C.M.O. 3.31.2009

Credit Market Overview
March 31, 2009

This morning the U.S. Department of Agriculture issues its spring-plantings report. This will provide a window into the planting plans of the nation’s farmers. The major choices here, given the concurrent growing seasons, are corn and soybeans. The major factor, this year at least, is cost.

Producing high bushel per acre numbers when growing corn requires more fertilizer, also known as Anhydrous, than growing soybeans. For the City Mouses among us that might not mean much but the Country Mices know that NH-3 is one of the key factors in the cost per acre of things grown (you still have to run the tractor and harvester over the same ground regardless of what you plant) and hence is a major contributor/detractor of profit margins.

With things as tight as they are all over these days the farmers are going to be keeping a watchful eye on costs. The other side of coin, however, is what they can get for what they’ve grown once they’ve grown it. Soybeans traded as high as $9.1475 a bushel (basis December) last week up 10.5% recently but have been trounced by Corn’s 14% gain moving from $3.0825 on March 2nd to $4.3475 last week.

The early estimates for today’s report are show that farmers will probably increase the acreage devoted to soybeans by about 3.5MM and reduce corn’s acreage by about 1.5MM.

This might be seen by some as the simple forces of supply and demand at work but even with the demand for gasoline down the federally mandated amount of ethanol that needs to be produced is higher for 2009 than it was in 2008 therefore taking more of what ever corn is produced off the market. (We will leave alone for the moment the disaster that the whole ethanol initiative has been in the United States.)

The point in bringing this up this morning is inflation. “Beans” as they are affectionately called by those who grow them might be cheaper to put in the ground but corn is what is used by the food industry. Lower acreage numbers and a higher ethanol requirement will push prices for the corn that remains up which will force the Kellogg’s and General Mills of the world to pass through the cost increases or suffer lower margins.

The rumbling surrounding inflation due to the amount of money the Fed is pumping into the system is already growing. The counter to this, some say, is that the length and depth of the recession is more likely to cause deflation. That debate will only be decided in hindsight.

It does seem logical that lower supply and equal to higher demand could put some upward pressure on corn prices. How that ripples through the economy raises, once again, the specter of “unintended consequences”.

Enjoy the week.

Jim Delaney

C.M.O. 3.30.2009

Credit Market Overview
March 30, 2009

When success depends on repeating a specific function with precision, minor variations in execution can wreak havoc with performance. Brain surgery, sports, and trading all come to mind. While trading is the least physical of the three, keeping one’s mind in the game is just as important when making split second decisions as it is when trying to hit the high inside fastball. When things are not going right, the place we are most often told to go is “back to the basics”, that is of course, when it’s not “to the locker room”.

Going back to the basics with regard to our current two outs in the bottom of the ninth, bases loaded, down by 3 runs, full count situation means looking for improvement in the two things that got us here. While I’m open for suggestion my candidates would be housing and the banks. Since the question of which came first is similar to the age old dilemma between the chicken and the egg I’m going with housing today.

There was recent news from Mountain House, CA of improvement in the home prices of that 2,600 unit master planned community which was followed by the announcement of a +5.1% MoM change in Existing Home Sales by the National Association of Realtors vs. an expected decrease of -0.9%.

Also of late, the Federal Housing Finance Agency reported that house prices rose 1.7% from December to January while the NAR’s Affordability Index (173.5 preliminary for February) is now 67% off its lows for this cycle and 52% above its 1991 year-end level after the 1990-1991 recession.

This was followed Friday by KB Homes’ (KBH) announcement of a “sharply” narrowed first quarter loss aided by fewer right downs and a 26% rise in net orders; the latter a result of reductions in cancellations. (Now before my perma-bear friends accuse me of going soft, I’m just talking about the news being less bad, not good, just less bad.)

The key to KBH’s recent success it seems is that they have been offering smaller, more affordable homes as a way to stay in the game while foreclosure sales push prices to bargain basement levels. “Homes must change with the times,” President and CEO Jeffrey Meager said in a recent earnings call adding that the “revamped” models will account for 50% of deliveries by year end.

Individual business strategy is a good way to differentiate yourself from your peers but it never hurts to fly with a tailwind and that extra push is being supplied by none other than Ben & Co. at the Federal Reserve. “The Federal Reserve’s announcement that it intends to purchase Treasury securities over the next six months caused bond yields to drop and mortgage rates followed.” Frank Nothaft, FRE CEO said recently.

“Rates for 30-year fixed mortgages peaked last year at 6.63% on July 24.” He continued, “With the most recent average 30-year fixed-rate mortgage, the interest rate difference is almost two percentage points; which amounts to a savings of about $225 in monthly mortgage payments for a $200,000 loan.” N.B. The average 30-year fixed-rate mortgage for the week ended 3/26/2009 was 4.85%, the lowest since FRE’s weekly survey began in 1971.

Take heart perma-bears, all is not, as the song goes; Sunshine, Lollipops and Rainbows. First there is the question of what happens if the recent improvements in housing turn out to be temporary. Peter Eavis reported in the WSJ that “policy makers fear that another downturn in housing prices could trigger a correlative increase in defaults, increasing foreclosures and forcing prices down even further”.

There is also the question of whether people are willing to take on new mortgages when the current raison d’être is to de-lever. During the ‘90-‘91 recession, personal disposable income covered 114% of household liabilities; that number was just 75% at the end of last year.

The other fly in the ointment is the jobs outlook. With non-farm payrolls decreasing by 650,000+ in February and a total of 12.5 million people out of work, not counting the “under-employed” we hear so much about, the propensity for even those with jobs to incur major expenses continues to ebb.

Data on delinquencies is not going in the right direction either. It appears defaults are now rising on loans made prior to 2006 when lending standards deteriorated quicker than good intentions at last call. First American CoreLogic reports that in January of this year Alt-A loans made in 2005 defaulted at a 4.2% rate up from 0.64% in January ’08. FACL also said that prime mortgages that didn’t qualify for FNM or FRE purchase were defaulting at a 0.56% rate vs. 0.07% in the same period a year ago.

The road ahead could also prove bumpy for KBH and other builders as the well of previously paid taxes begins to run dry. Loss-making companies can collect refunds on tax payments made over the previous two years. KBH is estimating a $220MM refund on that basis this year. Next year however, the refund bucket comes up with nary a drop.

Another builder, DHI, is expecting $677MM this fiscal year based on previously paid taxes and was lucky(?) enough to have paid taxes in 2007 so it will be in line for a similar albeit smaller refund next year. Beyond that only an improving economy can provide the foundation for profits.

Bringing this all back to the correlation between credit and equity; KBH’s stock price bounced off of the $8.00 level first set in November of 2008, in early March of this year and has since risen to $15.05, its closing price last Friday. The CDS market had not given a clear confirmation of that buy signal as CDS levels on KBH actually rose from 3/3/2009-3/9/2009 as the stock moved off the $8.00 support. The CDS price fell from 3/9/2009-3/18/2009 but leveled off before rising again on 3/23/2009.

The CEC Strategy requires consistent, negatively correlated movement between the CDS and equity to trigger buy and sell signals. The noise between these two markets in KBH at the moments brings to mind Robert Rodriquez’s of First Pacific Advisors response when asked if there was a key to his investment ethos. His mantra he said was “winning by not losing”.

Enjoy the week.

Jim Delaney

C.M.O. 3.27.2009

Credit Market Overview
March 27, 2009

“Still waters run deep.” The origin of this statement comes from the fact that shallow rivers are rough with waves as the rocks are close to the surface. Deep rivers have a lot of water between the rocks on the bottom and their smooth surface. Additionally, while appearing placid they move much more water towards the sea.

Events this week have proved this to be true once again as the congressional henchmen (p.c. henchpeople) noisily took swipes at Ben and Tim over monies promised to people that had not caused the problems but signed on to bring AIG to an orderly end.

Ben Bernanke always seems especially uncomfortable during those hearings as it just might be possible that his studies of our Great Depression and the Japanese economy in the 1990’s puts a lot of water (knowledge) between his outward demeanor and the giant boulders he knows this economy is coursing over at the moment.

