Credit Market Overview

March 10, 2010

http://www.marketstrategiesmgmt.

Before there were dedicated 24-hour sports networks ABC would broadcast “Wide World of Sports” every Saturday afternoon.  The tagline for that show: “Spanning the globe to bring you the constant variety of sport… the thrill of victory… and the agony of defeat… the human drama of athletic competition… This is ABC's Wide World of Sports!", seems as if it could apply to today’s financial markets without too much editing, “Spanning the globe to bring you the constant variety of economic indicators…the thrill of finding an indicator you can believe….the agony of finding out you can’t…the human drama of trying to make sense of all of the cross currents of information…these are today’s financial markets.”

In my effort to “span the globe” in search of information indicating whether this recovery is lasting or temporary I thought we might look at those things that span the globe.  Well, span might be a bit overarching, but at least those things that criss-cross it frequently and that would be the massive container ships carrying raw materials in one direction and finished goods in the other.

One of the main indices for shipping activity is the Baltic Dry Index (BDI), the “dry” here meaning not “wet” which really means anything that is not oil.  The problem is that what was a very accurate indicator of global commerce is being watered down by the supply of new ships that were ordered when it looked like the world would continue on its path to ever higher consumption. 

Given the lag between order and launch those ships are hitting the water at a time of less than peak demand.  “What you’re witnessing is a huge number of ships ordered during the peak of the market in 2007-08 being delivered now due to the usual lead times involved,” was how Amrita Sen, a commodities analyst at Barclays Capital in London put it.  Because of this Plamen Natzkoff, a dry bulk freight strategist at Citigroup in London, believes that the BDI “will be less responsive to shifts in demand as the over supply of vessels becomes more pronounced.”

Interestingly, as the fog rolls in on the BDI Genko Shipping has decided to carve out a piece of itself and offer 16.3MM shares of an entity it will call Baltic Trading (BALT) at about $15 per share.  This equity is meant to mimic movements in the BDI and if the IPO is successful, BALT will use the $245MM raised to buy six big bulk carriers which will ply the planets oceans in search of spot shipping assignments.  The entity will have no debt so its shares are designed to more accurately reflect changes in global shipping rates.

To the extent that BALT will provide a lighthouse of information on the dark waters of global commerce data there is a risk that folks might not like what they see. 

Shedding some of its own light on shipping, A.P. Moller Maersk AS (MAERSKB DC DKK) recently reported its first loss since the company floated its first boat in 1904.  “The loss was significant, but 2009 was an extraordinary year with historically low rates and low demand”, was how CEO Nils S. Andersen put it.  Nils went on to say that he expected Maersk to turn “a modest profit” in 2010.  Emphasizing his view that “shipping is not a commodity” and that Maersk “wants to provide superior service based on customer needs”.  These are wonderful sentiments but the BDI and BALT could make for some rough seas in convincing people of such.

There are no CDS traded on Maersk and there are no good substitutes within the CEC universe as all of the names there represent air and ground shippers.  It should be noted, however, that the CEC strategy is currently long 10 of the 11 stocks in that sector with the exception of YRC Worldwide (YRCW) which is more of a story stock at this point given its brush with bankruptcy caused by outsized pension obligations.

As for shipping in general, needless to say it would be a good thing if all those ships “spanning the globe” pulled into harbors of profitability.

Enjoy the week.

Jim Delaney



Credit Market Overview

March 9, 2010

http://www.marketstrategiesmgmt.

In solving most white color crimes the key to finding the culprits is following the money.  While in no way suggesting such nefarious goings on, it is quite useful to apply this tactic to Wall Street when trying to determine where the strength and weakness might be across various business lines and asset classes.

In early February Barron’s interviewed Roger C. Altman, CEO of Evercore Partners.  The part of that Q&A most germane to today’s theme was this “A” that came after one of Larry Strauss’s “Q’s”: “Historically, you see that the upcycles last five to eight years, and the downcycles typically two to three years. We have just come through more than a two-year down cycle, and it is clear to me that we have turned the corner.”

This view was bolstered when it was reported last week that when data from Capital IQ was analyzed by the WSJ it was found that the 382 non-financial firms in the S&P 500 were sitting on top of $932BN in cash and short term securities.  The answer to the question of what to do with all that dough has been in part supplied by the fact that stocks are still trading about 27% below their 2007 highs.

