Credit Equity Correlation Has Moved!

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Thank you,

Jim Delaney

C.M.O. 5.22.2009

Credit Market Overview
May 22, 2009

The telegraph was one of the earliest forms of long distance communication. Longer than you can ride and shout from horseback, send smoke signals or spend hoping the carrier pigeon doesn’t soak up any lead on his way back home.

Like “Coke” and “Xerox”, “telegraph” has also become a generic term to denote the indication of one’s intended motive. Think The Babe pointing towards the fence in the ’32 World Series, Joe Namath, who’s raised index finger has been copied in every set of team colors imaginable and how can we leave out the Three Stooges and Marx Brothers whose antics are so predictable it adds to the anticipation of the laugh to come.

The U.S. Government has been doing a little “telegraphing” itself as of late. Unfortunately, however, this one doesn’t end with somebody getting a ring or millions of people enjoying a hearty guffaw. It ends with higher interest rates, a lower Dollar and inflation well above a nickel and heading towards double figures.

Now, as with Joe and the Babe, certainty only comes after the fact and if the events of the last little while have taught us anything it is that things can change very quickly so this is no raised index finger and there is no pointing going on. (At least not yet, anyway.) More, just observations, like a set of directions with landmarks to watch out for. Some of which are beginning to appear, hence today’s topic.

There was a precipitous drop in the price of U.S Treasuries yesterday. It was caused, possibly, by the announcement that S&P had put the U.K. on negative credit watch. The connection the pundits were making is that the two economies are very similar and the crisis of confidence has been handled similarly in both economies so the issuance of massive amounts of debt (18% relative to GDP) by our friends across the pond is a premonition of what’s to come back here in the colonies.

Many people, including Milton Friedman in his book Money Mischief, predicted the consequences of using huge amounts of debt by the Government to cure economic problems such as the ones we are now experiencing and they, the consequences, look a lot like a devalued Dollar and inflation that begins to increase at an increasing rate.

The yield on the UST 10-year has been as high as ~5.25% going back to July of 2006 and June of 2007. It has also been down very close to 2% (January 2009) and yesterday closed at ~3.35%.

Financing for $1.197TN in congressionally approved spending plus additional government bond issuance brings the expected issuance total up to $2.1TN for 2009 according to Barclays Capital. This should be compared to $880 in 2008.

Besides the increased issuance you must also consider the Fed’s quantitative easing strategy or more easily put; robbing Peter to pay Paul. We are now buying debt at relatively high prices when there is an awful lot of “telegraphing” going on that rates are headed up and not down.

Since, as we all know, the price/yield relationship in bonds, owning Treasuries doesn’t appear to be the smartest trade at the moment. Sean Kelleher, a partner at JGC Management over there in “Joisey” estimates that the Trillion dollars worth of debt the Fed now owns could become 2TN in fairly short order. A 1% increase rates on that amount could cost you and me about $140BN in price depreciation.

And we don’t even get the right-off!

Happy Memorial Day weekend! See ya Tuesday!

Jim Delaney

C.M.O. 5.21.2009

Credit Market Overview
May 21, 2009

The amount of new issuance in the both the equity and debt markets has been prodigious since the first drips appeared to be falling from the ice that had frozen the capital markets after Lehman took on Arnold “Da Gubenator” Schwarzenegger’s character in Batman, Mr. Freeze.

This has been heralded as a sign of that we are on the road to recovery and the move in credit spreads has been impressive with the oft cited difference between risk free Treasuries and a pile of junk (bonds) moving from the big 2-0 down to the lowest “teen” there is.

There is another side to all of this joyous issuance however and it comes in the form of a “what-if”. Don’t they always?

This w/i comes from the middle word in one half the two elements that are used in the CEC Strategy. Since one half is equity we can leave that one out and go directly to the other half Credit Default Swaps. I think you can pick the middle out of those three.

Moody’s expects the default rate on junk debt outstanding to hit a high of 16.4% by November of this year. Standard & Poors has a slightly different trajectory projected with defaults hitting their apex in March of 2010 at the 14.3% level.

Since we can’t believe much of what either of these two say these days a look at hard facts might help. S&P recently put out a report that said that no less than 28 entities had negotiated with their lenders to “extend payment, convert debt to equity, purchase debt back at a discount, reissue debt at more favorable terms” or D, all of the above.

Those numbers are through the end of April and if you add 2, because you have to figure that’s already happened in May or will by month’s end, you get a total of 30 which is twice the total for all of 2008. Without adding the extras the existing total is still quadruple the occurrences of 2007.

Keep in mind as well that $190BN of this less than investment grade debt is due to come up for refinancing over the next three years. If there is a glimmer of hope it is that the schedule of maturities is $26BN, $44BN, and $120BN for 2009, ’10 and ’11 respectively.

This should work out just about perfect because 2011 is when a good portion of the “timely, targeted and temporary” monies in the pork-ulous bill hits the streets.

If, by chance, defaults do rise over the next trio of years Dianne Vazza, a MD with S&P is not too optimistic about what actual recovery levels would be. “I don’t expect recoveries to be as strong this time around as in the past cycles, when recoveries were typically around 45 cents on the dollar. They’ll be hurt by the lousy economy, wounded banking sector, a lack of debtor-in-possession financing and the crummy leveraged deals done by the private-equity sector in 2006 and 2007. There will be more liquidation, in which recoveries typically suffer, this time around.”

Well . . . thank you Ms. Vazza, I did not realize that the new Batman movie was going to feature a Ms. Freeze in the upcoming sequel.

The forecast for NYC is a very sunny high of 85 degrees. Take that Mr. & Ms. Freeze!

One more wake-up and a half-day for the bond market tomorrow. Almost there.

