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