Credit Market Overview

July 10, 2009

http://www.marketstrategiesmgmt.com

 On March 9^th of this year investment grade spreads on the CDX index peaked at 262bs and the high yield index peaked at 1925bps. The S&P had its lowest close on this very same day at 676.53.

For all intents and purposes that still holds as the closest thing we know as a true peek over the ledge into the abyss. That both credit spreads and equity prices hit their “ultimates” on the exact same date would, hopefully, dispel for many the anticipatory nature of CDS spread movement. It is, at its correlative high, a coincident indicator at best. But, as a coincident indicator, with a slight flair for anticipation, it has held its own through the thick and the thin on the roller coaster ride we have been on since August of 2007.

Since the days when the last market was called the “Wild West” and the participants, “Cowboys” it wasn’t because they were sitting around an “X” shaped trading desk with Michael Milken at its nexus on the western shore of these United States but more for the lawlessness with which it appeared that market conducted itself with.

The CDS market is still under that cloud but, given the true economic benefits it provides it will survive and prosper. Regardless of whatever Congress throws at it.

With all that said and knowing that the highest correlation between spreads and equity prices exists on the high yield end of the spectrum, and given that spreads; both high yield and investment grade have literally collapsed since the Ides of March, it is worth noting that some who are paid well to watch all things “Junk” have turned a bit cautious.

“There has been a huge rally in high yield [prices], with everyone repricing out of the depression scenario” Fred Hoff, manager of Fidelity’s High Income fund recently said. But “anyone with outsized expectations is likely to be disappointed “Jeff Tjornehoj countered when asked about the outlook from here. “There have been some fantastic returns, but those were historical high marks. It’s unlikely we’ll see those again.”

If then, we refer to Isaac Newton’s third law, which states: for every action there is an equal and opposite reaction; and take into account the wisdom of Mssrs. Hoff and Tjornehoj what can we expect from here?

If we refer to another noted scholar; a Leonardo, but not da Vinci, Fibonacci, high yield spreads could go back to 1269 or even 1433 without ruining the downtrend they began in March. Were this the case what would that imply for equity price you ask? Replete with the requisite admonitions; the 1/3^rd and ½ retracements from the rally off of the March lows would put the S& P at 843 and 811 respectively.

Enjoy the weekend.

Jim Delaney

Credit Market Overview

July 9, 2009

http://www.marketstrategiesmgmt.com

Alcoa (AA) has the aluminum, and reported 2Q09 results last night and Boeing (BA) uses aluminum to make planes and they’ve been plagued by a litany of problems in trying to get their new Dreamliner off the ground, literally, so I thought it would be worth a look at how things are going in getting from bauxite to business class.

AA reported a 2Q09 loss of 26 cents per share vs. an estimate of 38 cents. We’ve heard a lot instruction from the media on how to react to this earnings season and it mostly points towards ignoring the current numbers and focusing on what management says about the future.

Given that the second most uttered phrase for the talking heads is “green shoots”, which ranks just under some form of “and now a word from our sponsor”, it doesn’t seem like besting estimates by 31% is something you’d want to ignore. But hey, with all that time on the air, they’ve got to say something.

The real issue here could be that much of the recent demand for Aluminum has come from the China’s restocking effort and there are those that believe this is coming to an end. We will only know the answer to that question in hindsight. What we do know is that UBS recently cut its price forecast for the light but strong metal at the same time they were raising their price targets on a wide range of other things ferrous, non-ferrous and precious.

Deutsche Bank also follows the physical commodity space and their analysts expect production of 36.7MM metric tons, while demand is supposed to tally to somewhere around 35MM metric tons. Aluminum inventories were up 165% YoY as of May and BoAML reported that there are currently 17 weeks of supply currently available vs. a long term average of 7.

AA’s stock hit its low on March 6^th closing at $5.22. The CDS peaked the next business day 3/9 at 1156bps, which means that it would have cost you 11.56% of principal to insure AA’s debt against default back in March. In true inverse fashion the stock has risen and the CDS level has fallen to $12.22 and 387bps respectively, recently. Last night’s numbers: 449bps and $9.46.

And now for a trip on the Dreamliner, or in Boeing’s case, the nightmare in Everett. Boeing recently announced that they delivered four more aircraft in 2Q09 than they did in the previous 90 days. 4 is not a big number by itself but if you do a little back of the envelope calculation 4x$150MM=$600 it gets a little more significant. That’s the good news. The bad news has been all over the news and its all about delays connected to getting their new plane in the air. Manufacturing snafus have made delays in delivering the 787 about as frequent as fliers experience at your choice of airport around the world.

The most recent remedy has been the purchase of Vought Aircraft Industries which makes parts for the 787’s composite rear fuselage. This is the second time BA has had to buy a 787 part’s supplier in its effort to build a commercial aircraft from mostly composite materials.

