Goldman, Merrill Almost `Junk,' Their Own Traders Say (Update2)
By Shannon D. Harrington
March 2 (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.''
Credit-default swaps on the debt of Goldman, the world's biggest
securities firm, have risen to $32,775 per $10 million in bonds, up from
$21,500 at the start of the year, according to prices compiled by London-based
CMA Datavision. The price touched $35,000 on Feb. 28, the highest since June
2005.
Spokesmen and spokeswomen for Goldman, Lehman, Merrill and Morgan Stanley
declined to comment. A spokeswoman for Bear Stearns didn't immediately return
calls for comment.
Conceived to Protect
Morgan Stanley and Goldman were among the top five traders of
credit-default swaps in 2005, a group that represented 86 percent of the
market, according to a September Fitch Ratings report. Lehman, Merrill and Bear
Stearns were among the top 12.
Credit-default swaps that trade at such wide gaps below actual ratings
tend to rally, said David Munves, director of Moody's credit strategy research
group.
The contracts were conceived by Wall Street to protect bondholders
against default and pay the buyer face value in exchange for the underlying
securities should the company fail to adhere to debt agreements. An increase in
price indicates a decline in the perception of creditworthiness; a drop means
the opposite.
Contracts tied to Morgan Stanley, Merrill, Lehman Brothers Holdings Inc.
and Bear Stearns Cos. also are at 19-month highs.
Rising Prices
Morgan Stanley credit swaps have risen $10,000 to $32,775 this year, CMA
data show. Contracts on Merrill jumped $16,500 to $33,000. For Lehman, they are
up $12,440 to $34,440, and the swaps on Bear Stearns have climbed $12,080 to
$33,830.
By contrast, Deutsche Bank AG in Frankfurt, Germany, is trading near a
record low at 9,800 euros, according to data compiled by Bloomberg. And, a
Standard & Poor's index of investment bank stocks has fallen 6.29 percent this
year.
The increases were larger than an index that measures credit risk for
investment-grade companies in North America. The cost of protecting $10 million
in debt included in the Dow Jones CDX North America Investment Grade Index has
risen $1,250 to $34,750 this year, according to Deutsche Bank prices.
Lehman and Bear Stearns credit swaps traded as if their debt were rated
four levels lower than their A1 rankings. High-yield, high-risk notes, or junk
bonds, are rated below Baa3 at Moody's and lower than BBB- at S&P.
More Bearish
Credit-default swap investors are more bearish than bondholders, data
from Moody's Market Implied Ratings service shows. As of Feb. 28, the bonds of
Goldman and Morgan Stanley were trading as if the debt were rated a step below
Moody's official rating. Goldman has $171.6 billion in bonds outstanding,
according to data compiled by Bloomberg. Morgan Stanley has $168.5 billion.
Last year was the best ever for the five biggest Wall Street firms, whose
combined profit rose 33 percent to $132.5 billion.
Subprime mortgages, loans taken out by homebuyers with poor or limited
credit histories, typically charge rates at least two or three percentage
points above safer, so-called prime loans. They made up about a fifth of all
new mortgages last year, according to the Washington-based Mortgage Bankers
Association.
Subprime Turmoil
At least 20 lenders have shut down, scaled back or been sold this year.
Countrywide Financial Corp., the biggest U.S. mortgage lender, yesterday said
borrowers were at least 30 days past due at the end of last year on almost a
fifth of the subprime loans that it serviced for others.
``There's been a little bit of a reappraisal of the financial sector,
with a strong desire to get away from subprime exposure,'' said Scott
MacDonald, director of research at Aladdin Capital Management LLC in Stamford,
Connecticut, which manages $16.5 billion in assets.
Merrill equity analysts two days ago cut their recommendations on
Goldman, Lehman and Bear Stearns shares as well as that of European banks
Deutsche Bank and Credit Suisse Group to ``neutral'' from ``buy'' because they
said earnings will probably decline next month as investors become wary.
Bear Stearns's stake in non-investment grade retained mortgage
securities, or what its keeps from packaging loans into bonds, represents about
13 percent of the firm's ``tangible'' equity, according to CreditSights.
For Lehman, it's 11 percent. Goldman, Morgan Stanley and Merrill don't
disclose how much of their total retained securities are rated below investment
grade, or junk. Overall, their exposure is in ``the low- to mid-teens,''
CreditSights said.
Disclosure `Lacking'
``Disclosures are kind of lacking,'' Hofmann at CreditSights said in an
interview. ``They don't tend to break out the subprime piece of their retained
interest.''
Losses also may come from the banks' trading in mortgage bonds and
derivatives tied to them, the firm said. An index of derivatives based on 20
mortgage securities rated BBB- and created in the second half of last year has
fallen by more than a third since last month.
Companies with similar gaps between their actual rankings and ratings
implied by credit-default swap levels have outperformed their peers 87 percent
of the time over a one-year horizon, he said. Because an active credit swaps
market has existed for less than a decade, that percentage is based on only 37
observations, Munves at Moody's said.
At the same time, the same companies had an above-average risk of being
downgraded, with about 22 percent of them having their ratings cut, he said.
To contact the reporter for this story: Shannon D. Harrington in New York
at [EMAIL PROTECTED] .
Last Updated: March 2, 2007 10:08 EST
Terms of Service | Privacy Policy | Trademarks
[Non-text portions of this message have been removed]