With this in mind Ben had an interesting answer to the question “What keeps you up at night?” during a recent television interview. It wasn’t anyone of the myriad problems he is contending with on the surface these days. Instead he said, “The biggest risk is that we don’t have the political will, that we don’t have the commitment to solve this problem and we just let it continue. In which case, we can’t count on recovery.” I will leave you to decide how shallow or deep that statement is but I thought it had a pretty smooth surface.

Speaking of hidden rocks, I attended a talk at the NYSSA last night which was titled “The Investment Process”. It was an enlightening and informative evening and the speakers included Jason DeSena Trennert of Strategas Research, Steven Frenkel of eponymously named Associates Inc. and Mark Sladkus of Red Lighthouse Investment Management with David Darst MD Morgan Stanley as the keynote speaker.

It would take too much space to review the entire evening but I will share a few things with you here. Jason Trennert believes the investment process [in equities] is moving from an income statement focus to one focused on the balance sheet. I include this because this is one of the major tenets of the Credit Equity Correlation Strategy I have developed as it looks at the CDS market to generate buy and sell signals for equities.

David Darst, as many of you know from his frequent appearances on television, is a wonderful speaker with an engaging personality and had the audience in stitches more than once.

But since this is about rocks in the water I must say that Steven Frenkel’s segment was the most foreboding. Steven is a technician, which begs the question as to how he got to speak to a room full of CFA’s, and has studied market movement going back to ancient Rome. Steve’s specialty is the 75-year cycle (still waters, my friend) and he says that the move down in the stock indexes in 2008 broke a trend line going back to . . . . you guessed it, 1933.

He had presented his work to a group about a year ago and his talk last night compared what he said would happen vs. what happened. I believe the term “spot on” will attest to his accuracy. Steve was also nice enough to inform the crowd that the 75-year cycle just ended was the 5th 75-year cycle and that what happens after the 375th year is the Mac Daddy of 75-year cycle reactions.

Many pundits have suggested moving financial assets into physical assets such as cash and gold held in safety deposit boxes. To the extent that this is the modern equivalent of digging a hole and putting your money in it I can say that after hearing Mr. Frenkel speak I wanted to dig a hole and put myself in it.

Enjoy the weekend.

Jim Delaney

C.M.O. 3.26.2009

Credit Market Overview
March 26, 2009

In a sequence, were it scripted by Hollywood would not be believed, the media’s attention focused Tuesday on Messrs. Bernanke and Geithner tied to the stake as Congress fanned the flames and another episode of “Wall St. Witch Hunt” unfolded only to be followed yesterday by Jake DeSantis’ now famous resignation letter printed initially in the Op/Ed section of the New York Times but touched on by every news outlet by day’s end.

The pundits have been searching for capitulation since after Bear Stearns collapsed over a year ago and while still not evident in the indexes the 48 hours that encompassed Tuesday and Wednesday could well have been the equivalent if there was a measure for populist sentiment.

With all of the vilification those in the world of finance have received for assisting Congress in it’s quest to have every person in all 50 States own a home regardless of whether that was a prudent goal, given the pertinent economics, no one had cast the white light of truth on those on the dais.

No one until the people at the Essential Information and Consumer Education Foundation produced a recent report titled “Sold Out”. It has not been possible to read the entire 231 page report since first learning of it and this writing, but I will share with you a few fun facts:

From 1998-2008 the financial sector comprising the finance, insurance and real estate industries, contributed a total of $1.738BN to various political candidates. Additionally the group spent $3.3BN on officially registered lobbyists.

This was made up of $154MM in campaign contributions and $383MM in lobbying by Commercial Banks, $81MM and $122MM in those respective categories by Accounting firms, $220 and $1.1BN by Insurance companies and $512MM by Securities firms.

These numbers flowing from Wall St. to Washington do not exonerate the former in any way but just as important they provide at least a reasonable base from which to question whether those doing the skewering on Tuesday had not feasted on the spit-roasted pig themselves.

I quoted a line from Shakespeare’s Hamlet earlier this week with regard to the AIG mess but now it appears the age old advice that “people who live in glass houses should not throw stones” might be more appropriate.

It is hoped that Mr. DeSantis’ letter of resignation will once again allow all parties involved to focus on the real problem at hand and for a clue as to what that is we need only to remember the catch phrase from Bill Clinton’s 1992 campaign. “It’s the economy, stupid”

One more wake-up.

Jim Delaney

C.M.O. 3.25.2009

Credit Market Overview
March 25, 2009

Wall St. has often been described as a jungle and from the stories we read as children we have been told that the lion is the King of the Jungle. If, for the sake of argument, we accept these as true then in his day, George Soros was a lion. Mr. Soros contributed a piece to the WSJ Op/Ed section yesterday on the CDS market and what changes he feels should be made in the way it operates.

Before addressing the specifics of Mr. Soros’s suggestions I think it is important to review what exactly it was that made George a lion in his time. In 1992 George thought the British Pound was over-valued and began selling the currency short in hopes of profiting from his view. It is equally important to note that GS was operating in the FX market which, while deep and liquid, is to this day one of the least regulated markets that exists.

George built a position of over $10BN pounds using the cash as well as OTC derivative markets and eventually forced the Bank of England to withdraw from the European Exchange Rate Mechanism (a pre-cursor to the Euro) and devalue the pound. Taking on a nation’s central bank is a courageous thing to do but in order to win Mr. Soros could not concern himself with how his actions would affect millions of work-a-day Brits or the effects of his actions on the British economy. It is, after all a jungle and a lion must eat.

Given his past accomplishments I found George’s opinions on what changes should be made to the CDS market not completely in line with someone who has proven by his actions to be a champion of free markets.

Early in his piece GS rightly describes the reason for AIG’s demise as the selling of large amounts of CDS’s without properly hedging its exposure. Very shortly after that, however, he says that AIG would not have gone under if people that did not own the underlying bonds were not allowed to participate in the CDS market.

With all due respect to Mr. Soros I am going to debunk that premise immediately before reiterating the points I raised after Mr. Santoli offered a similar solution in Barron’s a few weeks ago.

AIG became insolvent because of the first point George mentions. They did not manage their risk correctly. The amount of protection AIG wrote, however, was less than the total issuance of CDO’s that existed at the time so AIG problems were not caused by an amount of open interest in the CDS market greater than the existing paper. They were caused, plain and simply, by AIG management who demanded that the Financial Products unit generate $1BN in revenue per year regardless of the risks attached. Therefore limiting CDS participation to bond holders only would not have changed the outcome for the CDS poster child of the credit crisis.

Yesterday’s Op/Ed piece also sites the limiting of CDS purchasing to bond holders as a way to prevent bear raids on the likes of Bear Stearns and Lehman Brothers. George Soros conducted a bear raid on an entire nation. He did so because he thought the currency was over valued and he did so by selling that currency short in what ever form he could; the cash market as well as non-exchange traded currency swap and option contracts with banks and investment banks as counterparties. Additionally he telegraphed his move through the press so that without actually colluding he made it easy for others to jump on board his trade adding even more ammunition to his assault.

As it turns out Bear Stearns and Lehman were proper targets of bear raids as their management’s, like AIG’s, mismanaged risk. I think George, of all people, would agree that regardless of the rules in place there are ways to express one’s views in the market place and to profit by them. In other words; where there is a will there is a way.

I also agree with George that the CDS market needs regulation. Not because the product itself is poorly designed but because the participants in that market place have proven that greed rules until fear takes over. (I am not denigrating greed here, just stating one of the basic concepts of the jungle.)

As for what kind of regulation would work best I offer here the same suggestions I made back on March 9th:

1) Place position limits on all participants that don’t own debt on the entity in question. (This is not to be confused with holders of short positions in the paper.) These position limits should apply across all asset classes on a combined basis so that someone shorting the stock cannot get around the reporting requirements for equities by using a combination of instruments to acquire a larger short position than otherwise possible given the reporting rules.