Jim Delaney

C.M.O. 5.20.2009

Credit Market Overview
May 20, 2009

As the S&P does its damnedest to stay above the 900 line and the bulls root for last Friday’s close of 882.88 to be the next highest low that comes when strings of higher lows and highs attach themselves together and grow horns it is worth remembering that the 882 level had been crossed 30 times between November 20th of 2008 and last Friday. Also keep in mind that it has occurred 10 times in the last 29 trading days. Obviously 882 is making quite a name for itself in the fight between support and resistance.

Speaking of fighting, if wars are won or lost in the trenches then it is usually with a little help from above. I’m not talking Devine intervention here I’m talking about all those great contraptions that drop bombs and fire Gatling guns and shoot rockets.

The markets have had stuff raining in from on high but it seemed more inclined to impede progress than to assist it. The “stuff” of which I speak was $34BN worth of share offerings; both initial and secondary that have been brought to market over the last two weeks. Which, if you don’t keep track of those sorts of things is half the 2009 total. Closer examination of the aerial reconnaissance shows almost an equal split between the semanas of $17BN each.

$34BN worth of equity and some more “less bad” but most certainly not “great” economic data and the SPX moved from 929.23 on 5/8/2009 to 882.88 on 5/15/2009 and then moved promptly away from that much visited level on Monday to close at 909.71. Is that low rumble the hooves of the cavalry riding in or the more distant thunder of stampeding bulls?

There has been supply on the bond side as well and although totals, as provided for the equity markets above, are not readily available suffice to say that there has been over $6BN worth of debt issued already this week.

The way to measure the market’s receptiveness in stocks is price, in bond-land it’s the spread at which paper is purchased above the similarly tenored Treasury. These spreads have been doing their own equivalent of a rally, excepting that everything happens backwards in bond-land so down means up.

The benchmark for these spreads in the non-investment grade area is the Merrill Lynch High Yield Master II Index which has seen these aforementioned spreads move from 20 full percentage points above the Treasury de choix to a mere 13 since the start of 2009. If you were to translate this into price it would be like owning a bond that started the year trading at 55 cents on the dollar that is now worth 71 cents on the dollar.

This 29% return, quite a good investment during any 138 day period, looks even more spectacular when you realize that the S&P is trading right around where it sang Auld Lang Syne.

Enjoy the week.

Jim Delaney

C.M.O. 5.19.2009

Credit Market Overview
May 19, 2009

Like the bedraggled hiker that catches up to the group only to have them start off again without the one who needs the rest actually getting any; Citigroup (C) issued $2BN bonds last Friday without the FDIC’s backing. The “too big to fail” guarantee, while not explicitly priced into the bonds is implicitly obvious as $50BN in TARP funds props up what would have long ago fallen down.

The $2BN issue which was over subscribed by $4BN is further evidence that 562.5bps above the 10-year Treasury that C paid investors was seen as the best ultimately risk-free risky asset for sale last week. Bid to cover ratios of 2:1 are seen as a sign of success when the Treasury itself issues debt and it will yearn, in the years ahead, for those types of numbers as it issues more and more debt. Bids for three times the amount of C paper for sale is enough to make even the Government jealous.

Citi’s CDS spread had come off its 666bps highs seen on April 1st of this year and traded as low as 343bps on May 8th. The 5 year benchmark quote was 412bps last Friday 20bps higher than yesterday’s quote. This would have put the 10-year CDS at ~373bps, about 190bps less than the market required to warehouse the Citi paper which, for intent and purposes, is white labeled Government debt. C closed at $3.64 yesterday down from $23.12 a year ago which would also be the 52 week high.

As for the group the hiker, we would say piker but there is nothing small about $50BN, was trying to catch up to? That would be Goldman Sachs (GS), Morgan Stanley (MS) and JP Morgan (JPM) who yesterday asked for approval to repay a combined $45BN in TARP funds. It should also be noted that the amount to be repaid for those three firms is less than the amount of TARP funds owed to the taxpayer by C.

A quick run through of how the troika stand. GS closed last night at $143.15 up from its March 9th low of $73.95. The CDS levels for GS were 371bps on 3/9 and 173bps yesterday. MS’s March 9th numbers were 476bps and $16.48 vs. 265bps and $28.28 last night. JPM numbers for the same dates were: 242bps, $15.90 and 110bps, $37.26

Going back a little farther the current levels for GS’s and MS’s CDS’s were last seen in early September (pre-LEH) of last year. A graph of JPM’s CDS’s looks a bit more like an EKG printout as the 110bps level, or thereabouts, has been seen a number of times over the past year. A low of 88bps was reached in mid-October of 2008 and a year ago JPM’s CDS’s were quoted at ~60bps.

How different things looked a year ago at this time.

Enjoy the week.

Jim Delaney

C.M.O. 5.18.2009

Credit Market Overview
May 18, 2009

The only thing possibly shorter than a “New York” minute is a “TV” minute as the latter seems to go by in a handful of seconds and nothing even close to 60.

Having done research on the OTC derivatives regulation proposed in a letter to Congress by Treasury Secretary Tim Geithner for an appearance on CNBC’s Fast Money on Friday and only getting through the first two bullet points, I thought I would give you the benefit of all my hard work.

The four objectives included in the letter are: 1) Preventing activities in those [OTC derivatives] markets from posing risk to the financial system; 2) promoting efficiency and transparency of those markets; 3) preventing market manipulation, fraud and other abuses; 4) ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties.

We can lop off the last one right off the bat since the events of the last year and a half have proven that even those parties that were supposed to be sophisticated weren’t that smart at all.

As for the other three let’s go through them one at a time: 1) Preventing activities in those [OTC derivatives] markets from posing risk to the financial system. That OTC derivatives played a part in the collapse of the global financial system is similar only to removing one of the blocks out of a Jenga tower. The need to place blame for the crisis it seems is most vehemently practiced by those whose own implication they are trying to hide.