The result is best exemplified by Walgreen’s (WAG) $618MM cash bid for Duanne Reade (Private).  Wade Miquelon, CFO of WAG reasoned it this way: “We are sitting on a lot of cash and generating a lot as well, sitting around on all that cash and have it earn very little really does not make a lot of sense.”  Wade went on to say, “We are conservative with our cash, but hoarding it right now isn’t probably the best use of it.”

Like the WAG deal, cash does seem to be king at the moment, or at least the preferred method of acquisition as through 2/28 the percentage of cash deals in the U.S. more than doubled from the same period in 2009 according to Thomson Reuters with 50% of this years deals being paid for outright vs. about 24% in 2009.

The activity appears to be stretching across wide swaths of the economy as India’s Essar Group just agreed to fork over $600MM greenbacks to buy U.S. coal producer Trinity Coal from U.S. based P.E. firm Denham Capital.  Additionally, while not the major thread of this morning’s monologue it should not be lost that there is increasing demand by the world’s fastest growing economies (India and China) to lock up supply of the raw materials those countries need to continue their growth.

Coal is used is used in those industries where a lot of heat needs to be generated and the two that come most quickly to mind are energy and steel.  That second use is adding more fuel to the M&A fire as Wayzata Investment Partners, a P.E. firm has been quietly acquiring small foundries across the U.S. in places like St. Cloud, Minn., New Castle , Ind. and Iron Mountain, Mich.  While the deals are not big ($70MM for Grede Foundries in St. Cloud) the folks at Wayzata believe the resurgent economy will make foundries a “hot” investment.  In support of their idea the national trade group for America’s foundries is quick to note that 90% of man-made products in the U.S. contain a part made in one of this or another country’s 2,100 foundries.

For proof of the “other country” part of that last statement we need to look no further than two of the grand pillars of the private equity business Kohlberg Kravis Roberts & Co. and TPG Capital who appear close to inking a deal to buy Morgan Stanley’s stake in China Capital Corp.  If successful KKR and TPG would split MS’s current 34.3% stake in CICC with Henry Kravis and David Bonderman, founders of their respective firms, gaining seats on CICC’s board.

Needless to say none of this activity would be going on if all of the very smart people involved in these deals didn’t believe the outlook for the world’s economy was more positive than negative.  It is also worth being reminded that bids, whether they come from another company or a P.E. firm, are usually at a premium to current market prices in order to entice holders to surrender their stakes.  As such M&A activity is usually not a bad thing for anyone lucky enough to own part of a target company or for stocks in general.

Investment grade CDS spreads continued lower yesterday closing at 83bps.  That level was last seen on Jan 10^th of this year while spreads were on their way up to their 106bps peak on 2/8.

High Yield spreads closed at 519bps yesterday which matched the 1/20 close, which like IG spreads, were on their way higher at the time cresting at 637bps on 2/15.

In the period leading up to the market’s highs in October of 2007 M&A deals were paid for with heaps of debt which was used to pay the acquirers huge upfront dividends.  The current mode of cash acquisitions leaves the acquisitors with a lot more skin in the game.  Needless to say, if you follow the money, this should lead to more careful corporate stewardship.

As for Mr. Altman’s view on the prospects of M&A, all we can say is roger, Roger.

Enjoy the week.

Jim Delaney

Credit Market Overview

March 8, 2010

http://www.marketstrategiesmgmt.com

Ben Bernanke has, at almost every opportunity imaginable, made it clear that interest rates will remain at “exceptionally low levels for an extended period”.  The only issue with any of this is that Ben works in Washington and whether the Fed is independent or not, you just can’t believe anyone in D.C. 

In order to corroborate Ben’s story a review of the opinion of some of the major financial institutions view on when rates will rise was published in the WSJ recently.  The results were that Morgan Stanley and UBS think it happens this July, Citigroup this October, Bank of America in January of next year, J.P. Morgan Chase in April 2011 and Goldman Sachs in January of 2012.