Moody’s Investor Service said there would be no negative effect on BA’s A2 rating although they did mention the purchase would diminish BA’s “financial flexibility”.

After the global explosion in spreads and falloff in equity prices in February of this year BA’s stock climbed from $29.36 on 3/3 to $52.83 on 6/8. Ipso facto the CDS peaked at 295bps on the early March date and retreated until 6/5 reaching a nadir of 93bp. The delay issues have since taken their toll with last night’s close showing a CDS level of 132bps and a stock price of $39.55.

Not to be lost in all of this is that as the need for greater fuel efficiency continues to grow the use of composite materials will probably also grow. This leads to the obvious question of what that does for AL’s prospects and AA’s as a result.

Enjoy the week.

Jim Delaney

Credit Market Overview

July 8, 2009

A list of the ironies that have associated economic events for the last two years and the market place’s reaction to them could fill an encyclopedia no less this humble page. Not the least of which is that after the 10^th wettest June since records began being kept in 1872 the “green shoots” withered vs. grew.

Or maybe it was that June 2009 was also logged as the 2^nd gloomiest month at the Blue Hills Observatory outside of Boston where records have been kept since 1885. “Gloom” is calculated based on amount of sunshine, precipitation and temperature.

The real culprit for the withering shoots it seems is not the weather at all but the employment picture or, really, the unemployment picture. The number of unemployed and underemployed continue to weigh on consumption which, for the umpteenth time, is 70% of our GDP.

The chain of events that starts with a lot of people out of work always seems to link back to the housing market and more specifically the number of people walking away from their homes which results in an increased number of foreclosures, which results in lower home prices in the surrounding neighborhood, which results in lower levels of equity for the other homes in the ‘hood, which results in even more owners walking away. Lots of gloom to be sure.

There are a few other factors helping to keep the foreclosure momentum going. The first is that “the Obama foreclosure-prevention plan was ‘built around the subprime crisis model, not the unemployment model’” according to Michael van Zalingen, director of homeownership services for the nonprofit Neighborhood Housing Services of Chicago.

The plan Michael speaks of was designed to incent mortgage servicing companies and investors to reduce mortgage-related payments to 31% of monthly income. The problem comes from the fact that many borrowers don’t have sufficient income to qualify for a loan modification. At a recent gathering 45% of the 900 attendees fell into the “non-qualified” category according to Mr. van Zalingen.

Deputy Assistant Treasury Secretary Seth Wheeler has said “We recognize the unemployment is a significant complicating factor. We are studying what more we can do”.

To the extent that focusing on foreclosures vs. employment is similar to trying to cure the symptom and not the disease it is also worth taking a look at where the majority of foreclosures are emanating from.

Here too it would appear tilting at the subprime windmill was as Quixotian as the phrase suggests as it appears, based on a study from McDash Analytics, a component of Lender Processing Services, a loan-level data source covering over 30MM mortgages, that equity and not loan type is the biggest factor in determining foreclosure probability.

The simplest way to present this is to say that while only 12% of the homes in the McDash database had negative equity they comprised 47% of the foreclosures. Some other data that support the McDash claim come from the Mortgage Bankers Association: 51% of all foreclosed homes had prime loans, not subprime and the foreclosure rate for prime loans grew by 488% vs. 200% for subprime loans since the 3^rd quarter of 2006.

The home builder ETF, XHB, closed last night at 10.86, very close to the 10.93 price seen on April 7^th of this year and about halfway up the “green shoots” shot.

Names the CEC Strategy is short in this sector include: BDK, HD, KBH, MDC, RYL, SHW, SWK, TOL and USG. At the risk of redundancy these shorts exist because of widening CDS spreads, first and foremost, being complimented by a falling stock price. These positions were put on at various times during May and have been in place since.

To the extent that we hear over and over again that the recovery won’t begin until housing recovers it appears that since the real culprit in the house price decline is employment we now have the dreaded “second derivative” situation.

Enjoy the week.

Jim Delaney

Credit Market Overview

July 7, 2009

Humpty Dumpty, which we all now know as an egg was a poem originally written as a riddle 1810 for which “an egg” was the answer. Egg shells crack when you drop them from a wall or even a few inches and the size of the mess is fully dependent on whether or not the egg itself has been cooked and if so, to what degree.

All this talk of eggs and walls and cracks does have a purpose as there could be evidence mounting that the nation we think of when we here the term “Great Wall” as opposed to HD’s “great fall” might be developing some cracks of its own in its efforts to stimulate its economy.

The controlled capitalism that China practices made it easier for the powers that be to insure that government stimulus programs were carried out as designed and have been a major factor in the GDP growth experienced in the “Middle Kingdom” while that same statistic was shrinking in just about every other economy across the globe.