A point that is conveniently and continuously kept on the down low is that in 1998 then Chair of the CFTC Brooksley Born asked Congress for the power to oversee financial derivatives but was denied such power on the advice of then Fed Chairman Alan Greenspan and Treasury Secretaries Robert Rubin and Larry Summers. Mr. Rubin then went on to Citibank and . . . well; we all know how that turned out.

Pure plain and simple, anything that can be bought or sold exposes the buyer and the seller to risk. Buying or selling enough of it can expose the party to sufficient risk to cause that party insolvency. When everyone does it to an extreme the system itself can become insolvent. There is risk in everything we do. Know it, measure it, control it, but don’t believe you can legislate it away.

2) Promoting efficiency and transparency of those markets. Efficiency and transparency are a good thing and inspire confidence in market participants. Having OTC derivatives cleared through a central counter party should go a long way towards making necessary transaction information readily available.

There is a potential issue here, though, and that it one of multiple clearing entities. The CME and ICE are already operating separate clearing houses. Competition is a great way to find the most efficient way of getting something done. If the goal of clearing OTC derivatives is to have all of the information in one place should something untoward happen then having two or more clearing houses works at directly cross purposes to that goal.

If there is a competition to see who would be the best clearer, that is one thing, having competition between clearing entities is quite different and will only complicate things should another crisis erupt.


3) Preventing market manipulation, fraud and other abuses. There is a push, as part of the proposed regulation, to have OTC derivatives become exchange traded derivatives. Some see this as a way to bring the light of day to a market that is often accused to operating in the dark of night.

Exchanges are very good at trading standardized products. When lots of people are all trading the same thing the markets become deep and liquid. The OTC derivatives markets were not created to avoid standardization but to facilitate the needs of the corporate world. CEO’s and CFO’s are good and running companies and keeping books. They are not necessarily good at figuring out how to transfer the very specific risk they have as a normal part of their business to the market through an exchange traded product.

The sell side firms provide a service to the corporations by performing this translation with highly customized solutions. The needs of the corporations are not going to change just because there was a financial crisis. Patrick M. Parkinson, Deputy Director of the Board of Governors of the Federal Reserve told the Committee of Agriculture this very thing to last November when he said “many CDS’s will continue to be transacted other than through the clearinghouses because of the non-standardized nature of the market”. Such transactions, he said, are “integral to the functioning of today’s financial markets”.

If there is a parallel here I believe it is the Interest Rate Swap market, which by all accounts, dwarfs the CDS market in size but has never garnered similar distain. In the earliest days of the IRS market there was a single Eurodollar contract. Swap levels given to corporate clients were priced to include the risk associated with not having a direct hedge. As the IRS market grew the demand for more back month Eurodollar contracts also grew until there was a contract to represent every calendar quarter from the closest in to a point 10 years away.

Having a good source of price discovery and a liquid hedging vehicle has allowed the IRS market to grow to a size that would not have been achievable without them. A standardized CDS contract would not do away with the OTC market but could actually help it grow.

Profit margins in individual transactions might be narrowed as a result of an exchange traded contract but if the IRS market is any indication, the size of the pie should grow such that even a smaller slice will mean more to eat.

Lastly, there is the politicization of the OTC derivatives issue. Congress is hell bent on finding a straw dog for the financial crisis that they themselves helped create by allowing FNM and FRE to buy all those mortgages that were very much less than prime. FNM’s $0.78 share price and its 2Q09 loss of $23.17BN and necessary infusion of an additional $19BN of taxpayer money stands as testament to that.

In Congress’ efforts to find something to hang in effigy the risk becomes that excessively tight regulation will hamper transaction flow. Capital is like water, it will flow along the path of least resistance. If Congress learns anything from its forays on Wall St. let’s hope they learn that lesson first.


Enjoy the week.

Jim Delaney

C.M.O. 5.15.2009

Credit Market Overview
May 15, 2009

. . . Slowly they turned, step by step, inch by inch. . .

No, it’s not an episode of I Love Lucy or The Three Stooges; it’s the banks and in another step towards normalcy(?) J.P. Morgan and American Express issued debt yesterday that was NOT backed by the FDIC. Besides, while I haven’t spent the time to count there are a lot more than 3 stooges in this caper.

JPM sold $2.5BN of 5 paper and American Express brought $3BN to the market successfully split between 5 and 10 year maturities. The JPM 5-year paper is a bullet with a 4.65% coupon and came at 275bps over the current 5-year TSY. The benchmark CDS on JPM was quoted at 120bps yesterday which puts the premium for balance sheet space at 155bps. Relatively speaking, not that onerous given some of the spreads seen earlier in the year. JPM is rated Aa3 by Moody’s, A+ by S&P and AA by Fitch.

AXP sold $1.25BN of 5 year notes with a 7¼ coupon at 530bps over the current TSY of the same maturity and $1.75BN 8 1/8’s maturing in 2019 at 505bps off the curve. The CDS levels in the 5 and 10 year area were 302bps and 234bps respectively. Notice here that as we discussed with GS the other day the CDS curve is still inverted with near term protection selling at a premium to the longer tenors. AXP is rated A3 and BBB+ by Moody’s and S&P in that order.

Whether it was patriotism shown by these two firms working so hard to get themselves to a point where they can repay the taxpayers their hard earned wages or the specter of having Uncle Sam’s nose in their business that, like a coyote caught in a trap willing to chew their own leg off, picked the lesser of two evils is for you to decide. I just think it’s worth mentioning that the credit markets are becoming amenable to taking on a little risk. Although, and this is just me speaking, buying AXP paper at 500+bps off the curve doesn’t seem that risky and is probably a pretty good deal.