The markets, for just about the entire time since the first tremors of the credit crisis were felt in July of 2007, have reacted to every event, both positive and negative, with highly correlated moves among assets within a specific class as well as the across the various asset classes themselves.  Evidence of this can be found in examining the moves of the major stock and commodity indices which rose in tandem from 2006 to mid-2008 and the fell in sync until March of 2009.  They have both since risen from the March lows and even stayed highly correlated in the latest mid-January to mid-February sell off, also recovering as if joined at the hip.

The pundits place the reason for this synchronicity as a result of the global nature of the crisis and the realization that a global recovery will ultimately be necessary to right the ship that is the super duper tanker of the planet’s economy.

With that in mind it is worth noting, Ben Bernanke’s intention for interest rates not withstanding, that rates on the short end of the curve have begun to move higher.  The yield on the 3-month T-Bill closed at 0.1359% on Friday after having bounced off of 0.0051% on 11/19/2009 and 0.0203% on Jan 11^th of this year.  3-month LIBOR has been as low as 0.24875% on four different occasions in the last four months; most recently on the 4^th of February.  That rate was set at 0.25219% on Friday.

Higher rates, in this context and coming from such low levels, can be viewed as a positive for the global economy as even with the sovereign debt problems of the PIIGS, 9.7% of the world’s largest economy officially out of work which speaks nothing of 16MM underemployed and a host of other worries the fact that 3-month Bills are no longer trading at -0.0410% as they were on 12/4/2008 shows the market’s confidence that the worst is behind us.

Given the empirical evidence stated above regarding the relationship between stocks and commodities it is also worth noting that Crude Oil closed at $81.50/bbl on Friday, the highest price seen for that contract since January 13^th of this year and 2 cents shy of $10.00 higher than its February 5^th close.  To the extent that stocks and commodities will continue to be linked this could portend well for equities.

Another member of the supporting cast for seems to be the hottest new play in town; “Bull Run” is volatility as measured by the VIX which closed at 17.42 on Friday.  That is the lowest close for that index since Mid-May of 2008 and if not for the opening level of 16.93 on 1/11 of this year the lowest level seen on even an intraday basis since the spring of ’08 I just mentioned.

Not to be left out in any of this Investment Grade CDS spreads as measured by the CDX IG Index closed at 85bps on Friday a level last seen on Jan 20^th.  As loyal readers of this space know, lower CDS spreads can be an indicator of higher equity prices both on an individual and index basis.  If there is a note of caution attached to the CDS level it is that unlike in more settled times, CDS spreads have a tendency to become more coincident during periods of high cross-correlation in asset classes.  That doesn’t take away anything from the 85bps close on Friday but only removes the tendency for CDS to be a leading indicator.

If the past 2½ years have taught us anything it is that anything can happen.  As such the only thing we can say with complete certainty is that as of the close on Friday things looked positive for Friday’s close.

Enjoy the week.

Jim Delaney

Credit Market Overview

March 5, 2010

http://www.marketstrategiesmgmt.

At at least one in our lives we have all heard or thought of the adage; “If you want something done right, you have to do it yourself”.  While many of the Bills clawing their way through Congress at the moment would seem to refute this as the government seems hell bent on legislating away the responsibility we all have  to ourselves, there are many instances where regardless of the outcome we will really only feel comfortable with the result if we are the one’s taking action.

With the “too big to fail” institutions now well along in the process of mending themselves, with much government help of course, the headlines are focused on the next attention grabbing event, wherever in the world that might be.  Back here in the good ‘ol U.S. of A. there is still a lot of mending that needs to be done and a most of that needs to occur at levels of the economy that rarely make the headlines, namely, the small and new businesses that employ many people and on whose growth the economy depends.

The Federal Reserve, Federal Deposit Insurance Corp and a host of other federal and state regulators issued a joint statement recently voicing their concern about the contraction of lending to small businesses as banks tighten lending standards in the wake of the credit crisis.  Part of that statement said that the regulators were working to, “ensure that supervisory policies and actions do not inadvertently curtail the availability of credit to sound small-business borrowers”

Sen. Jim Bunning (R., KY) believes it is those exact regulators that are the problem saying, “It’s the Fed regulators that have stopped the flow of money out of the community banks to the small-business person”.

In many cases the frustration in trying to get money from the banks has prompted the “I’ll do it myself” response and various types of lending, some formerly shunned, are rising to meet demand.

