington to help ease the housing crisis. Last week's move by regulators to reduce the amount of surplus capital held by mortgage titans Fannie Mae and Freddie Mac could help make home loans easier to find. But more direct efforts to stem foreclosures seem inevitable. The Federal Reserve's bailout of Bear Stearns may add to the political pressure to do something for homeowners, too. If the government chooses to rescue ailing homeowners, it should aim to keep its costs and legal hassles to a minimum. And any plan should acknowledge that most people want to remain in their homes -- even if their mortgage is worth slightly more than their house. Those who send their keys to the bank -- known as "jingle-mail" -- have serious negative equity in their homes, cash-flow problems or both. If the government can ease pressure on these homeowners' cash flows, there should be fewer foreclosures. Subsize There are options. The federal government could intervene directly, perhaps by subsidizing a temporary half-point reduction in interest rates for every percentage point a mortgage servicer cuts the rate. As government intervention goes, that approach would be fast and relatively efficient. It also would minimize moral hazard -- the reckless behavior of those who don't bear the full consequences of their actions. Refinance into lower-rate loans Other plans are more problematic. Economist Martin Feldstein, for example, proposed that the government refinance those with negative equity on their first mortgages into lower-rate loans. But that doesn't make much sense. Given the choice between walking away from a loan worth more than the value of a house, or replacing the debt with a nondischargeable government obligation for the same amount at a slightly lower rate, few would chose the latter. It would also be an unfair boon to investors in second-lien mortgages. Write off Rep. Barney Frank and Sen. Christopher Dodd take a different approach. The Democrats' closely related proposals would pressure lenders to write off part of the loans held by some two million households. The borrowers would then refinance into as much as $400 billion of new loans, insured by the Federal Housing Administration. Reducing the debt burden on these households would give underwater borrowers an incentive to stay put along with breathing room to make payments. But it isn't clear whether lenders will play along and reduce their loans by 15% of the current value of the homes, as the plan calls for. Buy the debt outright If not, the government might consider another option -- that is, if it wants to go down the route of actually creating equity for homeowners. A lot of the homeowners with 2006- and 2007-vintage adjustable-rate mortgages who are now losing their houses actually have positive equity on their first mortgage. The problem is, they also have second-lien mortgages. If the government were to buy that debt at a steep discount and slash the rates or principal amounts, it would ease borrowers' cash-flow problems and allow them to stay in their homes. The holders of the second-lien debt would probably jump at the opportunity, because, if the houses go into foreclosure, that debt would be worth less than whatever the government offers. Of course, this approach still creates moral hazard. But limiting the plan to those with positive equity on their first mortgages would minimize its total cost. However, it wouldn't be easy. The government would have to vet appraisals carefully to ensure it was dealing with borrowers with positive equity. Also, a lot of the loans are wrapped inside mortgage-backed securities. Pulling loans out of those securities could pit one class of investor against another, and could hurt those who have bet the securities will decline in value. The government would have to craft legislation to allow it to purchase the loans without setting off a firestorm of litigation. But if it succeeded, this approach might be a cheap and effective way to stem the rising tide of foreclosures.

CIT is reeling due to its venture outside its comfortable helm and reliance on securitization for funding

When Jeffrey M. Peek took the helm of CIT Group Inc. in 2004, the company had a reputation as a sleepy, but reliable, lender to small and midsize businesses. Today, CIT is reeling. The situation, some say, has its roots in Mr. Peek's attempts to rejuvenate the New York company. A veteran Wall Street investment banker, Mr. Peek steered CIT into investing heavily in subprime mortgages. It bought a student-loan company. And instead of holding many of its loans on its books, CIT sold them to outside parties. But last week, after ratings firms downgraded its debt, the company lost access to the funding that normally finances its day-to-day operations. CIT had to drain a $7.3 billion backup credit line, igniting fears that the company was headed for bankruptcy court. By selling more of CIT's loans to outsiders, executives figured the company would free up capital that could be used to make new loans. But when loan and securitization markets ground to a halt last year, the strategy came under mounting pressure. In addition to selling its loans, CIT also gets its financing from raising short-term and long-term debt via the capital markets. But, with investors worried about the declining values of lenders' assets, those sources have largely evaporated in recent months. The reliance on securitization "has contributed to the difficulty they are in," says Sean Egan, managing director at Egan-Jones Ratings Co., an independent credit-rating firm. "Because there's very little securitization being done right now, a major issue is whether the company will be successful in raising long-term capital sources." Meanwhile, in 2005, CIT jumped into student loans by purchasing Educational Lending Group Inc. CIT also started making more mortgages to people with weak credit histories. After decades of slow growth, CIT "ventured outside of its comfortable realm and aimed into higher-profit markets," Mr. Hofmann says. "They timed that very badly."