Besides these debt issues GS, BK and MS have all sold bonds to investors this year with GS being the first to sell non-FDIC backed paper. Additionally there has been $19BN in stock issued since the Stress Tests results were announced on May 8th and another $14BN in equity related offerings in 1Q09.

All of this adds up to roughly $670MM in fees as estimated by the WSJ, which has mostly been paid amongst the banks themselves. But, as they say; “charity begins at home”. I don’t know how this compares to the trillions of dollars in write offs but given how bleak the outlook was just a few short months ago it has to be a welcomed sign

Enjoy the weekend.

Jim Delaney

C.M.O. 5.14.2009

Credit Market Overview
May 14, 2009

Away from the much publicized bankruptcy of Chrysler and, shall we say, imminent entering of Chapter 11 by GM there is an interesting story going on in the REIT world with General Growth Properties.

What used to trade under the symbol GGP has now added that moniker reserved only for those that have gone to “11” instead of heaven the dreaded “Q” and trades as GGWPQ. This is the least of it however. It seems that on its way to bankruptcy General Growth or GG for short took 166 of its malls along with it.

This was an unprecedented move as the structure of these REITs separates the parent company from the operating properties through a “special purpose entity” which makes them in legal terms “bankruptcy remote”. As GG said in court recently, it doesn’t make them “bankruptcy proof”.

As the single largest CMBS borrower in a market that is itself $700BN this is not doing good things for CMBS’s or REIT’s. “The company is doing something that would damage the entire CMBS industry. The filing for so many of these well-capitalized performing malls is an outrage,” said Richard Jones, a lawyer at Dechert LLP, which represents some secured creditors in the bankruptcy case.

As it turns out the boards of these properties are small and their memberships are drawn from the same pool of candidates creating a lot of overlap amongst the 166 properties. Not unlike the stories we hear where the Chairman fill boards seats with cronies, just replicated 166 times from a group of what has turned out to be very sympathetic ears.

Adding to the intrigue is that Farallon Capital Management LLC just won a three way bidding war to provide DIP financing to GG yesterday over Bill Ackman’s Pershing Square and the usually victorious in all situations Goldman Sachs.

The interesting bit is not that GS lost but that Farallon, as well as some of the partners in the firm are already GG creditors holding an undisclosed amount of the debt.

J.P. Morgan once said that the way to make a lot of money was to “put all your eggs in one basket and then watch that basket very closely”. It would appear that Farallon is doing just that.

Since they are in bankruptcy proceedings the CDS levels for GG have been static since the filing. The news, however, has not been good for the REIT industry as a whole. The RWR an ETF constructed to track the Wilshire REIT index closed last night at $32.40 down from a recent high of $36.58.

In CDS land the spreads for the 17 REIT’s the CEC Strategy follows are all widening or begun to do so. Although there is no guaranty that things will happen in the future the way they have happened in the past, if the negative correlation usually seen between CDS levels and stock prices holds this would lead to lower prices for REITs.

Enjoy the day.

Jim Delaney

C.M.O. 5.13.2009

Credit Market Overview
May 13, 2009

In bubble history, our current dilemma is being blamed on leverage. It is leverage in the traditional sense as it involves owning things without paying for them completely, up front and in cash. The banks and (ex) investment banks have been vilified for anteing up just over 3 cents of their own cash on some positions.

If this 30:1 ratio of real to monopoly money seems extreme let us not forget that through the wonder of “stated income loans”, originally designed for the self-employed whose write offs diminish income beyond recognizable amounts, people with W-2’s were able to create money out of thin air and purchase properties with absolutely no money down by using the same financial vehicle called by a slightly different name; “liar loans”. We’ll just call that infinity:1 leverage.

The bubble that burst in March of 2000 also had involved leverage but it was of the intellectual variety. While pennies might not have bought you dollars worth of exposure “.com” was a currency unto itself and having that suffix and an IPO put you in the same league as the best and the brightest from Silicon Valley without even having to move there.

Many of the companies, with market caps reaching into the hundreds of millions, don’t exist today as many of the financial entities that lent money without checking whether there was the slightest possibility of being repaid either no longer exist or won’t by the time this is all over.

Through all of this one name in the technology space stands alone, Microsoft. It is also one of just a handful of companies left that can boast an AAA rating and it sold some bonds yesterday. All three were bullets (non-callable) and ranged in maturity from 5 to 30 years.

Institutional bond investors need diversification just as much as a portfolio manager in equities does. Being able to add a new name, especially one with three A’s tagging along is a rare opportunity so needless to say there was good demand for MSFT’s paper yesterday.

Starting with the shortest maturity let’s have a look at each issue. $2BN of 5-year notes came with a 2.95% coupon at 95bps off of the UST 1 7/8 of 2014. The benchmark CDS level for “Softie” was 37.5bps mid-market yesterday so even with MSFT we see the lingering effects of the credit crisis as physical debt is priced cheaper (higher yield) than the synthetic that can be manufactured through the CDS market.

$1BN of 10-year paper had a 4.20% coupon and was priced at 105bps off of the UST 3 1/8 of 2019. The 10-year CDS market was ~38bps mid. The longest piece of paper was $750MM of debt that matures on June 1st of 2039. It also came at a spread off Treasuries of 105bps but the Treasury in this case was the 3½ of 2039 which gave the bond a 5.20% coupon. There is no easily available CDS quote for the 30 year area but as can be seen from the Treasury curve things tend to flatten out on the far end.

Because there are so few AAA issuers and none such in the tech space I thought the best way to give MSFT’s debt sale some perspective would be to look at another piece of tech debt and also another AAA name. (Triangulation in the financial sense of the word.) CSCO sold three issues back in February; only one of those was non-callable and since we’ve already got some apples and oranges mixed in it is probably best to leave the callable paper out of this.

