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Monday, September 10, 2007 12:15 PM


Duration Mismatch Causing Severe Stress Everywhere


Bloomberg is reporting Wall Street Credit Costs Soar on Spread to U.S. Rates

Wall Street is getting no benefit from the biggest bond market rally in five years.

Lehman Brothers Holdings Inc. faces higher borrowing costs today than it did in June, even after the steepest quarterly drop in U.S. Treasury yields since 2002 pushed interest rates down for everyone from Procter & Gamble Co. to AT&T Inc. Investors are so leery of Bear Stearns Cos. that its 10-year bonds trade at a discount to Colombia, the South American nation that's barely investment grade. Goldman Sachs Group Inc. is being punished with a higher yield than Caterpillar Inc., the heavy-equipment maker.

Contagion from the highest delinquency rate on U.S. mortgages in five years is paralyzing some of Wall Street's most lucrative enterprises.

As mortgage applications drop, Lehman, the biggest underwriter of bonds backed by home loans, is retrenching. The New York-based firm plans to cut more than 2,000 jobs as it scales back mortgage lending at home as well as in the U.K. and South Korea. Countrywide Financial Corp., the largest U.S. mortgage lender, said Sept. 7 that it will eliminate as many as 12,000 positions in the next three months.

The five largest U.S. securities firms -- Goldman, Morgan Stanley, Merrill Lynch & Co., Lehman and Bear Stearns -- will have to fund $75 billion of loan commitments to LBOs at a loss because most investors have stopped buying that kind of debt, Citigroup Inc. analyst Prashant Bhatia estimated last month.

"They have been, to their ruin in some cases, borrowing short and investing long," said Jim Cusser, who helps manage $1.5 billion in fixed-income investments at Waddell & Reed Inc. in Overland Park, Kansas. "Now they're regretting that, because what they put their money into isn't panning out."

Keefe, Bruyette & Woods Inc. analyst Lauren Smith cut her price targets for Lehman, Morgan Stanley, Bear Stearns and Goldman today because widening risk premiums on company bonds have slowed borrowing and stalled buyouts.

Lehman's A-rated subordinated notes due in 2017 yielded 6.66 percent on Sept. 5, according to trades of more than $1 million on NASD's Trace system. The same day, Colombia's senior debt maturing the same year, though rated four levels lower, was at 6.47 percent. Bear Stearns's subordinated bonds maturing in 2017 also should command a premium over Colombia by virtue of their A rating, yet they trade at an even bigger discount.

Investors dismissed Bear Stearns's corporate A+ rating when it sold $2.25 billion of five-year notes in August, after two of the firm's hedge funds collapsed because of bad bets on subprime mortgages. They demanded a near-junk yield 2.45 percentage points higher than the comparable Treasury, four times the risk premium Bear Stearns paid on a similar sale in January.

The explosion in credit spreads on Wall Street may take an even heavier toll on profit next year, when the five firms have almost $133 billion of bonds maturing, according to data compiled by Bloomberg. Bond indexes maintained by Merrill show that the cost of refinancing that debt has swelled by about $1.3 billion since the beginning of 2007, excluding the cushioning effect of any interest-rate hedges.

"Any securities firm is an institution that requires access to capital to fund itself," said Mitch Stapley, who helps manage $12.7 billion at Fifth Third Asset Management in Grand Rapids, Michigan. Wider spreads "will impact their profitability," he said.

Goldman is the only firm to have distributed its refinancing obligations so there's no outsized amount of debt coming due in a single year. Merrill has $42 billion of bonds maturing next year, the most on Wall Street and about 50 percent more than in 2009. Morgan Stanley is next at $34 billion.

More Leverage

The securities industry has relied increasingly on borrowed money to boost profits and returns for investors. In the first quarter, Goldman had 24.7 times more in assets than it had in shareholders' equity, and the firm's return on the tangible portion of that capital was 44.7 percent. Five years earlier, in the first quarter of 2002, the leverage ratio was 16.8 and return on equity was 15.4 percent.
Duration Mismatch and Leverage

Leverage is a wonderful thing when spreads are moving in your direction. It's now payback time for those who borrowed short and lent long. Short term borrowing costs are rising while the value of long term assets, especially mortgage debt is sinking.

See Duration Mismatch to Bankruptcy (in one week flat) for the saga that caused Sentinel to go bankrupt in short order once their mismatch mattered.

The issue is not whether it's absurd for Lehman or Bear Stearns debt to be trading at a discount to Columbia, the issue is how much leverage Lehman (LEH), Bear Stearns (BSC), Merril Lynch (MER), Goldman Sach (GS), Citigroup (C), Morgan Stanley (MS) are using as well as the timing and size of needed debt rollovers.

It was a huge mistake for corporations to assume they could perpetually roll over short term debt at good prices. If you stop and think about it, many homeowners over leveraged in homes have a similar mismatch problem. Incomes have not risen as expected but short term financing costs have gone through the roof with no way to roll over the debt.