Sunday, March 23, 2008

Fed's Move to ease the concerns in MBS market

Repo The Fed has already announced several initiatives to provide additional liquidity to the MBS market, including expanded, longer-term repo operations in which bond dealers pledge MBS to borrow short-term funds from the Fed. Only MBS backed by the federal government or by the federally-sponsored mortgage agencies Fannie Mae and Freddie Mac can be pledged in such operations. Term Security Lending Facility The Fed has also unveiled a facility to lend dealers up to $200 billion in Treasury bonds, starting March 27, in return for a like amount of both agency-backed and other ("private label") MBS for up to 28 days. Discount Window Finally, on Sunday it announced a new facility under which bond dealers can borrow directly from the Fed's discount window with a wide variety of investment-grade collateral, including agency and private label MBS and corporate bonds. Outright Purchase Some on Wall Street have pressed the Fed to go further and purchase MBS outright. The Fed has the legal authority to purchase agency MBS but not private label MBS. It has been reluctant to do so since that could potentially distort the fundamental prices of such securities. Its recent steps were aimed at averting a crippling aversion by investors to holding any MBS irrespective of their fundamental value. Relex Capital Contraint for Fannie and Freddie The Fed has, however, lent its moral support to other initiatives to boost demand for MBS. Fed Chairman Ben Bernanke has called on Fannie and Freddie to issue additional capital, which would expand their ability to buy or guarantee MBS. He has also called for an expansion of the Federal Housing Administration's authority to guarantee troubled mortgages.

Saturday, March 22, 2008

'Doomsdays' and Bargains in CMBS

Commercial-real-estate debt has rallied after months of declines, but some fund managers are betting that top-quality securities can still be bought on the cheap. Their reasoning: Prices of top-quality commercial-real-estate debt are still at levels that are wildly out of line. Securities are priced at levels that imply default rates could reach 80%, or even 100%, of their underlying loans, they say. Historically, though, the worst period in the commercial-real-estate debt market saw defaults on those bonds reach roughly 31%. While fund managers concede that commercial real estate is entering a slump, they argue that the doomsday scenario reflected in prices of high-quality securities is unwarranted. "The implied losses are so severe that under any reasonable scenario you can't justify these levels," says Angelo Manioudakis, a portfolio manager at OppenheimerFunds. "There is still huge value." The culprit behind the apparent disconnect, mutual-fund managers say, is the scramble by banks and brokerage firms in recent months to hedge against commercial-real-estate loans made by those firms. That protection comes in the form of selling CMBX indexes, which are baskets of credit-default swaps on commercial-real-estate debt. Hedge funds, sensing an opportunity for a quick profit, piled on the selling with bets that the index would fall, further driving the index down. Thanks to this downward pressure on prices, the spread between U.S. Treasurys and the highest rated, triple-A CMBX soared. For the triple-A series 3 index, which tracked debt issued in mid-to-late 2006, the spread jumped as high as 2.70 percentage points from 0.60 percentage point at the start of the year. This in turn has translated into lower prices on actual securities. This past week, however, there was a steep decline in those spreads. The rally began after players took note that the CMBX indexes barely budged during the Bear Stearns turmoil despite the securities firm's exposure to commercial-real-estate debt. That was followed by reassurances from Lehman Brothers Holdings Inc. and Goldman Sachs Group Inc. about the relative health of their mortgage portfolios, as well as the Federal Reserve's steps to lower interest rates. These events sparked a rush by speculative players to buy back their short positions. Meanwhile, longer-term investors were encouraged by the bounce and also began to buy, players say. As a result, the spread on the CMBX Triple-A series 3 index has fallen to around 1.90 percentage points, its lowest level since late February. Nonetheless, that kind of a reading on the triple-A CMBX indexes implies cumulative default rates on the underlying loans of as high as 100%, players say, depending on the assumptions made for recoveries that would follow defaults. "If every commercial-real-estate loan is defaulting...I would consider a more appropriate hedge to be canned goods, ammunition, livestock," jokes Derrick Wulf, a portfolio manager at Dwight Asset Management Co. That implied level of default would "far exceed any experience that we've ever seen, even during the savings-and-loan crisis," he says. That isn't to say that there aren't big potential problems in commercial real estate. "There was a deterioration of [loan] underwriting quality and eventually that has to come to the surface...and we will see some very large loans experiencing a default," says Bryan Whalen, a partner at Metropolitan West Asset Management, which oversees $25 billion. One challenge for investors is that unlike residential-mortgage-backed securities, which are typically backed by hundreds of loans, it isn't unusual to see a single loan make up 10% of a commercial-real-estate-backed security. That leaves bondholders much more vulnerable to even a small percentage of defaults if they happen to own one that goes bad. Despite the compelling value that commercial-mortgage-backed securities offer, the lack of price stability is keeping many investors on the sidelines. The volatility of the CMBX is making it difficult to track the pricing of the bonds, says Sam Davis, a senior managing director at Allstate Investments LLC, part of insurer Allstate Corp., who manages a $7 billion commercial-mortgage-bond portfolio. Still, fund managers say the numbers just don't add up to warrant such low prices. Oppenheimer's Mr. Manioudakis notes that loans underwritten in 2007 -- a year that he says is "commonly believed to be one of the worst underwritten vintages" of loans -- haven't had as many first-year defaults as some prior episodes. Historic Lowe Default Rate in 2008 Still, fund managers say the numbers just don't add up to warrant such low prices. Oppenheimer's Mr. Manioudakis notes that loans underwritten in 2007 -- a year that he says is "commonly believed to be one of the worst underwritten vintages" of loans -- haven't had as many first-year defaults as some prior episodes. The first-year default rates on triple-A-rated 2007 debt has been 0.09%, Mr. Manioudakis says. Meanwhile, the default rate on loans underwritten in 1974 was 7.1% in their first year, and in 1975 the first-year default rate was 3.04%. Even loans underwritten in 1986 -- which would turn out to be the worst vintage of loans in the markets' history with the 31% lifetime default rate -- had a 0.92% default rate its first year, 10 times as high as the 2007 loans, Mr. Manioudakis says. A layer of protection There is another reason that some say triple-A commercial-real-estate debt is a safer bet than market prices indicate: The securities typically offer a layer of protection that isn't contained in residential-real-estate-backed debt. Most triple-A commercial-real-estate securities have a built-in cushion protecting investors from losses of as much as 30% on the underlying loans. Even after defaults, recovery rates on those loans can easily be 65 or 70 cents on the dollar. Fund managers also argue that there is an important difference between the commercial and residential real-estate markets. "If the market value of a [commercial] property declines, the owner isn't going to walk away from the investment if it's still producing positive income," says Dwight's Mr. Wulf, who has been buying top-tier, shorter-term commercial-real-estate debt with maturities of one to two years. Metropolitan West's Mr. Whalen is taking a cautious view of the commercial-real-estate debt market, especially anything outside the high levels of the capital structure. Still, he says, at recent levels "it's very attractive."

