Oh, how the mighty are fallen…
Some of the biggest securities firms’ own debt instruments are now trading as if they were five grades below their current S&P and Moody’s ratings. It’s pretty common when the credit quality of a company is deteriorating that the markets will mark it down before the rating agencies can change their rating. But this fast a move, and large a divergence, is unusual, to say the least. However, the perception of weakness does vary by type of instrument. The credit default swap pricing is giving the worst reading on the firms. The prices of their bonds are trading only one rating category below the formal rating.
Note we commented earlier on Goldman and Merrill acquiring failed subprime mortgage originators, wondering if they were trying to catch a falling safe. But the main issue here isn’t those acquisitions per se, but their broader exposure to the collateralized debt obligation market. Although the degree of disclosure varies by firm, each retains a portion of the deals that it packaged into CDOs. Their exposure, as a percentage of “tangible equity” is “in the low to mid-teens” at most of these firms. That’s a fairly big exposure, given that this stuff is (likely) volatile.
From a Bloomberg story, “Goldman, Morgan Stanley Almost `Junk,’ Their Own Traders Say.”
Goldman Sachs Group Inc., Merrill Lynch & Co. and Morgan Stanley, which earned a record $24.5 billion in 2006, suddenly have become so speculative that their own traders are valuing the three biggest securities firms as barely more creditworthy than junk bonds.
Prices for the contracts linked to the bonds of the New York investment banks this week traded at levels that equate to credit ratings of Baa2, according to Moody’s Investors Service. For Goldman, Morgan Stanley and Merrill Lynch & Co., that’s five levels below the actual Aa3 rating on their senior unsecured notes and two steps above non-investment grade, or junk.
Traders of credit derivatives are more alarmed than stock and bond investors that a slowdown in housing and the global equity market rout have hurt the firms. Merrill since 2005 has financed two mortgage lenders that subsequently failed and purchased a third, First Franklin Financial Corp., for $1.3 billion.
“These guys have made a lot of money securitizing mortgages over the years in a mortgage boom time,” said Richard Hofmann, an analyst at bond research firm CreditSights Inc. in New York. “The question now is what is the exposure to credit risk and what are the potential revenue headwinds if they’re not able to keep that securitization machine humming along.”
Credit-default swaps on the debt of Goldman, the world’s biggest securities firm, have risen to $32,775 per $10 million in bonds, up from $21,500 at the start of the year, according to prices compiled by London-based CMA Datavision. The price touched $35,000 on Feb. 28, the highest since June 2005….
Morgan Stanley and Goldman were among the top five traders of credit-default swaps in 2005, a group that represented 86 percent of the market, according to a September Fitch Ratings report. Lehman, Merrill and Bear Stearns were among the top 12.
Credit-default swaps that trade at such wide gaps below actual ratings tend to rally, said David Munves, director of Moody’s credit strategy research group.
The contracts were conceived by Wall Street to protect bondholders against default and pay the buyer face value in exchange for the underlying securities should the company fail to adhere to debt agreements. An increase in price indicates a decline in the perception of creditworthiness; a drop means the opposite.
Contracts tied to Morgan Stanley, Merrill, Lehman Brothers Holdings Inc. and Bear Stearns Cos. also are at 19-month highs.
Morgan Stanley credit swaps have risen $10,000 to $32,775 this year, CMA data show. Contracts on Merrill jumped to $33,000 from $16,500. For Lehman, they are up $12,440 to $34,440, and the swaps on Bear Stearns have climbed to $33,830 from $21,750.
Lehman, Bear Stearns
The increases were larger than an index that measures credit risk for investment-grade companies in North America. The cost of protecting $10 million in debt included in the Dow Jones CDX North America Investment Grade Index has risen $1,250 to $34,750 this year, according to Deutsche Bank AG prices.
Lehman and Bear Stearns credit swaps traded as if their debt were rated four levels lower than their A1 rankings. High-yield, high-risk notes, or junk bonds, are rated below Baa3 at Moody’s and lower than BBB- at Standard & Poor’s.
Credit-default swap investors are more bearish than bondholders, data from Moody’s Market Implied Ratings service shows. As of Feb. 28, the bonds of Goldman and Morgan Stanley were trading as if the debt were rated a step below Moody’s official rating. Goldman Sachs has $171.6 billion in bonds outstanding, according to data compiled by Bloomberg. Morgan Stanley has $168.5 billion.
Higher Rates
Subprime mortgages, loans taken out by homebuyers with poor or limited credit histories, typically charge rates at least two or three percentage points above safer, so-called prime loans. They made up about a fifth of all new mortgages last year, according to the Washington-based Mortgage Bankers Association.
At least 20 lenders have shut down, scaled back or been sold this year. Countrywide Financial Corp., the biggest U.S. mortgage lender, yesterday said borrowers were at least 30 days past due at the end of last year on almost a fifth of the subprime loans that it serviced for others….
Merrill equity analysts two days ago cut their recommendations on Goldman, Lehman and Bear Stearns shares as well as that of European banks Deutsche Bank and Credit Suisse Group to “neutral” from `”buy” because they said earnings will probably decline next month as investors become wary.
Bear Stearns’s stake in non-investment grade retained mortgage securities, or what its keeps from packaging loans into bonds, represents about 13 percent of the firm’s “tangible” equity, according to CreditSights.
For Lehman, it’s 11 percent. Goldman, Morgan Stanley and Merrill don’t disclose how much of their total retained securities are rated below investment grade, or junk. Overall, their exposure is in “the low- to mid-teens,” CreditSights said.
“Disclosures are kind of lacking,” Hofmann at CreditSights said in an interview. “They don’t tend to break out the subprime piece of their retained interest.”
Mortgage Bonds
Losses also may come from the banks’ trading in mortgage bonds and derivatives tied to them, the firm said. An index of derivatives based on 20 mortgage securities rated BBB- and created in the second half of last year has fallen by more than a third since last month.
Companies with similar gaps between their actual rankings and ratings implied by credit-default swap levels have outperformed their peers 87 percent of the time over a one-year horizon, he said. Because an active credit swaps market has existed for less than a decade, that percentage is based on only 37 observations, Munves at Moody’s said.
At the same time, the same companies had an above-average risk of being downgraded, with about 22 percent of them having their ratings cut, he said.
