We warned earlier that if conditions deteriorated in the financial markets, investment banks were particularly exposed by virtue of their taking on multiple exposures to the same underlying risk. For example, they lend to hedge funds via their prime brokerage operations, and also may be exposed to them by providing credit default swaps on assets they hold or providing customized derivatives.
Investors have awakened and realized that the unwinding of leverage represents not merely reduced profit opportunities for Wall Street, but is leading to significant losses on credit market positions which could reach a level that damages their equity bases. Prices of securities firm stocks and bonds have fallen sharply, and credit default swaps have spiked up to record levels.
If the credit contraction were to accelerate, the investment banks are the weak links in the financial system. In previous recessions, banks were still bigger players in aggregate in financial intermediation. When they engaged in profligate lending, such as doggy LBOs and lousy real estate deals in the late 1980s and took significant losses, the damage to their capital bases forced them to curtail lending, which produced a nasty recession.
This time around, investment banks are the dominant players in financial intermediation. In particular, a Bank of England report on financial stability singled out 13 “large complex financial institutions” such as Barclays, Goldman, Merrill, and UBS, as key players in global financial intermediation and that their concentrated risk exposure represented a source of systemic risk.
The risk of owning bonds of Wall Street firms soared and their stocks plunged as concerns escalated that investment banks will be hurt by losses from subprime mortgages and corporate debt.
Credit-default swaps on $10 million of Goldman Sachs Group Inc. bonds jumped as much as $18,000 to a record $85,000, according to broker Phoenix Partners Group in New York. Bear Stearns Cos. credit swaps surged as much as $29,000 to $110,000, also a new high. Lehman Brothers Holdings Inc. climbed as much as $24,000 to $104,000. Goldman shares declined as much as 4.7 percent, Bear Stearns fell 5.9 percent and Lehman dropped 5 percent.
“You have a stampede of the animals away from the watering hole,” said Scott MacDonald, director of research at Aladdin Capital Management in Stamford, Connecticut, which manages about $20 billion in assets. “Right now, everything that smacks of financial risk is backing out through the door.”
Risk premiums surged and stocks dropped after Absolute Capital Group Ltd., an Australian hedge fund, suspended withdrawals from two funds after forecasting losses on U.S. subprime mortgages. The credit swaps extended increases from yesterday when banks including Goldman were stuck with $20 billion in loans they couldn’t sell to finance buyouts of Auburn Hills, Michigan-based automaker Chrysler and Europe’s Alliance Boots Plc.
An increase in the credit-default swaps, which are five-year contracts used to bet on the companies’ creditworthiness, signals deterioration in investor confidence.
That confidence has been sapped after slumping demand for high-yield, high-risk debt forced almost 40 companies to rework or abandon bond offerings in the past three weeks, leaving banks holding at least $32 billion of risky debt on their own books. The decline threatens to bring an end to a record run for leveraged buyouts, which surged to a total $690.4 billion of deals this year, spelling a slide in advisory and underwriting fees.
The rising risk perceptions of brokers extended to stock indexes as well as those gauging the risk of owning everything from bank loans to subprime mortgages.
The AMEX Securities Broker/Dealer Index of 12 brokers dropped 4.5 percent, the biggest one-day decline since March, while an index allowing investors to bet on the U.S. leveraged loan market fell to its lowest since it began trading two months ago. Benchmarks gauging the risk of owning investment-grade corporate bonds in the U.S. and Europe had their worst day on record. An ABX index tracking default risk on the safest subprime bonds fell to its lowest ever.
“Investors are less risk tolerant,” said Camilla Petersen, an analyst at Atlantic Equities LLP in London who covers U.S. banks and securities firms. For the brokers, that means underwriting of leveraged loans and high-yield bonds may slow, she said. “It’s not a credit issue right now, because corporations aren’t defaulting on their debt. It’s more of a volume issue.”
Goldman Sachs analysts today took Merrill’s stock off their “conviction buy list,” saying in a note that “concerns about LBO activity and subprime/CDO exposure have pressured the stocks.” Future risks include “a prolonged slowdown in global equity markets, further widening of credit spreads or a decline in global GDP growth.”
Shares of New York-based Merrill tumbled $3.92 to a 10-month low of $74.18 as of 12:42 p.m. in New York Stock Exchange composite trading. Credit swaps on Merrill bonds rose as much as $28,000 to $90,000, the highest since October 2002, Phoenix prices show.
“Investors are jittery,” Petersen said. “So as soon as you get any prominent broker or analyst lowering their price target or downgrading the stock or pulling it off the conviction buy list, it’s just going to be sold down exponentially more than it would under normal market conditions.”
Credit swaps on New York-based JPMorgan Chase & Co., which is helping finance both the Chrysler and Boots deals, rose as much as $25,000 to $75,000, Phoenix prices show. JPMorgan shares dropped $1.52, or 3.4 percent, to $43.75.
The CDX North America Investment Grade Index, tracking the credit risk of 125 U.S. investment-grade companies, rose as much as $10,250 to $67,000 in New York, according to Deutsche Bank AG.
In Europe, the benchmark iTraxx Crossover Index of 50 European companies rose 40,000 euros to 404,000 euros, according to JPMorgan. The iTraxx Investment Grade index, comprised of 125 companies, rose 8,250 euros to 44,250 euros.
Default swaps on Deutsche Bank, Germany’s biggest bank, rose as much as 12,000 euros to 38,000 euros, according to Royal Bank of Scotland, from about 15,000 euros at the beginning of the month.
Deutsche Bank was one of eight banks stuck with 5 billion pounds ($10 billion) of loans for Kohlberg Kravis Roberts & Co.’s purchase of pharmacy chain Alliance Boots.
The LCDX index, tied to the speculative-grade loans of 100 companies, dropped to its lowest since it started trading May 22, signaling an erosion of confidence in that market. It fell 0.9 to 93.7, according to Goldman prices.
The CDX North America High-Yield Index, a gauge of U.S. junk-bond risk that falls as confidence erodes, dropped 0.94 to 91.94, according to Phoenix. The price implies it costs about $498,000 to protect $10 million in junk bonds, up from $471,000 yesterday and approaching a record $517,000 in May 2005, according to a JPMorgan pricing model and Credit Suisse Group data.
Delinquencies on subprime mortgages underlying benchmark derivatives indexes accelerated in June, increasing the chances that the bonds will default, reports yesterday showed.
Hedge funds run by at least seven firms reported or forecast losses after the rout in securities backed by subprime mortgages, some of which have lost at least half their value as defaults among the riskiest borrowers rise.
The ABX index tied to 20 subprime mortgage bonds rated AAA and created in the second half of last year dropped about 0.4 percent to about 94.13, according to a Goldman Sachs note to clients. The index has dropped 5 percent this month, suggesting a similar decline in the value of top-rated subprime mortgage bonds. Those bonds hadn’t lost much value until this month.
The 10-year interest-rate swap spread, a gauge of what companies pay over benchmark lending rates, rose to 74.2 basis points, the highest since February 2002.