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

[EJ]

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.

[akrowne]

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

I wouldn't expect government or health care to hold out.

All quarters are now screaming for something to be done about health care. This means cutting the spending in that sector, probably 30-50%. And that means jobs and income in that sector will plummett. It doesn't matter if this is through a single-payor system or reform of the tax laws to create "true" privatization; either way it will be dramatic and it will be soon.

As for government spending, well, we're just starting to see pressure for accountability for war and homeland security spending -- and that spending itself is being questioned.

I see 3-5 million jobs being lost in 5 years.

[jk]

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

All quarters are now screaming for something to be done about health care. This means cutting the spending in that sector, probably 30-50%. And that means jobs and income in that sector will plummett. It doesn't matter if this is through a single-payor system or reform of the tax laws to create "true" privatization; either way it will be dramatic and it will be soon.

have to disagree with this. a national poll published in the ny times a day or two ago showed a majority supporting universal healthcare. if health reform is done properly there will be a reduction in staff at insurance companies, but likely a continued increase in numbers directly delivering services.

[tree]

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

"Universal" health care: Like the sham plans delivered by Arnold and Romney that leave folks like me--over 50, self-employed and with a chronic illness--paying an impossible portion of our income for premiums on plans with multi-thousand deductibles and then co-pays to boot.

Single payer: Universal Medicare. Government administered. Pricing? Haven't heard the numbers yet.

Insurance companies? Government?

Awful choice. But we have to pick our poison.

Given that insurance companies have had this racket to themselves for so long, I'm willing to give govt. a try as long as federal or state single-payer plans contain an option for folks to buy private supplemental plans from insurance companies. But given that insurance companies are such large contributors to political campaigns, it'll take a higher level of health care pain than now exists in the population--in other words, many more uninsurable baby boomers--before something changes. But the time is coming, I think.

Everyone has finally figured that insurance shouldn't be tied to employment. But to set everybody adrift and say you must buy your own, like car insurance, is yet another pay day for insurance companies that solves no problems for patients. Lastly, I don't think health care insurance should be geographically based either. That prevents chronically ill people from moving for activities such as better employment or taking care of aging parents.

[jk]

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

Everyone has finally figured that insurance shouldn't be tied to employment. But to set everybody adrift and say you must buy your own, like car insurance, is yet another pay day for insurance companies that solves no problems for patients. Lastly, I don't think health care insurance should be geographically based either. That prevents chronically ill people from moving for activities such as better employment or taking care of aging parents.

mandatory private insurance wouldn't be too bad, provided insurance companies must accept all comers and it requires community rating over large geographic areas -- i.e. no "previously existing condition" penalties or exclusions. you can relocate and insurers in your new area of residence must accept you and must give you the same rate as everybody else for many miles around.

[grapejelly]

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

mandatory private insurance wouldn't be too bad, provided insurance companies must accept all comers and it requires community rating over large geographic areas -- i.e. no "previously existing condition" penalties or exclusions. you can relocate and insurers in your new area of residence must accept you and must give you the same rate as everybody else for many miles around.

mandatory private insurance is by far the best solution because it is competitive and free market driven.

To make sure everyone gets insurance, the insurance companies can be required to insure people with pre-existing conditions in proportion to the market share of said insurance company (a la risk pool sharing as they do with auto insurance in many states.)

I don't see anything wrong with letting insurance companies price their policies any way they want. The free market will take care of things.

And, the states should roll back all the stupid sops to professional cartels such as mandatory coverage for mental health, "well baby" care etc. So people can purchase a minimal coverage level if they want to.

I support mandatory self-invested health savings accounts also for everyone. Tax shelter the medical money, give the consumer the responsibility for spending their health dollars, and you'd see some real competition and price restraints in the market. Also you'd see more use of non-medical health care that is cheaper and often just as effective (Buteyko, acupuncture, Chinese herbs, etc.)

[Jim Nickerson]

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

mandatory private insurance is by far the best solution because it is competitive and free market driven.

To make sure everyone gets insurance, the insurance companies can be required to insure people with pre-existing conditions in proportion to the market share of said insurance company (a la risk pool sharing as they do with auto insurance in many states.)

I don't see anything wrong with letting insurance companies price their policies any way they want. The free market will take care of things.

And, the states should roll back all the stupid sops to professional cartels such as mandatory coverage for mental health, "well baby" care etc. So people can purchase a minimal coverage level if they want to.

I support mandatory self-invested health savings accounts also for everyone. Tax shelter the medical money, give the consumer the responsibility for spending their health dollars, and you'd see some real competition and price restraints in the market. Also you'd see more use of non-medical health care that is cheaper and often just as effective (Buteyko, acupuncture, Chinese herbs, etc.)

Not in a hundred years, and probably never, will the consumer in America be responsible (and knowledgeable enough) when it comes to spending their health care dollars. Doctors are relatively too smart and consumers are dumb when it comes to having any understanding of what they are purchasing. All the private insurance companies do is skim dollars that might otherwise in a better system go to buying hopefully good health care.

[jk]

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

And, the states should roll back all the stupid sops to professional cartels such as mandatory coverage for mental health, "well baby" care etc. So people can purchase a minimal coverage level if they want to.

disagree on the "stupid sops." instead of competing on efficiency, your proposal allows competition by limiting covered services. this leads to cherry picking on the one side, and self-selection on the other, driving up the costs of the non-mandatory services. this is contrary to what insurance is for: spreading risk. psychiatric illness, biologically based, are no less real than any other illnesses - you cater to prejudice. "well baby" care reduces sick baby care. you propose disincentivizing prevention, an economic loser of a policy.

[Ed]

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

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.

This seems really eerie to me,
even though I’ve long-reckoned ‘there’s a whole lot of thin ice’.
(My recent post is at
http://groups.google.com/group/misc....504907e59f9e04

[grapejelly]

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

disagree on the "stupid sops." instead of competing on efficiency, your proposal allows competition by limiting covered services. this leads to cherry picking on the one side, and self-selection on the other, driving up the costs of the non-mandatory services. this is contrary to what insurance is for: spreading risk. psychiatric illness, biologically based, are no less real than any other illnesses - you cater to prejudice. "well baby" care reduces sick baby care. you propose disincentivizing prevention, an economic loser of a policy.

it increases consumer choice and lowers cost by debundling services a consumer doesn't want to pay for.

Mental illness is extremely subjective. It is highly discretionary. We are almost all mentally ill according to the expansive definitions of that "profession".