CSCO’s 4.95% 10-year note came at 200bps off of the current Treasury at the time while the CDS for that maturity was trading at ~100bps. CSCO is rated A vs. MSFT’s AAA. From this we can see that the extra A’s and a slightly better credit environment allowed MSFT to issue paper 95bps better than CSCO.

JNJ is rated AAA by Moody’s, S&P and Fitch, which only gives MSFT AA+, so it is most certainly a premier piece of paper to own. Adding more oranges to the apple bin JNJ has not issued a 10-year non-call bond recently so we’ll have to use the 5.15% bond maturing on July 15th of 2018, issued last June.

This paper was sold at 103bps off the current TSY 10-year at the time. Here we have account for the optionality which would have made the spread wider but also that the markets had not completely imploded by last June so credit spreads were narrower. The CDX investment grade index was trading at ~113bps on 6/18/2008 vs. ~148 yesterday so that difference needs to be taken into consideration as well.

A lot of stuff to crunch on a Wednesday morning but hopefully an exercise that helps put the MSFT’s issues in perspective.

Enjoy the day.

Jim Delaney

C.M.O. 5.12.2009

Credit Market Overview
May 11, 2009

With the release of the “Stress Test” results last Thursday Treasury Secretary Timothy Geithner said that he was “reasonably confident” that the information would “make it easier for banks to raise new equity from private sources” while admitting that “we have a lot of work to do in repairing the financial system.” Concluding that “there is reassurance in clarity.”

There were a few bank CEO’s that questioned just how much “clarity” the tests actually brought with Richard Kovacevich, WFC’s CEO going out of his way to ingratiate himself with the powers that be by characacterizing the tests as being similar to the other word we use to describe a mule. Being the good CEO that he is, he got right to work and Wells was the first to issue stock after the tests were announced. And some good work it was too as WFC Wells sold $7.5 billion worth of common, above its originally planned $6 billion, or more than half the $13.7 billion indicated by the stress test.

Never one to be left too far behind John Mack jumped right on the capital raising band wagon and raised $4 billion in common equity, twice as much as planned and more than twice the $1.8 billion called for by the stress test.

One of the reasons these two firms were able to raise more than expected was that "A lot of money managers were underweighted in bank stocks relative to their benchmarks, and they've been panicked buyers because of what they see as an inflection point," says John McDonald, banking analyst at Sanford Bernstein.

Why the turn-around? “In February, some financial stocks were trading like insolvency was a foregone conclusion. The market now realizes these banks are going to survive,” said Jeff Harte, senior banking analyst at Sandler O’Neill + Partners.

Jeff’s colleague at SO+P, Brian Sterling who is co-head of investment banking added to the positive tone, “What we’re starting to hear from investors is a view that these companies were oversold and, although things are bad, they’re not as bad as was baked into the assumptions.”

Be that as it may there are others who are a bit more cautious. Joshua Seigel, managing principal at StoneCastle Partners thinks “there is some demand in the market to raise a certain amount, but whether you could find $60 billion in the next couple of months is highly unlikely.”

That is an interesting viewpoint given that “analysts at RBC Capital Markets estimate that 60% of the top 100 U.S. banks that weren’t included in the stress tests would need to raise capital based on the Fed’s loss assumptions.”
While the 19 banks that were part of the stress test have gotten most of the press they are a small portion of the 8,000 banks that exist nationwide not including the 33 that have already failed this year bringing the total to 58 since the beginning of 2008.

The goal for all of the institutions included in the stress test and the even broader category of those that received TARP funds is to pay those monies back and get back to the business of banking. Ken Lewis the ex-Chairman but still CEO of BoA is looking at a variety of ways to get Uncle Sam out of the guest room including selling business lines and other assets in addition to raising capital. “Our game plan is designed to help get the government out of our bank as quickly as possible.”

“As quickly as possible”, sounds fast; but will it be?

Enjoy the day.

Jim Delaney

C.M.O. 5.11.2009

Credit Market Overview
May 11, 2009

. . . Was your trip successful Mr. Holmes? The usual, Watson, murder, robbery; crime must pay as there hasn’t been any slow down in it that I can see.

Haven’t read a paper all week better catch up on the news. Hand me my glasses please Watson. Thank you. Gee, these seem a bit different; did you get me new glasses? Yes, Mr. Holmes they’re rose colored, seem to be quite the thing, everyone is wearing them now-a-days.

Well as long as they work . . . now let’s see Tuesday, May 5th “More Banks Will Need Capital”; Wednesday May 6th “BofA Faces $34BN Gap”; Thursday May 7th “Banks Need at Least $65 Billion in Capital”; Friday May 8th “Fed Sees Up to $599 Billion in Bank Losses”

None of this sounds too good Watson; markets must have gotten pummeled this week. Well actually quite the opposite Mr. Holmes, the Dow was up 362, or 4.4%, to 8575 on the week, the S&P 500 jumped 52 to 929, its 5.9% gain the biggest since late March while the Nasdaq rallied for the ninth straight week up 20, or 1.2%, to 1739. The Russell 2000 gained 25, or 5.1%, to 512 which puts it up 46% in the last nine weeks, Sir.

That’s amazing Watson. I wouldn’t have thought the market would have interpreted the news as positive but I have to tell you Watson, I do like these glasses. Everyone’s wearing them you say? Makes sense, I do feel better since I’ve put them on.

Since you seem to have followed the action pretty closely, Watson, what went on in the credit markets?

Well Sir, 3 month Libor was set at 93bps on Friday, which was the first time it has been below 1%. Below 1%, Watson, has that ever happened before? No Mr. Holmes, it hasn’t and if you remember it was as high as 4.87% just last October.