Friday, March 21, 2008

LEH Q1 2008

Overall --NI $489 million, $0.81 per share, 57% drop from Q1 2007($1.15 billion, or $1.96), 59% drop from Q4 2007 (886 million, $1.54) --Net Revenue $3.5 billion, 31% drop from Q1 07(5 bil) and 20% drop from Q4 07(4.4 bil) Segments -- only FI capital market suffered --Capital Market: 1.7 bil revenue, 52% decrease from from 3.5 Q1 07. ----FI:0.262 mil, 88% from 2.2 bil Q1 07 ----Equity:1.4 bil, 6% increase from 1.3 bil (drivers prime borkerage and execution service) --IBanking: $867 million, an increase of 2% from $850 million Q1 07 (driver: M&A) --Investment Mg: 968 mil, an increase of 39% from 695 mil. ----Asset Mg: 618 mil, 49% from $416 mil ----Private Wealth Mg: 350 mil from 279 mil, 25% Costs: -- eff cost control, still has more room to cut --Non-interest expenses $2.8 billion, $3.3 billion Q1 2007 and $3.2 Q4 2007. --Compensation and benefits as a percentage of net revenues was 52.5%, 49.3% Q1 and Q4 2007. Liquidity and Funding -- shfit to long term funding --liquidity pool of $34 billion Q1 08. other unencumbered assets of $64 billion and our regulated entities had unencumbered assets of $99 billion. --Our policy is to operate with an excess of long-term funding sources over our long-term funding requirements (“cash capital surplus”). We seek to maintain a cash capital surplus at Holdings of at least $2.0 billion. As of November 30, 2007, our cash capital surplus at Holdings increased to $8.0 billion, up from $6.0 billion at November 30, 2006. --Long-term borrowings (less current portion) increased to $123.2 billion at November 30, 2007, up from $81.2 billion at November 30..(50% increase) Asset Quality -- appropriate hedge --Mortgage: Gross writedown 3 bil, but net bil 0.6 bil, remaining exposure 31.8 bil ----Prime and Alt-A: 14.6 bil --CMBS: gross writedown 1.1 bil (3%), net 0.7 bil, $36.1 bil --Leveraged Financing: writeoff 0.7(3%), net 0.7, exp 28.7(70% high yield) --