2) Holders of debt on an entity should be allowed to hedge 100% of their net long holding and any amount, up to but not exceeding, the limits described in 1) above.


I am not convinced that CDS contracts need to trade on an exchange as the well-oiled machine that is the foreign exchange market trades and settles Trillions of dollars of exposure a day without cataclysmic affect. The populist movement en vogue today will probably require the politicians to make this happen. The ICE and CME have already set up clearing entities. My feeling here is that the participants in the CDS market brought this on themselves and now they will have to live with the consequence.

I am still curious as to why George Soros, vacuus par speculator that he was has turned away from the thing that made him great. The lion is old, yes, but one has to wonder; is he sharpening his claws or looking at his paw to see where they used to be?

Enjoy the week.

Jim Delaney

C.M.O. 3.24.2009

Credit Market Overview
March 24, 2009

Steve Kroft admonished President Obama while interviewing him this past Sunday evening on 60 Minutes for mixing laughter with his discussion of a financial system that, even with the market’s latest run up from its March 6th lows, is still in precarious shape at best. “Are you punch drunk?” Kroft asked the President at one point. “No, No. There’s got to be a little gallows humor to get you through the day.” The President chuckled.

If there are laughs to spare someone should share one with Barney Frank whose latest solution to recovering the 0.0001th of the money the government has pumped into AIG is to sue the firm as a shareholder. If there is one thing Mr. Frank should know it’s that getting lawyers involved costs both time and money; neither of which AIG seems to have enough to spare at the moment. It brings to mind the line in Hamlet that ends “doth protest too much, methinks”.

Secretary Geithner did not spend any time on the lighter side of things during his interview with the Wall Street Journal on Sunday. He did, however, out line his plan (this time with specifics) for introducing private capital into the process for alleviating toxic assets from the balance sheets of the countries weakened banks. The market voted in favor of the plan, at least for one session, as the S&P index racked up gains that put a “7” handle on the percentage change number.

Accentuating the positive yesterday was the MoM change number for Existing Home Sales which increased 5.1% between January and February vs. an expected decrease of -0.9%.

While well aware that care must be taken when examining existing home sales numbers because of the foreclosure issue a look at the recent housing situation in Mountain House California by the Wall Street Journal might provide some clues as to what kind of progress is being made out where real people live in real homes.

At one point last year 90% of the mortgage holders in this 2,600 unit master-planned community owed more on their homes than the homes would sell for. 2009 has seen a bit of a turn around however as sales by one builder are already 30% over the run rate for all of 2008.

A couple bid on a house listed for $299,000 with hopes of taking advantage of the depressed housing market only to find they were one of 12 bidding on the home which ultimately sold for $330,000. There is no getting around the fact that the house in question here sold for $781,900 in 2007 but with 48 homes sold and another 59 in escrow vs. 19 sales in the year-earlier period, per MetroList Services Inc. there could be a glimmer of hope that, if nothing else, at least the rate of decline might be slowing.

Problems still exist and California’s unemployment rate of 10.5% in February is one of the highest in the Nation. Foreclosures rose 5% last month in the state so it would be foolish to believe that all of the problems are in the past but with the Mountain House Little League roster growing to 220 from 178 last year there might be specks of light on the horizon. The principal of the local elementary school recently remarked; “People I see here have as much hope as I’ve seen in a long time.”

We know from the movies that “Hope Floats” now let’s see if it can grow.

Enjoy the week.

Jim Delaney

C.M.O. 3.23.2009

Credit Market Overview
March 23, 2009

David C. McCullough said “History is a guide to navigation in perilous times” and there are few who would not call these times perilous. A month or so ago comparison’s between the present and the Great Depression were every where and none of them encouraging. The volatility of daily market moves, the percentages lost by the indexes over various time periods as well as the number of unemployed and the rate at which their ranks were growing were the stuff of headlines and bylines.

The comparisons to history continue but there is an interesting twist as of late and it is shedding light on what, for most of us, was considered a very dark time. Paul Kasriel, director of economic research at Northern Trust and Michael Darda, chief economist at MKM Partners point out in this weeks Barron’s that the economy did quite well between 1933 and 1937 with GDP expanding at 9.5%/yr during the five year period. The key it seems was the government’s purchases of its own paper starting in 1932. Equities, always wanting to be where the action is, rose four-fold during the same quinquennis.

Aldous Huxley also thought there were things to learn from history but to AH the “enigmatic lesson of history” was “that from age to age nothing changes and yet everything is completely different”. Having all lived through the latest bubble, some of us a few more than that, hearing that “things are different this time around” produces that same queasy feeling you get between the time you hear the horn blow and tires squeal and then metal crunch and glass shatter.

Now, too, there are many disbelievers. John Gray of the London School of Economics reviews Globalization and Its Enemies a book by Daniel Cohen in the current “The New York Review of Books”. His comments include his opinion of quantitative easing which he sees as a way to “re-energize the economic activity so that society can borrow itself out of debt.” The possibilities for droll clichés here are endless so I will say nothing.

Peter Schiff of Euro-Pacific Capital who recently penned The Little Book of Bull Moves in Bear Markets is in the same boat with Mr. Gray stating recently, “The Federal Reserve finally made clear what should have been obvious for some: The only weapon that the Fed is willing to use to fight the economic downturn is a continuing torrent of pure, undiluted inflation”.

People with skin in the game a.k.a the “buy-side’ are not convinced the Fed’s latest moves work either as a recent poll by the “sell-side” found 20% or respondents über bearish seeing the low in the SPX in the 400-500 range, 30% thinking we revisit the 600-700 area with the remaining half thinking the low is in.

We could argue the semantics of which half carries more weight given that the 30% that sees another trip down to “6” handle land could prove to be right without disproving the 50% that think the low is in but the point here is that when asked “How are things in Glocca Morra?” it would not appear the answer is all “Sunshine and Buttercups”.

Enjoy the weekend.

Jim Delaney

C.M.O. 3.20.2009

Credit Market Overview
March 20, 2009

There were some dramatic reactions to the Fed announcement of its planned purchase of treasuries and additional assets in mortgage backed securities. The bond market reacted immediately with the 30yr Bond contract settling up 5 2/32 on the day on Wednesday after establishing an 8 27/32 range for the day. To put this perspective the Bond contract’s range on March 18th eclipsed all of the price action going back to January 22nd. The stock market had a good day too albeit achieving a smaller net gain within a smaller daily range.

Moving outside these two markets Gold reversed a down move that had peaked on 2/20/2009 and looked set to close lower than all prices since that date before the Fed’s announcement. Afterwards it did a 180 and made a $64 move higher before settling ~$40 higher on the day. The U.S. Dollar, as measured by the DXY contract lost ~2.30 within a half hour of the announcement and traded as low as 82.63 or ~3.85 lower by 11:30 yesterday morning.

The price of a barrel of oil also moved higher as a result of the Fed’s action on Wednesday. Having made its lows for the session around 11:30 that morning (similar to the Dollar) and closed at its highs for the day afterwards. It, like the Dollar and Gold continued their moves yesterday as the market digested the Fed’s actions.

The interesting question here is what is the market digesting? The final round of G-20 talks occurs this weekend with all of the big machers heading to London. In the first two episodes of this mini-drama 3rd level and then 2nd level potentates met so that there would be no surprises when the big guns showed up. The U.S. has been pushing for globally coordinated round of stimulus while the Eurozoners have wanted to shift the effort towards increasing financial regulation.

Does the Fed’s action on Wednesday show that the U.S. is ready to put their money (literally) where there mouth is and inject liquidity into the system at all costs? Does the U.S. think this will help persuade the other nations to take complimentary actions?

It could be argued that the U.S. has the most at stake as the single super power left with more of its debt held by foreign nations than any other country and its currency considered the world’s reserve exchange mechanism. There are those too that see the current crisis as one stamped “Made in U.S.A.” on the bottom and as such expect Uncle Sam to clean up his own mess. Given the interconnectedness of the World economy, can this still be considered a rational approach?