And just because debt of major U.S. corporations is trading at a discount to Columbia, does not necessarily mean that U.S. debt is misspriced. I sense emerging market debt is yet another shoe to drop. For more on the idea that "It's Raining Shoes" please see A House of Credit Cards.

Profit at companies dependent on short term financing is going to impact corporate bottom lines. This is yet another reason stock prices have more to drop.

Forward looking earnings estimates are far too optimistic which is one problem in and of itself, but the second problem is that in an attempt to keep earnings up, more layoffs in the financial sector are coming. This is going to further fuel enormous problems in the jobs market. See Moonbats Active Again in Massive Jobs Disaster for a look at the grim jobs picture.

Just a Mortgage Related Problem?

Inquiring minds might be asking if this is just a mortgage or housing related issue. The answer is no, it's a universal lending issue as explained by "Minyan Peter" Loan Types This Credit Cycle... All the Same To Me.
While subprime mortgages may be the first to surface (which makes perfect sense to me, these were the most stretched borrowers), there are significant similarities across all major US loan categories in this credit cycle - from car loans to credit card loans to home equity and higher quality mortgage loans, all the way to LBO loans. The underpinnings for growth were fundamentally the same. How?
  • An unprecedented volume of loans in this credit cycle were originated for sale. Whether these were car loans from the Big Three or LBO loans, securitization or outright sale was an integral part of the business model.
  • With securitization came an unprecedented reliance on the rating agencies for asset quality judgment. If the rating agencies liked it, it was liquid. (And what I don’t think anyone has thought through is the liquidity consequences of hundreds of billions of dollars of securities being downgraded simultaneously by the rating agencies. In the old days, the rating agencies gave big companies a little time to get their liquidity house in order before they hit them. How do you handle that when you are talking about potentially whole asset classes?)
  • Many of the lenders/investors were thinly capitalized, gaining access to the credit markets through the underlying ratings on their collateral and standby liquidity facilities from a major bank. Further, and as a consequence, there was a serious asset/liability mismatch with many long-term assets funded in the short-term credit markets. While the CP conduits were rooted in funding short term trade receivables, their use has now stretched to finance 30 year mortgages.
  • Many of the ultimate lenders/investors (hedge funds, CDO sponsors etc.) were start ups. Like the dot.com boom, if you had a concept as to how to make money using leverage, you had access to capital.
  • There were aggressive covenant/credit terms in the underlying loans. One of the clear consequences of an originate-for-sale underwriting mindset is that unless someone else says no, anything is possible.
  • Loan maturities were stretched, and, in some cases, even waived. For example, the average maturity on a car loan originated in 2006 was 65 months up from 48 months in the last cycle. And the use of PIK bonds became standard operating procedure in the LBO market.
Finally, and with all due respect to my younger banking brethren, there was inexperience through a real credit cycle. Yes, 1998 was a battle, but it has been a full generation (almost 20 years) since the last really tough, “banks being taken over by the regulators,” credit cycle. I would suggest we have a lot of generals in the financial services sector right now who have never seen a war. And I can tell you that watching a bank CEO turn over the keys is an experience you never forget.

-Minyan Peter
Inquiring minds might be asking "Who is Minyan Peter and what are his credentials?" The answer can be found in his first post on Minyanville in Minyan Mailbag: A Bird's-Eye View of the Credit Conundrum
I am a new Minyan, but in my former life I helped build and ultimately ran a Wall Street asset-backed securities business, was treasurer of a top credit card company and treasurer of one of the largest banks in the Midwest.

....
More of his thoughts can be found in Minyan Mailbag: Brave New World For Debt Issuers.
Every corporate treasurer knows there are only two times when you issue long term debt: when someone is throwing money at you and you are stupid not to take it and when you absolutely have to.

...

this is not what a normal investment grade fixed income market looks like. This is an in-distress, by-invitation-only market. And the longer this goes on, the more lesser-quality corporations will become stressed. Some will draw on their bank credit lines, and some will bite the bullet and pay up to get things done. But watch this space. This will be one of the first tells as to whether the credit environment is getting better or worse.

-Minyan Peter
In a Minyanville Buzz just this morning Minyan Peter shared this view:
In the category of you never know where you'll find something out... My inlaws got a call from their broker in South Carolina offering them a new 30 year Barclay's (BCS) preferred at 7 1/8%. Total deal is $300 mln: 12 mln shares at $25 each, minimum of $1,000 increments.

Better than any headline I have read, this tells it all. What would cause Barclay's, probably the best retail banking name in Europe, to feel the need to come to the U.S. for a retail targeted preferred? And, to my point on Friday, why would you issue preferred stock now unless you absolutely needed capital?
Thanks Peter for sharing your views with us on "The Ville".

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

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