So Treasuries rising as well, Watson? Only the yields Sir, which you know is not good for prices. Yes, I know Watson, yields up; prices down, go on. Well Sir, Government debt is trading at yields we saw last November with the 10-year yield rising 13bps this week closing on Friday at 3.30% and the Long Bond yield rose even more, 19bps, which put that rate at 4.28% late Friday. People do seem to be concerned with how much debt it will take to finance the stimulus package, Sir.

So has that pushed up yields on Corporate debt as well Watson? No Mr. Holmes, spreads actually came in last week. Those CDX indexes you follow, well the Hi-Yield number is down to 1010 after closing last Friday at 1123 and the Investment Grade numbers were 143 this Friday versus 164 last Friday.


Well seems like people aren’t concerned about too much then Watson. Come to think of it, there probably isn’t anything to worry about. Where did you say you got these glasses from Watson?

Enjoy.

Jim Delaney

C.M.O. 5.8.2009

Credit Market Overview
May 8, 2009

The free marketers . . . yes, I know it Friday morning but I said “free marketeers” not “three musketeers” have been clamoring lo’ this entire crisis of credit, confidence and confusion to let the forces of supply and demand do what they do so well and allow evolution sort out who really belongs on the next branch of the financial tree.

Dwight D. Eisenhower warned in a speech in 1961 of the growing symbiotic relationship between the military and the nation’s private corporations. The line from that speech that best sums Ike’s message is as follows: “In the councils of government, we must guard against the acquisition of unwarranted influence, whether sought or unsought, by the military-industrial complex. The potential for the disastrous rise of misplaced power exists and will persist.”

A little known fact here is that DDE originally named the issue by its three sources, military-industrial-congressional complex but removed the final element as that was the same august body the President was delivering his speech to and fellow Republicans did not want to deal with the repercussions of its inclusion.

There is at the very least the possibility for this same co-dependent relationship to form, if it hasn’t already, with our present day leaders owning portions of the institutions other offices of the government are supposed to regulate. The first evidence comes as the CEO of GM is ousted and the manner in which the surviving banks do business is examined at more microscopic levels.

It is good, in all of this, that there are some who are chomping at the bit to repay the Government its money and get on with their business. It is also interesting that the current plan for when to let that happen has elements that make sense from an economic standpoint.

The major obstacle or in the politically correct vernacular, challenge, that the banks must overcome before paying back TARP funds is the ability to issue debt without the FDIC subsidy, TLGP. Ah, Darwin at his finest!

For an example of what this means, economically, we need look need look no further than the poster-child for the financial-congressional complex, Goldman Sachs. GS recently issued $2BN five-year notes sans TLGP at around 4.1% over the 5-year T-note. A few weeks prior they issued some three year paper at 2.17% over the 3-year T-note.

Now, just so we don’t get the apples to oranges rebuttal let’s go to the CDS curve for GS to make apples into oranges or vice versa. The mid point of the 3-year CDS market in GS was 217bps as of last nights close, the 5 year CDS; 196. I will talk about this inversion in a minute but one thing at a time.

The difference between the two CDS tenors is 20bps. This would mean that 3-year GS paper sans TLGP should be around 410bps – 20bps or 390bps off of Treasuries. This compares to the 217bps the TLGP paper was issued. In this case the market is requiring 173bps of additional yield to compensate for not holding the FDIC’s hand. That equates to $17.3MM per BN issued more interest expense per year. On last year’s balance sheet GS had ~$185BN of long term debt. 173bps on that comes to about $3.2BN. Not an insignificant amount.

A firm like Goldman might be able to earn its way through the additional interest expense and could believe doing so is well worth the distance it would buy from Congress’ prying eyes. Others might not be so fortunate but if the goal is to get the credit markets flowing again maybe only those who can ride without training wheels should be allowed to ride alone.

OK, a quick bit about the CDS curve inversion and then it’s off you go. The difference between the 3 and 5 year CDS’s I mentioned before was 173bps. Looking at a wider maturity range we see an even wider disparity in the CDS levels as 6mos CDS for GS closed at 255bps mid last night while the 10-year closed at 165bps mid, a difference of 90bps.

That the 6mos level is higher than the 10-year level seems to run counter to all the “liquidity preference theory” stuff we learned in ECO-101, buy why? Very simply, and quickly, people are willing to pay more to insure against a GS default in the next six months than they are for 10 years because they see the default risk higher for GS in the short term. It’s one of those; “if we can just get through this we’ll be OK” sort of things.

So there it is a little history, a little economics and way too long before the weekend starts.

Enjoy.

Jim Delaney

C.M.O. 5.7.2009

Credit Market Overview
May 7, 2009

The Oracle of Omaha said in his Op/ed piece in the NY Times last October that “a simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful”. Fittingly WB wrote that in the middle of a month that has some of the worst stock market memories history has known. The S&P closed at 940.55 on October 17, 2008 and if you pulled a “Van Winkle” between then and now you’d think: Not bad Warren, down a little over 2% but you’ve been down at least that much with your positions in Coke, and Salomon Brothers, back in the day so I’m sure you’ll be fine.

What you would have missed is the harrowing trip from the mid 900’s to the mid 600’s and back and while we will never know how greedy Mr. Buffett or anyone else was down where the devil plays it does make sense that capitulation came when everyone stopped looking for it and started looking for the nearest exit.

The rush to get out does not seem to have been countered by a rush to get in but the few brave souls that have ventured to the long side haven’t had to push very hard to move things up a fair amount in the process.

In some cases it might be argued that the only bravery needed was to keep the algorithm running, shut your eyes and hope for the best. Like the people who close their eyes and step on the gas when they have to pass a big truck on the highway; I might die doing this but at least it will be over quick!

It has also been interesting to see what has moved in this move and how some of the most time tested and oft-repeated axioms have once again held true. (How else to you get to be time tested and oft-repeated?)