The other question to be asked regarding Ben’s move on Wednesday is whether it will produce confidence that we are on the road to recovery or, like the drowning man, are we simply acting out of desperation? How this is seen is important here at home but isn’t it equally if not more important to consider how it will be viewed by the World whose nations represent our investors and trading partners?

The other set of questions that need to be considered are those of inflation expectation. Last year oil traded up to $147bbl and the media was howling that the government was focusing on the ex-food and energy component of CPI when the 95% of the people the President is redistributing wealth to spend a disproportionate amount of their income on filling up the car and putting food on the table. Will the Fed’s move on Wednesday bring back last year’s weak dollar strong oil environment? If so, is this what an economy struggling to its feet really needs?

Inflation also plays into the current budget projections. Without getting into whether Christina Romer’s projections for a 23% increase in U.S. economic output over the next 4 years is too optimistic when the compared to the 17% increase projected from the summary of private economists that make up the Blue Chip Consensus. Inflation, should it rear its ugly head in a meaningful way, could change the current budget projection for 70% of the 23% coming from real growth while 30% is the result of inflation.

A decrease in purchasing power brought on by inflation will help erase the massive debt load this country now carries and is projected to carry more of, but will it help the work-a-day folks that have dutifully paid their mortgages while they watched their retirement accounts lose 40% of their value?

This crisis, from its genesis in reduced lending standards by FNM and FRE, has produced a long line of unintended consequences. Most of these have come from the people we have entrusted not asking a simple question: What if?

Let us all cross our fingers and hope beyond hope that someone somewhere is asking that question now.

Enjoy the weekend.

Jim Delaney

C.M.O. 3.19.2009

Credit Market Overview
March 19, 2009
http://creditequitycorrelation.blogspot.com/

Yesterday’s announcement that the Fed would purchase $300BN in long term Treasuries and boost its purchase of mortgage debt by $750BN to a projected total of $1.45TN caused a rally in the debt world that, at least in the case of the 47bps drop in the yield of the 10 year note, had not been seen since 1987.

It would seem, however, that the move was not totally unexpected. The Bank of England instituted its quantitative easing program last week with purchases of 2BN pounds worth of Gilts on March 11th followed by the announcement of additional 5BN pounds purchase scheduled for today. Yesterday the BOE unanimously voted to cut the base rate (equivalent to our Fed Funds rate) to 0.5%.

Brian Edmonds, head of interest rates for Cantor Fitzgerald was quoted this past Monday as saying that the BOE move “probably steps things up a notch” for the Fed. “I don’t think they have much choice here.” He went on to say when asked if the Fed would announce such a program after this weeks two-day meeting.

If you are wondering what is to be expected after such a historic move, a look across the pond might some yield clues. European companies offered a total of E10.0BN worth of bonds in the last week alone with issues from Phillip Morris International, Deutsche Lufthansa, Daimler, E.ON and Telefonica. This pushed the total for this year to E100BN vs. E105BN for all of 2008.

CDS and cash market spreads did not move in appreciably yesterday but this is not unusual on days when the volatility in the Treasury market is high. Similar to what occurs in the stock market when there is intervention; correlation has a tendency to move towards 1.0 while dispersion goes in the opposite direction (0.0). If anything a sharp rally in Treasuries usually causes some nominal widening of spreads on cash corporates as it can take a day for that market to catch up.

Mohamed El-Erian, the co-top-everything at Pimco but most probably single heir apparent to Mr. Gross was on the little screen speaking with Maria Bartiromo shortly after the close yesterday. In a possible attempt to draw the heat away from CNBC’s own Jim Cramer, Maria attempted to lure M. El-E into the bottom picking game asking him if he would put his own money in the stock market at the moment.

Cool, calm and collected Mohamed explained that while the Fed’s move would help increase liquidity in the debt markets it could take some time for these actions to filter through to the equity markets.

This is in line with previous comments we have heard from the folks at Pimco and almost every other guest given the chance to voice their opinion in the media.

If there is a speck of light at the end of the tunnel it is that Ben Bernanke, for what ever problems his actions cause down the road (those pesky unintended consequences), he is working to stem the spread of this crisis with tools rarely if ever used before.

As Dick Hoey said on Bloomberg TV yesterday, “If you have to use swamp water to put out a house fire you can’t worry about what it will do to the curtains.”

Enjoy the week.

Jim Delaney

C.M.O. 3.18.2009

Credit Market Overview
March 18, 2009
http://creditequitycorrelation.blogspot.com/

Magicians and pickpockets practice the art of deception. In the first case we gladly pay to be deceived, in the second we would pay even more not to be. In order to perform their acts successfully however, both groups must understand the value of distraction; have quick hands and perfect timing.

It is not known whether Congress hopes to join the first or second group, but which ever book they are reading it is obvious they are up to the chapter on distraction as the bru ha ha they have sparked over the $167MM paid to AIG employees seems trifling when compared to the $170BN they pumped through AIG to settle that company’s seemingly ceaseless desire to continually double down on ever increasingly bad bets. If you stand back far enough it is quite a funny sight.

The rest of Wall St. and most probably Bank of America, is enjoying the brief respite of having their own compensation plans under the arc lamps and microscopic vision of Congress. I would imagine Ken Lewis is sleeping for the first time in weeks.

To show their appreciation the constituents of the XLF rallied 6.49% yesterday while the CDS for C, COF, MS, BAC, GS and JPM all continued to narrow with all but C and COF back below the levels seen on February 23rd and seeming to head for the end of February lows.

It has yet to be determined whether “what leads you down leads you up” or “new bull markets require new leaders” will win the battle of the adages but going into 1st quarter earnings season the one thing that can be said is that “hope springs eternal”.

Even further from the fray Fortress Group received a double mention in the papers yesterday. The first was an announcement that its 4th quarter net loss was $140MM or $1.50 a share vs. $29.3MM or $0.43 a share for 4Q07. The stock closed last night at $1.59 after having closed as low as $1.08 on March 6th so people must feel that the money they have refused to return to investors will produce enough fees to make up for the firm’s bad bets.

The other bit of news surrounding FIG was their interest in the TALF plan. That smart guys on Wall St. think they can beat the magicians, the pickpockets and the government at their own game is not news. What is interesting is how the banks have morphed their TALF oriented offerings for investors such as FIG.

Initially purchasing the TALF securities from a dealer would also give that dealer unfettered access to the customer’s books. This requirement was instituted by the Fed during the TALF creation process. It was not acceptable to FIG and its brethren so a few banks, JPM and Barclays PLC specifically, have created investment vehicles which allow investors to circumvent many of the Fed’s restrictions.

JPM and Barclays have now set up trusts to buy the TALF securities, (to say these vehicles look a lot like CDO’s would be an understatement) with money borrowed from the Fed. The investors then buy the trust certificates earning TALF security type returns without all those messy Fed regs.

This all obviously helps the Treasury spend an additional $1 Trillion of Federal Reserve financed money. Given that the investors only have to pony up between $5 and $14 to buy $100 worth of returns means that it cannot be hurting firms like Fortress either.

While Congress is diligently practicing its distraction exercises it had better keep its timing sharp or someone will ultimately figure out that not only are they trying to get back from AIG’s employees 1/1000 of what they spent on AIG’s IOU’s but that the TALF plan is a thinly veiled bailout of the hedge fund industry.

Hey, if you’re going to increase taxes on the top 2% of wage earners you have to make sure the 2% is worth taxing.

Enjoy the week.

Jim Delaney

C.M.O. 3.17.2009

Credit Market Overview
March 17, 2009

“Beware the Ides of March”. For Caesar these words had dreadful consequences and from his point of you, yes, unintended too. In the financial markets there is a Caesar as well only this one might seem a cross breed with Medusa as many times throughout this financial crisis we have seen multiple extensions of this self-proclaimed “Emperor for life” appear in crucial positions in Washington simultaneously.

If all of that was not enough to give it away the company in question is Goldman Sachs and it seems as if being the co-focus of the cover page in this week’s Barron’s did as much for it’s stock as the seer in ancient Rome did for Caesar’s life expectancy.

