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Thread: Goldman, Merrill Almost `Junk,' Their Own Traders Say

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    Mar 2006
    Boston, Mass.

    Default Goldman, Merrill Almost `Junk,' Their Own Traders Say

    Goldman, Merrill Almost `Junk,' Their Own Traders Say

    March 2, 2007 (Shannon D. Harrington - Bloomberg)

    Goldman Sachs Group Inc., Merrill Lynch & Co. and Morgan Stanley, which earned a record $24.5 billion in 2006, suddenly have become so speculative that their own traders are valuing the three biggest securities firms as barely more creditworthy than junk bonds.

    Prices for credit-default swaps linked to the bonds of the New York investment banks this week traded at levels that equate to debt ratings of Baa2, according to Moody's Investors Service. For Goldman, Morgan Stanley and Merrill that's five levels below the actual Aa3 rating on their senior unsecured notes and two steps above non-investment grade, or junk.

    Traders of credit derivatives are more alarmed than stock and bond investors that a slowdown in housing and the global equity market rout have hurt the firms. Merrill since 2005 has financed two mortgage lenders that subsequently failed and bought a third, First Franklin Financial Corp., for $1.3 billion.

    "These guys have made a lot of money securitizing mortgages over the years in a mortgage boom time,'' said Richard Hofmann, an analyst at bond research firm CreditSights Inc. in New York. "The question now is what is the exposure to credit risk and what are the potential revenue headwinds if they're not able to keep that securitization machine humming along.''

    AntiSpin: The answer to that question, according to our interview with Jim Finkel, whose company Dynamic Credit Partners, LLC, creates CDO packages for hedge funds and bond portfilios, is: a lot of exposure.

    I interviewed Jim recently and the first part is available today here.

    Jim has been in the CDO market for more than twenty years. He was lead banker for Numera Securities starting in 1992, helped form Bear Sterns' structure products group 1995, was a pioneer in the euro CDO market in 1998, and founded Dynamic Credit in 2004.

    Below are the headlines.

    Part I (20 min. - Available for free to all)
    1. A CDO is like an apartment building–and they make money as long as all the "rooms" are rented out, and "tenants" are paying the rent
    2. One hundred times leverage
    3. Risks of CDOs
    4. Billion dollar deals with $10 million of equity
    5. Spread compression tends to be vintage specific
    6. Hidden factors within the securitization market
    7. A rolling loan gathers no loss
    8. Buy-back obligations will lead to more bankruptcies
    9. Major risks lurking in speculative and second homes
    Part II (30 min. - Available to iTulip Select subscribers next week)
    1. Risks of financial engineering and transaction based lending
    2. Competition among lenders leads to bad loans
    3. Efficient market theory will win: lenders who make bad loans will go bankrupt
    4. Sound loans depend on market-priced housing values and accurate FICO scores–but both are gamed
    5. Mortgage derivatives indexes use optimistic model based valuations
    6. Financial engineering will create problems when mark-to-model becomes marked to market
    7. Holders of distressed mortgage securities will find themselves competing for a very small group of buyers
    8. Debt markets lulled in a cradle of comfort by past bale-outs, leading to the kind of craziness we see today
    9. Between 45% and 60% of all bank loans are going into PE deals
    10. Private equity bubble is even bigger than mortgage bubble, and serious macro-economic fallout is more likely
    11. If housing decline 15% to 20% nation-wide, the mortgage securities market will be in dangerous, uncharted territory
    12. Bracing for the expected distress
    Jim is less than sanguine on both the mortgage and Private Equity debt bubbles, but is optimistic about the prospects of making money in the secondary markets, much as Dynamic did following the period of corporate junk bond distress in the early 2000s. We will check back in with Finkel in a few months to see how Dynamic Credit is doing and how his predictions are holding up.

    The news that junkification has reached the top Financial firms came as a surprise. Earlier this year The Trumpet reported in America: Home of “Junk”-Rated Companies:
    Flea market and garage sale enthusiasts often find the allure of discovering treasure among junk intoxicating. Junk collectors read on, because the biggest junk market in history is here: the U.S. stock market.

    An incremental but dramatic shift in the credit worthiness of corporate America has occurred over the past two decades. Most companies now have junk-grade B credit ratings. The A category investment-grade ratings that dominated the U.S. corporate credit landscape just a couple of decades ago are becoming rarities.

    American industrial corporations just set a new record according to credit rating agency Standard & Poor’s. Seventy-one percent of all U.S. industrial corporations tracked by the agency now have “junk” quality status (BB ranking or lower). As recently as 1980, fewer than a third fit that description.

    Today, an amazing 42 percent of the approximately 2,000 monitored nonfinancial, non-utility corporations have credit ratings of B, one step deeper into junk status than BB, and the lowest credit rating that isn’t vulnerable to immediate default. In 1980, only 7 percent of companies had that dismal rating (Wall Street Journal, January 4).

    Only six nonfinancial corporations currently qualify for the highest label of AAA—a sharp contrast to previous decades.
    Financial companies have represented the top tier of corporate debt ratings, until now. What does this say about the health of the FIRE economy? It appears to be following the Industrial Economy into the junkyard.
    But investors should pay close attention to credit ratings. Historically, companies with junk credit ratings have been extremely vulnerable to bankruptcy. And because these companies have so much debt (which is usually a big reason why they have such a dismal credit rating in the first place), when they collapse, shareholders are typically left holding an empty bag.

    Among one survey of approximately 120 B-rated companies that borrowed money through debt markets for the first time in 1996, just 6 percent have since paid off their debts. According to Standard & Poor’s, a full third of the corporations in this study defaulted or went into bankruptcy procedures; another third have been taken over by other companies.

    For investors, the financial downgrading of corporate America could have important stock-market implications. Don’t be fooled by recent record stock market heights that may be obscuring the financial fragility of many companies. Over the long term, financial fundamentals most affect a business’s viability and therefore valuation and stock price. “If credit quality is decreasing, there will [eventually] be effects on stock prices—sometimes dramatically nasty ones,” warns Harry Koza, senior Canadian markets analyst at Thomson Financial.

    When so many corporations have such poor credit ratings, it is a sign of underlying weakness in the sector and the economy as a whole. Mounting credit downgrades have historically preceded lower gross domestic product growth. Therefore, a rapidly rising number of credit downgrades, which is what seems to be occurring today, may be a harbinger of a recession.

    “It bodes very bad if we have a hard landing,” said Martin Fridson, publisher of the Leverage World research service. “Given today’s ratings mix we could have default rates that would make even the ‘Great Debacle’ of 1989-1991 … pale by comparison.” He warns that even a softer landing could still cause default rates to jump to the high single digits.
    Many people left unemployed by the high technology industry downturn headed off into either real estate or financial services. Real estate is early in a game that may well go into extra innings, leaving health care, government, and the military as the remaining growth areas to provide employment should a great debacle ala early 1990s re-occur, or if we get something worse. With news of the junkified financial services industry, a future reflated, post housing and Private Equity bubble U.S. economic landscape is starting to sound more like the old Argentina every day.

    Last edited by FRED; 03-02-07 at 11:34 PM.



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