“What leads you down will lead you up” comes to mind with the financials up 100% off their lows they have definitely been the poster child for this entire cycle. The Nasdaq too, made up of about 100 names you do know and many more you don’t, is far out pacing the broader, “higher quality” some might say, indexes.

This has also proved true on the fixed income side of things as High Yield bonds a.k.a. Junk is up 11.47% as a whole but digging a bit deeper we see that the stuff close to the border (BBB=good; BB=not so much) is up only about 7% while deep down in CCC land the price of paper has risen about 22%. For those not completely familiar with the ratings latter triple C is still three notches off of the bottom rating of D. (The numbers here are taken from the Merrill Lynch High Yield indexes.)

The warning that most often accompanied the hype of “spreads of 20% over Treasuries available on Junk bonds” a months or so ago was that the wave of defaults coming would do more damage to a portfolio of high yield bonds than the high spreads could fix.

This has not proved to be the case thus far as the HYG ETF a more readily trackable proxy for a portfolio of Junk was up almost 14% in April while 40 individual issues defaulted including the headline grabbing Chapter 11 filing of Chrysler in the last week of the month. HYG started the year at 76.01 and closed yesterday at 76.66 (let’s call it even for the year) while a total of 102 issues defaulted.

Steady and still floating looks a lot better than swamped and it’s also nice to see that through the worst of the storm the part of the bond market that is supposed to deliver “equity like” returns is doing just that.

I truly doubt we are out of the woods just yet and cannot get Marc Farber’s comment that “a true bull market never stands on one leg” out of my head. In present context that would mean a revisit to something near the devils playground. It also needs to be recognized that with stocks and bonds moving higher in tandem the progress the markets are making is balanced and that is never a bad thing.

One more wakeup!

Jim Delaney

C.M.O. 5.6.2009

Credit Market Overview
May 6, 2009

Ever since Bear Stearns was medivac’d to the intensely expansive care unit at J.P. Morgan the markets have had to contend with processing not only the abnormal changes brought on by a global financial system moving quickly from Code Blue to Code Black (the latter being a D.O.A. without the O.A.) but the ad-hoc efforts of the Federal rescesitators trying any number of methods and approaches to keep the global economy from flat lining.

I have tried, in that time; to relate how changes on the credit side of things were affecting things on the equity side. I might have also slipped once or twice in the process with a snide remark on any given initiative’s purpose or actual effectiveness versus the spiel given to sell it to the taxpayers or the leaders of other nations.

As such and in the spirit of callin’em like I sees’em there were some interesting announcements this week that I think are worth relating here as they pertain to the credit markets and the possible first warm rays of sun they are feeling even as we here in New York slog through weather that seems more appropriate for early March than early May.

The news that really caught my eye was the release of lending numbers for the Small Business Administration. Some of these are for the period from January to mid-March which, given that we hadn’t even hit the lows in the stock indexes yet, make them all that more impressive.

The bellwether category for SBA loans is the 7(a) program. For this type of loan the average number of approvals has risen 28% to 796 totaling $796MM from 622 loans totaling $117.9MM in January. Additionally, since the mid-March date SBA administrator Karen Gordon Mills says the volume of new loans has risen another 20% to about $1.3BN. “We’re looking at that as certainly not conclusive that everything is fixed, but we may be turning a corner” SBA spokesperson Mike Stamler said.

Some of these SBA loans are bought and sold on GovGex.com an online secondary market exchange for bundled SBA-backed loans. According to the Government Accounting Office 35% of the loans approved in the 7(a) program were traded on the exchange in February up from 24% in January. To give you a bit of perspective, 45% of these same such loans were traded during the September 2007 – September 2008 period. Giving the quantitatively inclined a shiver you might say we’re halfway back from Code Black. Also encouraging is that the number of bids per loan has more than doubled to about 6.7 since mid-March.

The increase in volume and activity can be attributed to a few things including a mid-March speech by President Obama’s in which he indicated the allocation of up to $15BN in federal funds to unfreeze the secondary market for these loans as well as a temporary reduction in the fees paid by small business borrowers and an increase in the federal guarantee of these loans from 85% to 90%.

I don’t have the stat’s handy at the moment but we’ve all read the percentage of people employed by small businesses and the ripple effects (I’m talking positive here folks.) that growth in small businesses can have on the community and the economy as whole.

Beyond that any sign of credit moving more freely has got to be welcomed.

Enjoy the week.

Jim Delaney

C.M.O. 5.5.2009

Credit Market Overview
May 5, 2009

We’ve all heard the market adage that a bull market climbs a wall of worry. I’m thinking they should change that last word to “wonder” as the move off of the March lows has been spectacular to say the least and if you can believe the media (rhetorical question) one that has left many wondering: “How did I miss that move?”

The “fake it till you make it” crowd also seems to be gaining some credibility as last month’s better than expected Industrial Production and GDP numbers in China were given an eye-roll by most as it was ventured that the long/strong arm of the government in the People’s Republic could manufacture economic statistics with the same efficiency that the factories there produce washing machines. (Disbelief runs deep after you see C trade at 79 cents.)

That there was so much emphasis on the personal consumption numbers portion of our own GDP figures last week seemed an equally implausible effort at making believe the car was running fine when it was just rolling down hill. All of this incredulity was given a jolt yesterday as the PMI index for China’s manufacturers came in at 50.1.

There is no doubt the car was rolling down hill but now the question must be asked whether it was to gain some momentum before popping the clutch and could the global economic engine, long thought to be China on the next leg up, be sputtering to life?

The move in the indexes, did leave some at the station but regardless of how little the financials now count in the indexes the move in the previously mentioned C from a low close of $1.02 on March 5th to $4.01 on the day before most of us pay our taxes, sans the head of the IRS of course, was a something only those who jump out of airplanes without parachutes would have participated in.