GS was down $4.90 yesterday, 4.96% for those who prefer things in percentage terms. This needs to be put in context however as it had also enjoyed a 33.6% run off of its near term low close of $73.95 on March 9th. 33.6% is a pretty long way to go in 4 trading sessions and it is without question that any investor would think they had Caesaresque qualities if they could put together a portfolio of stocks to perform similarly every 5 days.

The CEC Strategy bought GS on March 12th and unfortunately, MS on Friday. There is hope, however, as the CDS spreads for each of these names (the main driver of the CEC Strategy) continued lower yesterday closing at 258.35bps for GS after peaking at 371.5bps on March 9th. The same day the stock closed at the previously mentioned low.

The move down in GS’s CDS equaled 30.46% by yesterdays close so the negatively correlated CDS/equity relationship seems to be moving in near lock step both with regard to timing and degree. From years of observation I can tell you that is a rare occurrence.

MS the other company to make Barron’s front page suffered a worse fate losing $2.39 or 9.40% yesterday. The CDS spreads here too continued lower yesterday having moved down 116.22bps or 24.45% since March 9th. The stock had outperformed GS in the short term gaining $8.95 or 54.31% in the same period GS rose 33.6%. The move in MS did not have the symmetry of GS’s and is much more typical of how the CDS/equity relationship seems to operate.

The financials, in general started the day strong only to fade in the afternoon. Exceptions here were C, FNM and FRE but gains of 30.90%, 28.57% and 21.43% respectively need to be put in context as starting the day with stock prices of $1.78, $0.42 and $0.42 it doesn’t take a big $ move to make a big % move.

In context, given the choice, how many would prefer to be among that group of three just mentioned vs. the co-stars of the cover page?

Enjoy the weekend.

Jim Delaney

C.M.O. 3.16.2009

Credit Market Overview
March 16, 2009

CEC Portfolio Composition

Throughout the turmoil that has beset the markets and the economy since the housing market became a house of cards there have been certain words or phrases have dominated the lexicon. “Credit Crisis” and “Bailout” come to mind as does “irrational exuberance” for that period when the bubble was still inflating. It was de rigueur for a while to measure how important a word was by stating how many times it had appeared in the media in the recent past. I do not have access to any such word counters but I can tell you that the phrase I am constantly bumping into these days is: “unintended consequences”.

Konrad J. Friedman defines this phenomenon as “the proposition that every undertaking, however well-intentioned, is generally accompanied by unforeseen repercussions that can overshadow the principal endeavor.”

It would take at least a month’s worth of C.M.O.’s to discuss every instance where the government’s interventions in the financial markets have produced said “consequences” but I will limit it to one example on one day. There will be too much to discuss as the week unfolds to spend time tilting at every congressionally constructed windmill.

Kathleen Shanley, Senior Bond Analyst/Finance with Gimme Credit is interviewed in Barron’s this week. She begins by explaining the difference between a bond and a stock from the investor’s point of view saying; “The bondholder doesn’t have the potential to share in the upside of a company’s growth, so the most a bondholder gets back is their principal and interest.” Kathleen goes on to explain that in the case of a bankruptcy what the bondholder does have is a “senior claim in the capital structure.” “As a bondholder you don’t have the opportunity for a large upside [equity holders], but you are more protected on the downside.”

Ms. Shanley says that things now are different than a few years ago, when debt financed LBO’s and share buybacks favored equity holders as the leveraged transactions bought shareholders out at a high price while the debt got downgraded, sometimes to Junk.

Understanding that reward is in proportion to risk, it makes sense that there would be a group of investors that would eschew the upside of stocks for safety of bonds.

Based on there place in the capital structure along with the billions in dollars of aid they have received from the government one would expect that the bond’s of the nation’s largest financial institutions would be trading at levels indicative of a low risk of default.

Such, however, is not the case. Yield spreads on bank bonds are averaging 8.23% relative to Treasuries and 3.65% more than industrial companies according to Merrill Lynch index data. To put this in perspective this relationship was the opposite way before August of 2007.

The clue as to why this might be the case comes from U.S. Representative Brad Sherman, CA, Dem who was recently quoted as saying; “These banks can go into receivership, shed their shareholders, shed or reduce the amount they owe to their bond holders and come back out much stronger institutions.”

John Bartko, a credit analyst with S&P thinks the fears exhibited by the high spreads are well placed. “It’s only intuitive that the government would contemplate the thought, ‘why are we only putting this on the taxpayer?’” Additional government assistance could carry with it “the possibility that debt holders could then be required to participate”.

Mehernosh Engineer, a strategist at BNP Paribas SA, London thinks; “We’re seeing the start of next leg of the crisis and that’s going to be financial bondholders taking a haircut as lenders default. There’s been a perception that banks’ senior bondholders are untouchable, but that’s going to change.”

Where are the “unintended consequences” in all of this? According David Darst, an analyst at FTN Equity Capital Markets, “Most U.S. bank debt is held by insurers and foreign investors, with a small portion owned by mutual funds.” Foreign investors (China, the largest holder of U.S. Treasuries) are already voicing concerns regarding the quality of Uncle Sam’s debt and many have already been burned by investments in the preferred shares of FNM and FRE.

Raising the specter of senior debt losing its inherent protection for its holders will only add to the spreads required by investors to buy the debt. This can only increase the amount of interest these institutions are required to pay to service the debt and therefore delay if not prevent the return of these companies to profitability.

Equity holders are always aware of the risks they take when purchasing a stock and that risk is always 100% of the money invested. Bondholders, be they the insurance companies which many depend on for retirement income as well as the traditional “term” products or foreign investors who fund the massive deficit this country now has and which is expected to grow to previously unheard of levels in the years to come, did not sign on for the questionable return of their principal and interest.

So before Washington starts bringing bondholders to the barber shop one can only hope that they realize the repercussions of the “unintended consequences”.

Enjoy the weekend.

Jim Delaney

C.M.O. 3.13.2009

Credit Market Overview
March 13, 2009

It’s a bit ironic that on Friday the 13th, after a three day 10.97% run off the lows in the SPX, the market seems to be gaining a bit of a pulse which cannot be said for any of Jason’s victims.

The CEC Strategy developed buy signals in GS, PHH, FCX, AGN, BBY, KSS, TJX, GLW and PX yesterday as well as short signals in ETR, FE and SO.

In late February it was the other way around with a majority of shorts being generated (AET, CI, GR, UNH, WLP, AYE, DTE, DUK, ED, FE, MIR, DVN, XOM, NUE, IR, MHK, RPM, AVP, JNJ, ABC, LLY, LLL, MDT, BA, GD) and just a few longs (MLM, PCG). These second set of positions was closed out on Monday in anticipation of “Turnaround Tuesday” and having a decent unrealized P/L number in the books.

CDS spreads, at the index level, spent from January 6th to March 9th of this year moving from 1100 to 1924.6 in the high yield area and 194.7 to 261.9 on investment grade paper. The high yield index has since come down to 1714.2 a 210.4 point or 10.93% reduction, while the investment grade index now sits 25.6 points or 9.78% lower at 236.3.

It should be noted that it is rare for the CDS and stock indexes to move in such close proportion, especially in the short term so no conclusions should be drawn from the similar percentages of those moves.

What has been good to see is that as CDS spreads have come down and as the market moved higher these past few days, correlation among the names in the CEC universe has come off the “lock limit up” figure of 1.0 that it had once again regressed to during the 1/6/ - 3/9 period. This had also occurred a number of times last year, Bear Stearns, TARP announcement, AIG and the pure despair that overtook the markets after Lehman’s collapse.

The high correlation, low dispersion (I say tomato, you say tah-mah-to) environment does not allow the CEC Strategy to fully exhibit its strengths as differentiation between the specific economics of individual companies is superseded by what can best be described as macro panic or euphoria depending on the government’s latest action.

Being up ~11% after starting the year down 226.72 S&P points or 25.1% and 888.62 points or 56.78% since October of 2007 doesn’t mean it’s all up from here by any stretch of the imagination. What is encouraging however, is that if even for brief periods, the natural characteristics of the markets come back when the imminent threat of “incoming” from Washington subsides, if even just at tad.