One case of Repo deal

4.5 Tril market size: The over-the-counter repo market is now one of the largest and most active sectors in the US money market. Repos are widely used for investing surplus funds short term, or for borrowing short term against collateral. Dealers in securities use repos to manage their liquidity, finance their inventories, and speculate in various ways. The Fed uses repos to manage the aggregate reserves of the banking system. What are Repos? Repos, short for repurchase agreements, are contracts for the sale and future repurchase of a financial asset, most often Treasury securities. On the termination date, the seller repurchases the asset at the same price at which he sold it, and pays interest for the use of the funds. Although legally a sequential pair of sales, in effect a repo is a short-term interest-bearing loan against collateral. The annualized rate of interest paid on the loan is known as the repo rate. Repos can be of any duration but are most commonly overnight loans. Repos for longer than overnight are known as term repos. There are also open repos that can be terminated by either side on a day’s notice. In common parlance, the seller of securities does a repo and the lender of funds does a reverse. Because money is the more liquid asset, the lender normally receives a margin on the collateral, meaning it is priced below market value, usually by 2 to 5 percent depending on maturity. The overnight repo rate normally runs slightly below the Fed funds rate for two reasons: First a repo transaction is a secured loan, whereas the sale of Fed funds is an unsecured loan. Second, many who can invest in repos cannot sell Fed funds. Even though the return is modest, overnight lending in the repo market offers several advantages to investors. By rolling overnight repos, they can keep surplus funds invested without losing liquidity or incurring price risk. They also incur very little credit risk because the collateral is always high grade paper. Repos are not for Small Investors The largest users of repos and reverses are the dealers in government securities. As of August 2006 there were 23 primary dealers recognized by the Fed, which means they were authorized to bid on newly-issued Treasury securities for resale in the market. Primary dealers must be well-capitalized, and often deal in hundred million dollar chunks. In addition there are several hundred dealers who buy and sell Treasury securities in the secondary market and do repos and reverses in at least one million dollar chunks. The balance sheet of a government securities dealer is highly leveraged, with assets typically 50 to 100 times its own capital. To finance the inventory, there is a need to obtain repo money in large amounts on a continuing basis. Big suppliers of repo money are money funds, large corporations, state and local governments, and foreign central banks. Generally the alternative of investing in securities that mature in a few months is not attractive by comparison. Even 3-month Treasury bills normally yield less than overnight repos. Clearing Banks and Dealer Loans A securities dealer must have an account at a clearing bank to settle his trades. For example, suppose ABC company has $20 million to invest short term. After negotiating the terms with the dealer, ABC has its bank wire $20 million to the clearing bank. On receipt, the clearing bank recovers the funds it loaned the dealer to acquire the securities being sold, plus interest due on the loan. It then transfers the sold securities to a special custodial account in the name of ABC. Since government securities exist as book entries on a computer, this is a trivial operation. The next morning the dealer repurchases the securities from ABC, pays the overnight interest on the repo, and regains possession of the securities. Assuming a 5% repo rate, the interest due on the $20 million overnight loan would be $2,777.78, which is based on a 360-day year. If both parties agree, the repo could be rolled over instead of paid off, thus providing another day of funds for the dealer and another day of interest for ABC. If the dealer is short on funds needed to repurchase the securities, the clearing bank will advance them with little or no interest if repaid the same day. Otherwise the bank will charge the dealer interest on the loan and hold the securities as collateral until payment is made. Since dealer loans typically run at least 25 basis points above the Fed funds rate, dealers try to finance as much as they can by borrowing through repos. By rolling over repos day by day, the dealer can finance most of his inventory without resorting to dealer loans. It is sometimes advantageous to repo for a longer period, using a term repo to minimize transaction costs. Clearing banks charge a fee for executing dealer transactions. They prefer not to issue large dealer loans because it ties up the bank’s own reserves at little profit. In truth, there is not enough capacity in all of the clearing banks in New York to provide dealer loans sufficient to cover the financing needs of the large securities dealers comments: will repo rate impact a dealer's liquidity 2.what is the dynamics of repo rate when underlying collateral, like Treasury, is in high demand, dealers will lower repo rate, disencouraging money leader to take awsy collateral. Why? not cash