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