From the death toll it seems no one needs to spend time on Crystal Lake. I’m sure, however, that many of us wouldn’t mind a peak inside a crystal ball.

Enjoy the weekend.

Jim Delaney

C.M.O. 3.12.2009

Credit Market Overview
March 12, 2009

In the first part of this millennium the two major rating agencies, Moody’s and S&P, competed fiercely to place “AAA” stamps on a host of collateralized debt products being produced by those that were paying their fees.

In a bit of a turn-around in late April of 2008 (post Bear Stearns) S&P published a report lowering its assumptions for the amount of money investors might receive after defaults of subprime mortgage bonds, leading to downgrades of the CDO’s they had given their blessings to.

The report said that S&P’s new recovery assumptions put the percentage of loss at 100% for any class of debt rated A or lower and moved just slightly above that (95%) to any class rated AA. Saving the best for last the company stated that junior AAA tranches should expect loses of 65% and super-senior AAA tranches, 40%.

S&P and its major competitor, Moody’s, did not stop there and have since downgraded CDO tranches numbering in the tens of thousands. Again, a case of closing the gate after the horse is gone. Additionally, these two companies have now focused on sovereign debt and appear to be falling over each other to add names from Western and Eastern Europe to the list of possible downgrades.

Speaking yesterday at the U.S. Chamber of Commerce Jamie Dimon asked the audience if at any point during the current crisis anyone had moved their money from more risky to less risky investments. Although the camera did not pan the room it appeared from Mr. Dimon’s expression that there was a healthy positive response.

Mr. Dimon then pointed to those same people and said that they helped contribute to the credit crisis. There was a bit of nervous laughter but stepping back for a moment it is easy to see that Jamie was right. By when you think about it by moving to more conservative investments (a.k.a. cash) the investing public had migrated away from the risk side of the spectrum creating more selling pressure on “undesirable” assets. JD immediately comforted those who had replied affirmatively saying it was the logical thing to do; intimating that it was completely in line with the constructs of basic human nature.

Taking this revelation from the individual to the institutional level it is easy to see that the rating agencies, while placing their seal of approval on instruments that were purchased by investors around the globe, helped to inflate the bubble, they have also added to the carnage via downgrades as the World’s economy has contracted.

While it is not a stretch to think that S&P and Moody’s are now taking a hard line on ratings to prevent the possible end of their current, albeit until recently, extremely lucrative business model by demonstrating that they’ve changed their fast and lose ways. Their actions also make clear that regardless of direction, the rating agencies have acted with only their own interests in mind and to repeat myself from above: “completely in line with the constructs of basic human nature”. As a result they have proven once again that in all things market related “caveat emptor” is the order of the day.

Jim Delaney

C.M.O. 3.11.2009

Credit Market Overview
March 11, 2009

Given yesterday’s respite to the selling which had reduced the S&P from it’s 903.25 2008 year end close to 676.53 on Monday I thought I would discuss something that caught my eye in the papers recently and by papers I mean the two august publications put out by Dow Jones; The Wall Street Journal and Barron’s. Doing so before yesterday’s rally would have been a little too much like kicking a dog when it’s down and there’s no good karma coming from that.

The cover story in Barron’s this week, written by Andrew Barry, gives a litany of reason’s why calling for the Dow Jones Industrial Average to hit the 5,000 level was not something Andy and his editor thought was in the cards.

To bolster his argument Mr. Barry uses our President’s recent remark that “stocks are cheap for long term investors” as his opening salvo. He goes on to say that stocks also look cheap relative to book value, price/earnings multiples, U.S. economic output, gold, and a normal level of corporate earnings. Andrew adds that the huge amount of cash sitting on the sidelines argues well for impatient investors to release the hounds well before the big hand on the Dow clock points to 5 and the little hand points to 000.

Everyone is entitled to their opinion and a well structured argument carries its own merits. In light of this I am not going to work here dispel any of Andrew’s optimism. I would like to point out; however, that given the cover story I thought Barron’s would have peppered the paper with equally bullish articles and opinions as a show of real support.

What the paper did instead was to print excerpts of David Rosenberg’s piece “A Depression Style Jobs Report” in Alan Abelson’s column, a bearish follow up piece by Felix Zulaf on the page immediately preceding Mr. Barry’s article as well as an interview with David Levy, Chairman of the Jerome Levy Forecasting Center titled “No Doom, Just Gloom”.

Before I get into specifics of what the market practitioners had to say it should also be noted that the lead story in the Money & Investing section of Monday’s Wall Street Journal was titled: “Dow 5000? There’s a case for It”. Wouldn’t it have just been easier for Barron’s to give poor Andy a towel, point him towards the showers and say; “Not this week kid”.

Since his name came up first we’ll start with “Rosie” whose nickname inside “Mother Merrill” belies his outlook on all things economic at the moment. (Just in case the title of his piece didn’t give it away.)

With respect to the amount of space I have left I will repeat the one quote from Rosie I think reflects his sentiment. “The extensive deleveraging, as the credit excess and asset bubble of the last cycle continues to unwind, is exerting a powerful negative influence on the real economy that is far beyond our collective professional or personal experience.”

To summarize the Felix Zulaf follow up article one needs only to read the caption under the picture accompanying the article which reads: “It’s a depression environment”. To be fair, FZ said he saw a bear market rally in the offing of somewhere between 25%-40% lasting 2-4 months. Afterwards, however he predicts the S&P will bottom in 2011 with the SPX boasting a “4” out front. Felix believes that: “Policymakers and investors still don’t understand the process at work in the world economy”.

David Levy, as the title of his article reveals, doesn’t see the end of the world before us, just a million miles of swap to be slogged through. He does see some firmer footing some time in 2010.

Since we live in a democracy I think it best to count the votes and by my reckoning it looks like 1 yay and 4 nays if the vote is on whether the bottom has been reached.

Enjoy the week.

Jim Delaney

C.M.O. 3.10.2009

Credit Market Overview
March 10, 2009

If there is any truth to the adage: “It’s not what you know, but who you know”; then you might consider a slight variation on that theme: “It’s not who you are but who you follow”. Jeffrey Immelt stands as testament to this second phrase as coming to the helm of luxury liner General Electric after Capt. “Neutron” Jack was never expected to be an easy voyage.

Investors on the good ship GE, enjoying quarter after quarter of Jack’s “perfectly groomed” earnings were lulled into complacency like those lying on the sun deck of a Caribbean cruise. Unfortunately, it wasn’t long after poor Jeffrey grabbed the wheel that hurricane season started.

If there is another old saw to be considered here it’s probably: “timing is everything in life” and due to factors way beyond his control Mr. Immelt’s timing in taking the helm could not have been worse.

JE most recent misstep was guaranteeing the safety of the dividend earlier this year and then cutting it by 68% in late February. Implied volatility on GE has closed as high as 149.5268 since its 97.5067 close on February 26th. CDS spreads have also widened during this time moving from 660bps on the benchmark 5-yr on 2/26/2009 to a new all time high of 1037.21 last Thursday. For some perspective realize that in the heady days before August 2007 CDS spreads on Junk were as low as 300bp.

Given the tumult in the world the question becomes not whether Jeff is as good as Jack but whether he is navigating the sea of tsunami’s well enough to get the ship and all its passengers back to port. (Read keep the AAA rating.)

On the dividend front it is safe to say GE is not alone. JPM, DOW, MOT, PFE, TXT, CBS and NYT have all cut dividends recently (apologies if I left anyone out). Howard Silverblatt, an analyst with S&P said recently that dividend payments among companies in the S&P 500 were down 24% from a year ago. Howard went on to say that this years projection for dividend cuts would be 23% which would make it the worst two year span for dividends since 1938.

One of the factors leading up to these cuts, HS believes, is that the market has grown less inclined to punish dividend reductions. “They are not as painful as they were a year ago” he was quoted as saying. (Someone please tell that to Mr. Immelt.)