The National Small Business Association said in its semiannual survey that about 25% of business owners relied on vendor credit to meet their capital needs between August of 2008 and December of 2009.  That was up from about 18% prior to the start of the crisis.  Additionally vendors appear more open to extend interest-free pay cycles and offer discounts on promptly paid invoices.

Justin Schaldone, CFO of eFashion Solutions LLC, says he is paying more of his vendors directly giving him some negotiating power which has resulted in and extension of pay cycles to 60days and discounts of between 5%-10% for prepayments.

Weezabi LLC, a three person company, and one of the few licensed to make “Crimson Tide” merchandise for the University of Alabama, needed to fund the production of 60,000 T-shirts after the school’s football team made it to the National Championships in December.  Since no banks were willing to lend the needed funds, Seth Chapman, CEO, turned to FTRANS an Atlanta-based lender.  “If it wasn’t for that loan, we would have missed the boat on all of this hot-market stuff”, he said.

None of the companies mentioned in today’s piece are big enough to have CDS contracts traded on them.  I couldn’t even find stock symbols.  The important point here, however, is that the small companies mentioned are, in many ways, the life blood of this economy and economies around the world.

The good news is that one way or another and against some pretty tall odds the spirit of entrepreneurs has not been dented.  I started this piece with one adage and I will finish it with another, “Where there’s a will, there’s a way”.

I am confident there isn’t anyone in Washington that can legislate that away.

Enjoy the weekend.

Jim Delaney



Credit Market Overview

March 4, 2010

http://www.marketstrategiesmgmt.com

Have the horses all escaped?  Has the barn door been locked and nailed shut?  Has every precaution been taken to ensure that those things that created the last crisis won’t create the next one?

From the parade of TARP and TALF recipients that were forced to endure made for TV congressional hearings put on to allay any fears in those people who believe what they see on TV that those on the dais were really looking out for the good of their constituents and not just campaign funds for the next election, I think we can say yes to all of the above.

Now that we’re all feeling completely safe and secure in the ability of regulation to prevent anything bad from ever happening again I would like to ask a question.  Have you ever heard of a “Longevity Swap”?

Longevity swaps are the latest concoction dreamed up by the same financial engineers that brought you CDO’s^3, CBO’s and a rash of other products that could be made to look like completely harmless, safe as money in the mattress investments; until they weren’t.

Technically speaking, longevity swaps are a risk transference vehicle used to move the liability that pensioners in a specific pension fund will live longer than the actuarial models say they are supposed to.  Now, unlike some of the early proposals in the health care initiatives where Rahm Emmanuel’s brother raised the concept of offing people once they got too old, pension funds are required to pay the allotted amounts for as long as the pensioner lives.  By using longevity swaps the pension fund can remove some of this liability.

The Life and Longevity Market Association came into existence on February 1^st of this year with the goal of taking longevity swaps into the “mainstream”.  Which I take to mean making sure investors around the world buy a whole bunch of them and the products created with them so we can have another complete global meltdown in 10-15 years.  John Fitzpatrick, a partner and director of the LLMA, has a slightly different view of the product and said “the group wants to produce ‘standardized products that will attract investors and create liquid market’”.

Jonathan Graham, head of longevity swap pricing at Swiss Re said: Longevity capacity exists within the insurance market at present but there simply isn’t enough to cover the long-term future needs”.

The list of players are names we can all repeat in our sleep by now; Deutsche Bank, J.P. Morgan Chase, Royal Bank of Scotland, Axa SA, Legal & General Group PLC, Pension Corp, Prudential PLC, Swiss Re and Credit Suisse.

If your next question is, how far along is this product?  Last week BMW off loaded £3BN ($4.65BN) of U.K. pension risk to Deutsche Bank which was the largest deal to date in Britain.

While this all might seem like the brand spankingest new thing, longevity swaps have existed for some time.  France used one in 1997 to reach its 3% of GDP deficit goal to stay within the confines of the Eurozone when it took on the pension liability (off balance sheet) for a €5BN payment (on balance sheet) from France Telecom and Antigone Loudiadis, the woman now known as having arranged the infamous currency swap between Greece and Goldman, is now at another Goldman subsidiary, Rothesay Life, and has been transacting longevity swaps since 2005.

Financial innovation is a great thing and unlike Mr. Volcker, for whom I have the utmost respect, I do not think the ATM was the only new thing to come along in the last 25 years that has value.

