Credit Default Swaps Put Goldman, Merrill, Lehman and Bear at Junk Levels

Credit default swaps prices have risen sharply all over the globe. Nevertheless, the CDS related to the debt of major Wall Street players have been particularly hard hit, which isn’t surprising, given their LBO financing commitments, exposure to hedge funds via their prime brokerage operations, and falling profitability. Some experts, however, think the CDS are oversold and represent a buying opportunity.

From Bloomberg:

On Wall Street, Bear Stearns Cos., Lehman Brothers Holdings Inc., Merrill Lynch & Co. and Goldman Sachs Group Inc., are as good as junk.

Bonds of U.S. investment banks lost about $1.5 billion of their face value this month as the risk of owning the securities increased the most since at least October 2004, according to Merrill indexes. Prices of credit-default swaps based on the debt imply that their credit ratings are below investment grade, data compiled by Moody’s Investors Service show.

The highest level of defaults in 10 years on subprime mortgages and a $33 billion pileup of unsold bonds and loans for funding acquisitions are driving investors away from debt of the New York-based securities firms. Concerns about credit quality may get worse because banks promised to provide $300 billion in debt for leveraged buyouts announced this year.

“The market is being driven by fear,” said Mark Kiesel, who oversees $80 billion of corporate debt at Newport Beach, California-based Pacific Investment Management Co., manager of the world’s biggest bond fund.

Credit-default swaps tied to $10 million of bonds sold by Bear Stearns, the second-largest underwriter of mortgage bonds, rose to about $110,000 on July 27, from $30,000 at the start of June, indicating growing investor concerns.

The contracts, financial instruments based on bonds and used to speculate on the chances of default, imply a rating of Ba1, one level below investment grade and six lower than Bear Stearns’ A1 ranking, according to New York-based Moody’s.

`Wall of Worry’

Prices of credit-default swaps for Goldman, the biggest investment bank by market value, Merrill, the third largest, and Lehman, the No. 1 mortgage bond underwriter, also equate to a Ba1 rating, data from Moody’s credit strategy group show. Bonds of New York-based Goldman and Merrill are rated Aa3, seven levels higher than swaps suggest. Lehman is rated A1, the same as Bear Stearns.

About 1 percent of the thousands of companies followed by Moody’s have a gap of more than five levels between their actual and implied rankings, analyst Tony Smith said in a July 19 report titled “Broker Securities Climb a Wall of Worry.”

Spokesmen for the firms declined to comment or didn’t return phone calls. High-yield, or junk, bonds are rated below Baa3 by Moody’s and BBB- by Standard & Poor’s.

Credit-default swaps are the fastest-growing part of the derivatives market. Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates.

Losing Value

Investment-grade bonds of brokerage firms lost 0.47 percent on average since June, while securities with similar ratings returned 0.19 percent, according to Merrill indexes. Finance companies are the biggest part of the corporate bond market, accounting for 40 percent of the $2 trillion of debt outstanding, according to New York-based Morgan Stanley, the second-biggest investment bank by market value.

Investors demand an extra 1.25 percentage points in yield to own the bonds of brokers instead of Treasuries, up from a low of 0.64 percentage point on Jan. 29. The wider spread represents an extra $6 million in annual interest for every $1 billion they borrow.

Lehman sold $1.5 billion of 6 percent notes due in 2012 earlier this month at a price to yield 1 percentage point more than Treasuries with a similar maturity. The company sold five- year debt with a 0.62-percentage-point spread on Jan. 9.

The difference adds up to $5.7 million a year in extra interest. The price of the new securities fell to 99.8 cents on the dollar to yield 1.38 percentage points more than Treasuries yesterday, according to Trace, the bond-price reporting system of the NASD.

Skittish Investors

Investors grew more skittish about the credit markets this month as mortgage defaults increased and at least 40 bond and loan sales faltered. U.S. foreclosures rose 58 percent in the first half of 2007 from a year earlier, as more homeowners fell behind on payments, according to a report yesterday by RealtyTrac Inc., an Irvine, California-based seller of foreclosure data.

Concerns escalated last week after banks including Goldman, Bear Stearns and New York-based JPMorgan Chase & Co., the No. 3 U.S. bank, were left holding $10 billion of loans they provided for the buyout of Chrysler, a unit of Stuttgart, Germany-based DaimlerChrysler AG, by Cerberus Capital Management LP in New York.

JPMorgan was among at least eight banks holding about $10 billion of loans for Nottingham-based Alliance Boots Plc, the U.K.’s biggest pharmacy chain being purchased by Kohlberg Kravis Roberts & Co.

Fewer Cylinders

Financing leveraged buyouts and bundling subprime mortgages and bonds into other securities called collateralized debt obligations generated about $21 billion in fees last year, data compiled by Freeman & Co., Thomson Financial and JPMorgan Chase show.

“The brokers were hitting on all cylinders,” said Chuck Moon, who manages $30 billion as head of investment grade credit at Hartford, Connecticut-based Hartford Investment Management Co. “Now there are a couple of cylinders in question.”