While investors may not be punishing the “cutters” as harshly they seem even less enamored with the names that pay dividends as a whole. Nicholas Bohnsack of Strategas Research Partners, a New York research firm, recently found that since November 21, 2008 dividend paying stocks have underperformed their non-paying brethren.

“In an environment where there is a massive flight to quality, you would expect companies that are offering yields to do better. That has absolutely not been the case.” Mr. Bohnsack said recently. He goes on to reason that the price declines of the dividend paying stocks reflect the market’s perception of the eventual need for those companies to lower payouts in order to conserve cash flow and bolster the balance sheet. “It is almost the purest read on confidence that we have.”

If that is true it might be pure but it doesn’t seem all that confident.

Enjoy the week.

Jim Delaney

C.M.O. 3.9.2009

Credit Market Overview
March 9, 2009

These are historic times for many reasons; The U.S.A. elected its first Black President and the economy is experiencing a contraction that brings to mind some of the most severe in this Nation’s existence.

Additionally a majority of investors have lost confidence in the markets. One of the most often sited reasons for this are the issues connected with the Credit Default Swap (CDS) market. It has been blamed for causing the downturn in stocks, the collapsing of the global economic system and if you look hard enough, the common cold.

Today the Intercontinental Exchange (ICE) begins operating a clearing house for CDS contracts after receiving approval from the SEC on Friday and the Federal Reserve last Wednesday.

I believe this step is a positive one for the CDS market and to the extent it helps bring back confidence a positive step for the marketplace in general.

There has been much written regarding the evil loosed by trading Credit Default Swaps. A lot of what I have read seems to have come more from emotion than fact and some, while eloquently written, was not authored by anyone with practical market experience.

I have purposely stayed out of the fray as it seemed best to ignore the static. In this weeks Barron’s Michael Santoli, whom I would expect to be knowledgeable in things market related, made the statement that the only people that should be allowed to trade CDS contracts are the people who own the bonds.

Having traded in the equity, fixed income and futures markets, the first two in both cash and derivatives and the third being a derivative itself I am a bit flummoxed as to why everyone is trying to reinvent the wheel with regard to CDS trading.

As a counter to Mr. Santoli’s point, there are two designations for participants in the futures market: hedger and speculator. Where would the hedgers lay off their risk if the market did not allow speculators to take the other side of the trade? The hedgers are people involved with the physical commodity, farmers, miners, processors and are in the market to reduce risk not increase it.

The speculators are in the market to profit from price movement regardless of direction and take the risk the hedgers are trying to alleviate. To prevent the speculators from controlling the price movement there are limits placed on the number of contracts they are allowed to hold.

The equity market too has controls in place to prevent misdeeds. Anyone owning more than 5% of a company is required to report his holdings to the SEC within 10 days of the “acquisition event”.

The equity and futures markets are deep, liquid, vibrant, healthy markets and while those with mal-intent might wish the rules did not exist it is a long term positive for the rest of us that they do.

The CDS market was extremely profitable for the dealer community for many years because of the products opaqueness and lack of regulation. Having worked at a firm that provided inter-dealer liquidity in the CDS market it was not unusual to see bid/offer spreads between the sell side firms 1/10th of the bid/offer spreads shown to buy side customers. This created an incentive to keep things as they were and make as much money as possible.

Given the products profitability it is not a stretch to think that anytime unpleasant noises were heard from those proposing regulation a call was made to the lobbyists in Washington and the game continued.

AIG is the poster child for what was wrong with the CDS market but here too it was not the product but more that AIG’s Financial Products subsidiary wrote billions of dollars of CDS contracts without hedging any of its exposure. Is that a problem with the product or with risk management at AIG?

As is clearly evident at this point the CDS market needs to be regulated to some extent as the major participants have proven through their actions, that they are unable to police themselves.

Before we put manacles on top of the handcuffs however let’s take a look at what regulations are in place in other markets that are operating efficiently and use those as a model for the CDS market.

Enjoy the weekend.

Jim Delaney

C.M.O. 3.6.2009

Credit Market Overview
March 6, 2009

I have heard the current malaise described as the “Great Recession” and a “Contained Depression”. Both of these terms hesitate to put the current socio/economic environment into the same category as the Great Depression and possibly with good reason.

The Bureau of Labor Statistics releases employment numbers for February this morning at 8:30. Estimates range as high as 8% for the unemployment rate and non-farm payrolls could fall as much as 750,000.

Whatever the published number are there are also an additional 1.4MM people receiving government benefits under a new program launched last year and a sub-category I had not heard of until recently, mass layoffs (50 or more people at one time), doubled in January.

These all paint a pretty dire picture of the world as it stands today. The question is how does it really compare with that earlier time in our great Nation’s history?

By 1933, 25% of all Americans were unemployed, and 11,000 of the country’s 25,000 banks had failed. Household income had declined by 40% and home building had shrunk by 80%. Industrial production was down 45%.

I am not saying we’re going there and I’m not saying we’re not. The CEC Strategy has made most of its money on the short side of things since October of 2007 but I probably would have bet the house writing $2.00 puts on Citigroup (C) back then too!

Since we’re relating things to the GD today 6,860 was the level on the Dow that erased 50% of the rise from the 1932 low to the 2007 high. For those having a “slow” morning that’s half of 75 years worth of gains gone in 16 months.

For the S&P fans out there, an uptrend line initiated at the 1982 lows that had provided support for the market since was broken on the first close below 700.

Estimates for when positive growth returns seem similar to those orders you get from people that just can never pull the trigger and are a euphemistic variation on the Good Till Close order with the last word in this case meaning near and not the opposite of open.

This entire debacle has been a study in unexpected consequences. We can only hope the lesson ends soon.

Enjoy the weekend.
Jim Delaney

C.M.O. 3.5.2009

Credit Market Overview
March 5, 2009

Do you remember those word problems in math class: A car is traveling west at 30 mph. Another car is traveling east at 20mph . . . etc. OK, so keep channeling your grade school math class and use the information below to answer the questions that follow.

If you agree to invest at least $10,638,297.87 you can:

a) Buy AAA bonds backed by loans from the sale of cars in the U.S. but not necessarily from an auto manufacturer headquartered in the U.S.A.

b) Achieve a yield to maturity of between 12%-16%.

c) Borrow up to 94 cents of every dollar you invest at Libor + 1.00% (~1.30% +1.00% = 2.30%) from a lender that can print money at will

d) Walk away from the non-recourse loan at anytime with no penalties

c) Pay your top executives as much as you/they please

Questions

1) Would you participate in this bond offering?

2) Do you think this bond offering will increase the number of cars sold in the U.S?

If you answered YES to question 1 than you could probably get a job at Blackstone, Fortress, Cerberus or Millennium as all four of these entities are looking seriously at the latest “fix” to come out of Washington to spur the economy back to it’s consuming ways. (An added benefit is that if you went to work at either of the first two names mentioned, given where the stocks of are trading, you wouldn’t have to worry about getting back dated options as the stocks are cheaper than most option premiums.)

Mr. Schwartzman, chairman of Blackstone Group LP, believes the plan will be successful in bringing investors back to the securitization markets saying: “You need a robust securitization market to reestablish a broad lending platform in the society.” (It is amazing to see how altruistic people become when they have their hand in Uncle Sam’s pocket.)

When asked about the new offering the President himself was quoted as saying: “This will help unlock our frozen credit market, which is absolutely essential for economic recovery.”

If you answered YES to question 2 I’m not saying you’re wrong but I would refer you to Mssrs. Gross and Attebury. “PIMCO Bill” is not so convinced of the programs resounding success. “It may be the same problem we have with the banks, you can bring the horse to water, but they may not drink.” Thomas Attebury, partner and PM with First Pacific Advisors, is “not a believer in this. There is a reason credit is contracting – because the economy is in recession and banks typically raise their lending standards to protect their precious capital.”

As with all things, time will tell. I do want to make one observation here. I find it interesting that Congress has gone out of its way to make a helluva lot of noise regarding the changes they want to make to reduce the attractiveness of choosing “Hedge Fund Manager” as a career goal. At the same time, however, they are going out of their way to design sweetheart deals like the one described above to fatten the purses of those managers and doing so with subsidies from the U.S. taxpayer.