For all of the talk of the three letters of recovery; V, U and L, the last of which looks very little like a recovery at all, there has been adamant discourse about why this one [recovery] won’t look like the first one [V]. To the extent that this whole thing is far from over, the sliver of market time Feb 13th and March 23rd looks pretty “V” to me.

The credit markets experienced a bounce of their own during this period but only if you look at prices ass spreads look more like the ball was thrown against the ceiling. Here too the most drastic moves were in those bonds that looked most deadly, or really just mostly dead.

Laurence Fink, CEO of Black-Rock, said recently that the low yields on Treasuries was pushing investors further out the risk spectrum and in the time just past that meant paper branded CCC. Most of this paper was trading below 50 cents on the dollar while the S&P was clicking off triple sixes and the postponement of Armageddon has done for these bonds what it did for stocks and as such yields came down as prices rose.

We’re back to even, or thereabouts, on the year if your yardstick is the S&P. So far, so fast both down and up it’s been like getting caught in a revolving door and winding up right back where you came from.

The question is where do we go from here?

Enjoy the week.

Jim Delaney

C.M.O. 5.4.2009

Credit Market Overview
May 4, 2009

The precipitous drop in real estate values, both residential and commercial is a pretty good indicator of just how much fluff the easy credit in the first part of this decade created. Confirmation of this, as if some were needed, can also be found in the art market. In 2006 a single painting by Pablo Picasso sold at Sotheby’s for an even $100MM.

This coming Tuesday, when the spring auction season starts, there are a dozen works, that if all sold at the high end of their estimates, might just make it to that same 9 figure number. The estimate for the entire spring auction series is expected to generate somewhere between $179MM-$256MM versus $411MM last fall and $742MM a year ago. What a difference a year makes!

For those of us who can only dream of making $100MM in a life time let alone pay that amount for a little binder, pigment and canvas, mortgage rates matched the record low rate set two weeks ago of 4.78% for a 30-year fixed rate loan according to Freddie Mac. In its quarterly refinancing report FRE said that about half the borrowers who refinanced lowered their annual interest rate by about 20%.

What makes this a little more interesting, if you can stand the suspense, is that the move in mortgage rates occurred during a week when the yield on the 10-year Treasury, the note used as the benchmark for mortgages, rose to its highest level in 2009. The latter caused in part by the record $71BN in 10 and 30 year securities to be auctioned by the Treasury in its May refunding. The other factor pushing Treasury yields higher was the sale of those securities by mortgage investors.

Investors in the mortgage market use Treasuries to adjust the duration of their portfolios. As rates in general rise the duration of mortgages tends to lengthen as less refinancings occur. To counter this effect players in the mortgage market will sell Treasury securities. The move higher in the 10-year note yield caused some of this duration adjustment. “It’s either happening, or it’s the fear of it happening and people not wanting to get caught in the trade”, Adam Brown of Barclays Capital said.

In this case it seems to have been caused more by the fear as the move down in mortgage rates would only serve to increase the number of refinancings, bringing in the duration of the mortgage backed securities. The movement in opposite directions for Treasury yields and mortgage rates also served to narrow the spread between those two securities and as we all know from reading this column every day narrower spreads occur when there is less perceived risk in the market place.

Enjoy the week.

Jim Delaney

C.M.O. 5.1.2009

Credit Market Overview
May 1, 2009

The economic numbers yesterday continued to paint a less than sunny picture for the economy but from the market’s reaction to the recent statistical releases it would appear that investors are not only wearing rose colored glasses but that those glasses also have photo-chromatic lenses which increase the intensity of their “rosiness” as the news becomes less so.

Much has been written of the political wrangling going on over spending the stimulus money which is serving no other purpose than to delay the small portion of funds (20%) actually scheduled for this fiscal year.

Through all of this however there is a ray of light on the horizon and like the sun it comes from the east, only this east is the Far East and its source is China.

I do not speak or write Mandarin but I’m thinking the symbols for the phrase “shovel ready” must look like the outline of a crane (not the bird) and a bulldozer as just 11 days after the Chinese government approved a $930MM tunnel, bridge and expressway project in East China drilling equipment was already on site.

Where this helps the good ‘ol U.S. of A. is in places like Peoria Illinois; home of Caterpillar Inc. (CAT). James W. Owens left his [rose colored] glasses off when he spoke on a conference call following CAT’s 1Q09 earnings announcement on April 21st saying that plunging sales and the cost of thousands of layoffs were the factors contributing to the company’s first quarterly loss in 17years. He made specific mention at the time that he thought the Obama administration “should have allocated more money for public works under its stimulus plan”. Jim was equally less than optimistic when asked to project CAT’s full year sales and profit as it was at that time “extremely difficult to know how our customers will respond”.

Varying slightly from the well known song title, what a difference 11 days makes. A more recent conversation with Jim found him very much upbeat as CAT’s “excavator sales in China have returned to record levels in recent months, bouncing back from plummeting sales over the winter”.

When asked about future prospects from the land of a billion people he said China continues to have a great need for infrastructure and that projects there could start much more quickly there than could similar projects in the U.S. “It’s something like nine weeks in China versus nine months in the U.S.”

CAT’s CDS/equity relationship is a text book example of the negative correlation these two markets are supposed to exhibit. Additionally, given that the company’s fortunes are tied to global growth a chart of the two price streams represents a short history of the effects of the crisis we have experienced over the last 20 months or so.

With CAT’s CDS continuing to move lower from its March high of 427bps and the stock climbing off its March 2nd low of $22.17 (154bps, $35.58 as of last night’s close) things seem to be improving for CAT.

Who knows, maybe this recovery will have one of those little stickers on the bottom that says: “Made in China”.

Enjoy the weekend.

Jim Delaney