Bond and credit-default swap prices suggest Wall Street firms are no safer for debt investors than companies teetering on the edge of investment grade, including mining company Freeport-McMoRan Copper & Gold Inc. in Phoenix and Stamford, Connecticut-based copy machine maker Xerox Corp.

Credit-default swaps tied to $10 million of Freeport’s bonds cost about $115,000 and those linked to Xerox’s debt trade at $96,000, according to CMA Datavision. Xerox bonds are rated Baa3 by Moody’s and BBB- by S&P. Freeport’s are ranked Ba3 by Moody’s and BB+ by S&P.

Pimco Buys

That may be a signal to buy, said Moon. Bonds of brokers are “attractive” because yields have widened so much compared with Treasuries, he said, declining to comment on whether he’s adding them.

The growth in credit-default swaps allows finance companies to hedge more of their risks than a decade ago, Moon said. “I don’t think it’s a disaster because, quite frankly, the institutions have become more sophisticated about their risk management practices.”

Pimco bought bonds of banks and brokers in the past two weeks, expecting them to sustain earnings growth and benefit from global mergers and acquisitions, Kiesel said. Profits at Bear Stearns will rise to $14.53 a share this year and $15.66 in 2008 from $14.27 in 2006, according to the average estimate in a Bloomberg survey of 16 analysts.

Reasons to Buy

Merrill’s MOVE Index, a measure of expectations for Treasury volatility, reached 92.6 on July 26, up from a low this year of 51.2 on May 15. Merrill reported a 31 percent rise in second-quarter profit on July 17, while Lehman’s earnings rose 27 percent to a record.

“We have been adding, I wouldn’t say we’ve been power- lifting,” Kiesel said. “You want to leave some powder dry as you’ve got an unprecedented amount of high-yield supply that’s hitting the market. That’s a train coming down the tracks. So stepping in front of that takes some guts.”

Banks have agreed to provide bonds and loans for buyouts including the $25.6 billion takeover of Greenwood Village, Colorado-based credit-card processor First Data Corp. and the $45 billion acquisition of energy company TXU Corp. of Dallas. If they can’t find investors for the debt, the banks may have to provide it themselves.

Pimco is still “underweight” in corporate debt, meaning it owns a smaller percentage than is contained in their benchmark index. The firm is a unit of Frankfurt-based insurer Allianz SE.

Marking Down

Bear Stearns analyst Ian Jaffe raised his recommendation on broker debt to “overweight” from “underweight” on July 13 because risk premiums increased and the economy is growing. Jaffe, who is based in New York, declined to comment.

CreditSights Inc., an independent bond-research firm in New York, also says investors should buy broker bonds.

“We’ve been probably the earliest and biggest critics of the brokers for the proprietary trading risks they’re taking and the private-equity lending,” said David Hendler, the head financial services analyst at CreditSights. “We’re saying the fear and spreads don’t make sense.”

Banks face losses from acquisition-related debt because they typically sell the bonds and loans later at a discount. Treasury Secretary Henry Paulson, a former Goldman chairman and chief executive officer, described the credit markets decline as a “wakeup call” for banks in a July 26 interview.

`Got a Problem’

“They’ve got a problem,” said Daniel Fuss, vice chairman of Loomis Sayles & Co. in Boston, which manages $22 billion in bonds. “It’s pretty bad. They’re going to have to go back to the private-equity people” to renegotiate their lending commitments, he said.

The perception of the risk on Bear Stearns bonds has risen more than its competitors on concerns that a decline in new securities backed by home loans will reduce earnings. Sales of mortgage bonds may tumble by a third to $556 billion in the second half of this year compared with the first six months, Lehman debt strategists said in a July 30 report.

Bear Stearns last month was forced to extend $1.6 billion in credit to one of two hedge funds that collapsed from bad bets on securities backed by mortgages to people with poor or limited credit.

“You’re getting paid for their concentrated exposure to mortgage risk,” CreditSight’s Hendler said. “A lot of investors are trying to gauge subprime risk and how it affects their direct exposures. There is a lot of negative, fearful behavior.”

Credit-default swaps tied to $10 million in bonds of Goldman Sachs, the world’s most profitable securities firm, rose as much as $26,000 to a record $105,000 on July 27, according to broker Phoenix Partners Group in New York. The default swaps traded at $81,000 yesterday.

“Fundamental credit research does not mean anything at all in this environment,” said Scott MacDonald, director of research at Aladdin Capital Management in Stamford, Connecticut. “People are just trying to get out of the way.”

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2 comments

  1. "Cassandra"

    one wonders whether or not IF GS had remained a partnership that their market behaviour & risk-appetite would have more mirrored that of a “principal” rather than that of “an agent”, the latter meaning being entirely in the pejorative.

  2. Yves Smith

    Cassandra,

    I was at Goldman many years ago, while it was still a partnership. While the firm had a big risk arb operation (Rubin once headed it), it was otherwise very chary of taking risk, and not merely trading risk. Even very junior people were made aware of where contractual and other risks lay, and the firm would not budge from its standard contractual provisions (the only exception was clients that had grandfathered language). Similarly, any new corporate or institutional client relationships had to be approved by the management committee.

    The Goldman of today bears perilous little relationship to the firm in its partnership days.

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