Kind of like getting yelled at in the front yard where all the neighbors can see and then walking around to the kitchen window for your slice of fresh baked pie. After all, you have to protect those campaign contributions.

Enjoy the week.

Jim Delaney

C.M.O. 3.4.2009

Credit Market Overview
March 4, 2009

After declaring GE’s dividend sacrosanct Jeffrey Immelt’s recent reversal begged of episodes that have become all too common since stocks peaked in October of 2007. (How different did things look back then?!). Members of the “C” suites of Bear Stearns and then a few months later, Lehman Brothers appearing on the small screen declaring “All is well in Happy Valley” only to collapse a short time later.

Cries of predatory hedge funds profiting from those events seem toothless now that many of those same funds had their worst year on record and have seen withdrawals of double digit percentages and as the WSJ recently reported are being besieged by additional requests in the 20%-30% range.

Credit default swap levels for GE have risen from as low as 324 on January 6th of this year to an all time high of 1029.44 in New York yesterday. Everyone it seems s been focusing on the problems the company is facing here in the States with it financial subsidiary GECC which, while not is involved in the residential mortgage market provides financing for commercial real estate and other ventures at the business to business level.

The recent troubles of countries like Poland, Turkey and some of the Baltic States are also having an affect on GE’s prospects. The company’s 2008 annual report said that 11% of it’s financial receivables were in developing markets (Eastern Europe and Mexico). The WSJ estimates that the Eastern European portion of this exposure could amount to $30BN.

Adding to investor’s anxiety is the current debate by European Union leaders as to how to handle what is becoming an increasing dicey situation in Eastern Europe. The EU’s charter expressly prohibits the bailing out of any one member by another member. That same set of rules also requires members to keep deficits below 3% but it looks like 7 of the 15 Eurozone countries could cross that line this year.

Germany has much to lose in all of this as the Eurozone countries are that nation’s leading export market. Having the most solid economy in the region is good for Germany in that there are fewer questions of it’s surviving the current global crisis.

That question doesn’t seem to elicit the same answer with regard to Germany’s weaker siblings however. While no one is asking out loud yet, there are doubts about how financially conservative Germany would react if asked to participate should one of the euro-family fall gravely ill.

With the gap between yields on German bonds and the bonds of some of the weaker links at levels not seen since the Eurozone’s inception 10 years ago it might be a question the market is already answering.

Enjoy the week.

Jim Delaney

C.M.O. 3.3.2009

Credit Market Overview
March 3, 2009

Although this Nation’s financial brainiacs have created enough toxic assets to virtually sink the world’s economy, the U.S.A. has long stood as a symbol of capitalism in one of its purest forms. In a perverse sort of way, manufacturing AAA securities from sub-prime mortgages and selling them to unsuspecting buyers stands as a perfect example.

The current crisis is turning many things upside down at the moment so it should come as no wonder that there are lessons to be learned from two unexpected sources, namely the Germans on marketing and the Chinese on economic policy. Who’d a thunk a stodgy Western European nation could beat Madison Avenue at its own game and a Communist country could take the U.S.A. to school on stimulating the economy.

Germany has instituted a “scrap” bonus for people who trade in an old car to buy a new one. The E2,500 ($3,200) payment is made by the government to people who scrap a car that is at least nine years old and buy a new car that meets the latest emissions standards. Does it work? So far 134,000 people have applied for the bonus and that number is rising by upwards of 7,000 people a day.

“It’s a real sales boom” says Ceyhun Tan a Volkswagen dealer in Berlin whose February sales were two-three times what they were a year ago. Sabine Mumm, a librarian from the north of Germany said “All the available cars were gone, especially the small cars. It was really hard even to get the dealers attention.”

The program is so successful that France, Italy, Spain and even Slovakia are adopting the theory both with cars and other big ticket items. If there is a hitch in all of this for Detroit is that German auto manufacturers actually make cars people want to buy.

From the north of Germany we travel to Beijing where they are preparing for the parliament’s annual meeting which is heralded at China’s “political event of the year”. Eyes are on the world’s third largest economy as the country is one of the few left that is experiencing positive, albeit lower, growth. “China has the resources to reinvigorate and reorient its economy.” Cornell University professor, Eswar Prasad, recently stated. He went on to say “This could have a broader payoff for China in the international arena by providing support for global demand.”

Wen Jiabao, China’s premier said motivating buyers in China was different than in other parts of the world because “Consumption is not based on slogans, but on whether consumers really have money in their pockets.” The government is also encouraging workers that have lost their jobs to start their own businesses by offering tax incentives and training opportunities. In addition to only spending what they have the Chinese save around 25% of what they earn.

What’s interesting here is that a country founded on the principals of Karl Marx has only slated 8% of its 850BN Yuan($124BN) stimulus package for things like health care (1%) and public housing (7%).

So while they might like it in their fried rice the Chinese seem to have no room for pork in their stimulus.

Enjoy the week.

Jim Delaney

C.M.O. 3.2.2009

Credit Market Overview
March 2, 2009

There seems to be one thing that still has value on Wall St. and that is scarcity. Chevron (CVX) and Abbott Labs (ABT) took advantage of the infrequency with which they issue debt to tap the capital markets for a combined $8BN last Thursday issuing $5BN and $3BN respectively. Total issuance in the investment grade space was $10BN on that day.

Jim Merli, head of U.S. Syndicate at Barclays Capital said “Right now, I do think the investment grade asset class is enjoying the spotlight.” Jon Duensing, a principal at Smith Breeden Associates thought one of the reasons the debt sold well was that “new or less-frequent high-quality issuers have generally met with strong demand as investors seek to add new issuers to their portfolios.”

The CVX offering was actually made up of three issues: a 3.45% note maturing in 2012, a 3.95% note maturing in 2014 and a 4.95% note maturing in 2019. All three pieces came at 195bps over their respective T-note maturity so there was no credit premium across the issuance curve for CVX. Looking at the CDS market for last Thursday mid-market spreads were 97bps, 102bps and 108bps for the 3, 5 and 10 year tenors which shows that investors required a premium of 97bps on the 2012 piece and 93bps and 87bps on the 2014 and 2019 pieces to tie up hard earned cash over where the bonds could be synthetically created.

ABT was the other big issuer last Thursday. Here too there were multiple maturities involved as $2BN of a 5 1/8 note came at 220bps over the T 2 ¾’s of 2019 and $1BN of a 6% bond maturing in 2039 was issued at 235bps over the T 4 ½’s of 2038. There was a 15bp credit premium for the longer dated ABT issue but since all of CVX’s issues were in the “intermediate” tenor and the 2039 ABT issue is definitely in the “long maturity” camp it is a bit like comparing apples and oranges.

With this in mind we can still look at the physical/synthetic premium on the two ABT pieces. We will, however, have to use the 10yr CDS spread for both since there is no readily available quote for 30yr CDS on ABT. Using a mid-market spread of 95bps for the 10yr CDS the note and bond required premiums of 125bps and 140bps respectively to attract buyers since of the physical paper over its synthetic equivalent.

Remember too, that as was stated earlier, there was strong demand for the CVX and ABT paper as they do not issue often. It is fairly safe to assume then that more frequent issuers will have to pay an even higher premium to their synthetic equivalents to raise capital.

That these two issuers were able to sell debt says that there is some thawing in the credit markets. That the spreads on the physical debt were reasonable says that people are willing to buy names that they don’t see that often. That the spread between the physical and the synthetic is as wide as it is shows that all is not quite right in the credit markets just yet.

There is scarcity and then there is scarcity. It was reported in the WSJ recently that a leather armchair once owned by Yves Saint Laurent fetched 21.9MM Euros or $28MM at a 3 day auction of the designer’s estate by Christies. Given his predilection for high ticket make-over’s it begs the question, was John Thain was the undisclosed telephone bidder?

Enjoy the week.

Jim Delaney