I think the real point here is that innovation is as inherent and necessary on Wall St. as evolution is to Darwin’s finches.  To believe that risk can be legislated away will put us all right next to the Dodo Bird.

For the most part, the names listed above as participants in the longevity swap market are tracking the current move lower in CDS spreads and higher in stocks that began back on February 8^th.

The longevity swap market is still in a nascent stage and as such none of the institutions mentioned have substantial risk to this product.  As with most if not all financial innovation, longevity swaps are at the stage where they are addressing an economic need; over burdened pension plans and an increasingly long lived populace.  If any of the lessons of the last crisis have been learned, and I know that is a stretch, than longevity swaps do not necessarily have to be a problem waiting to happen.  For that, however, we will have to wait and see.

Enjoy the week.

Jim Delaney

Credit Market Overview

March 3, 2010

http://www.marketstrategiesmgmt.

There is a famous Indian legend that depicts six blind men encountering an elephant.  Each in turn walks up to a different part of the animal and as such comes away with a different impression of what the beast actually is.  To give you an idea here is the second paragraph:

The First approach'd the Elephant / And happening to fall / Against his broad and sturdy side / At once began to bawl: "God bless me! but the Elephant / Is very like a wall!"

This story came to mind while hearing of some of the changes the International Monetary Fund (IMF) has been considering as possible policy objectives in the wake of the credit crisis and the effect it is having as it ripples through some of the less stable economies.

The credit crisis itself is a result, in part, of this kind of thinking but not by the IMF but by that other supra-national financial body the Bank for International Settlements (BIS).  As a part of what is known as Basel II, the BIS decided to allow banks to base capital requirements on the volatility of the instruments they were reserving against.  The lower the volatility the less capital needed.  This was supposed to be a more enlightened form of risk management as it allowed banks to use more of there capital which, it was thought, would allow them to prosper during the “Great Moderation”.  Needless to say when things became “un-moderated” there weren’t enough reserves and . . . well, you’re living through the rest of the story.

So now that we’ve come through what is hopefully the worst part of the storm everyone is running around trying to close all those gates that the horses left through.  Not to be left out the IMF has a few proposals of its own.

One of the more interesting comes from the IMF’s top economist, Oliver Blanchard, who reasons that if the world’s developed economies were to target an inflation rate of 4% instead of the current 2% than the next time there is a credit tsunami there will be more room to lower rates, relieving the need for measures such as quantitative easing and TARP and TALP initiatives.

One of the other ideas being floated is that emerging economies should institute tax and regulatory regimes to moderate the vast inflows of capital they are experiencing as investors leave the hobbled west behind and seek markets where they expect stronger growth.

The IMF is also urging the leaders of the world’s western economies to coordinate regulation via multilateral agreements to remove the possibility of regulatory arbitrage.  Dominique Strauss-Kahn, the IMF’s managing director said recently, “I am worried about the possibility of inconsistency of different countries proposals”.

The latest idea to be floated is one where the IMF would provide assistance to a group of countries vs. individual nations which is intended to remove the stigma associated with receiving aid from the world’s lender of last resort.  While on a grander scale, this would seem to be somewhat similar to the U.S.’s Federal Reserve encouraging the use of the Discount Window during the depths of the crisis.

To discuss the pros and cons of each initiative would take many more pages than I have neither the time to write nor you, the time to read.  The lesson here is similar to that of the blind men and the elephant and that is that perspective makes all the difference when making decisions.

With that said there are two encouraging things to report in the credit markets.  The first is that sovereign protection for Greece closed at 320bps last night, down from its recent high of 428bps on 2/4 and the lowest close since that date.  Whether the austerity plans or the unwillingness of its stronger Euro partners (Germany and France) to let Greece fail are the cause of this or even if it is the combination there of, the global financial system didn’t really need a sovereign default to deal with at the moment so averting that disaster has to be a good thing.

The other credit related news pertains to AIG whose CDS closed at 409bps last night.  Given that in more normal circumstances 400bps would be nothing to brag about AIG has been through nothing that looks like normal circumstances.  The last time AIG’s CDS traded lower than last night’s close was September 8^th of 2008.  Hopefully I don’t have to recount for you what happened right after that.

Enjoy the week.

Jim Delaney