At a time when loan volume is up about around 30% in China it appears bank earnings are down and because the new loans have been made as corporate profits were falling, the riskiness of those loans is something people are taking notice of. “Everyone agrees that China’s stimulus lending is damaging future bank balance sheets” Daniel Rosen, a partner at Rhodium Group and a visiting fellow at the Peterson Institute for International Economics said.

It has been a trying time for the world as a whole and the deficits being piled up have caused consternation here in the U.S. as well as a downgrade of Ireland by S&P and the placement of Britain on negative credit watch. Mr. Rosen understands the need to act but cautions that “pillaging bank balance sheets is not a strategy for recovery”. Isn’t that a lesson we have all learned by now!

Wang Zhenning, spokesperson for the Industrial & Commercial Bank of China Ltd. counters Daniel’s warnings by saying, “We have never loosened our risk control assessment, not even for government-stimulus projects and infrastructure lending”.

Given that the government in China has, now, has only slightly more say as to whether Wang gets to keep his job than the CEO of GM in this country, it would be hard to imagine a different response.

Problems are also starting to appear at the sovereign level as China’s plans to hold its budget deficit to 3% of GDP are being scrutinized. The questions arise because it is not certain that all of the debt being issued within the country’s borders is being properly recorded.

The push to get China’s economy moving has left local authorities with a requirement to get projects under way but has not provided the funding for those projects, resulting in exponential growth of local government liabilities. Stephen Green, an economist with Standard & Chartered in Shanghai puts a spin on the adage about a “free lunch” when he stated, “There is no such thing as a free stimulus package”. He goes on to say he believes, “There is a huge amount of unreported government debt, and we’re adding to it now clearly.”

Ma Guoxian, a specialist on public finance at the Shanghai University of Finance and Economics, concurs saying, “Giving local governments some freedom to stimulate the economy is necessary, but the problem is that we don’t know what they’re doing. This could become a big fiscal burden in the future”.

At the sovereign level benchmark default protection for China peaked at 220bps on March 2^nd and moved down to 70bps 3 months later, almost to the day. As of last night close that number was 77bps.

There are no CDS quoted on the local government debt that appears to be the crux of the issue here but with the country’s CDS trading near its lows the market appears to be ignoring the cracks at the moment.

Hopefully “All the King’s horses and all the King’s men” won’t be needed to put China back together again once the crisis has passed.

Enjoy the week.

Jim Delaney

 Credit Market Overview

July 2, 2009

http://www.marketstrategiesmgmt.com

 It took me a while to figure out why the market did not react negatively to the additional 79,000 job cuts the ADP Employment Change report revealed yesterday, missing the forecast by a full 20% and then it struck me; with one of the largest redistribution of wealth programs in progress, it doesn’t matter, nobody will need a job anymore. Healthcare will be free, unemployment benefits will continue to be extended and the top 2% of the residents in the new UUAS (Union of United American States) will pay for everything else through a system of taxation that will make being successful about as much fun as Bernie Madoff is going to have for the next 150 years.

California Governor, Arnold Schwarzenegger declared a fiscal state of emergency yesterday to try to break the budget impasse in that state resulting from years of monetary mismanagement. As CA is finding out; “when the outflow exceeds the inflow the upkeep becomes the downfall”. Even having a co-cigar smoking chief of staff (D., Susan Kennedy) hasn’t seemed to help.

California is not in distress alone as it was recently reported in the WSJ that unemployment rose in all but two states last month and reached its highest level in 33 years in eight of the 50. Michigan has at least 14.1% of its population out of work, a level not seen since the early 80’s. Oregon’s percentage of unemployed came in at 12.4% and Rhode Island and South Carolina posted rates of 12.1%.

The problems in the auto industry have Michigan in the spotlight for another reason as well; a dramatic increase in welfare applications is expected in January as one in seven of the 680,000 residents now receiving jobless benefits see those expire. “We’re expecting a huge influx of applications in the next few months”, Barbara Anders, Dir. Michigan Dept. of Human Services.

States are looking at a number of options to increase revenues with CA and PA in particular proposing what is known as a “severance tax” on oil and natural gas properties. Arkansas instituted a similar tax in January of this year and Alaska raised its severance tax last year. “Given the economy, any source of revenue is significant”, a spokesman for Pennsylvania Governor, Ed Rendell said recently.

CDS levels for CA have actually come down recently closing at 290bps last night after peaking at 331bps on June 23^rd. Prior to the credit crunch CA’s CDS’s ranged between 70-90bps and hit their all time high in December of last year at 456bps.

Michigan’s CDS follow a similar path with slightly different numbers as pre CC levels were around 50bps and the December 2008 high was 406bps. MI’s CDS level was 282 as of last night’s close.

Now that you’ve enjoyed the short week, enjoy the long weekend!

Jim Delaney

Credit Market Overview

July 1, 2009

http://www.marketstrategiesmgmt.com

 If sixty is the new forty and as the hedge funds were saying last year, flat is the new up, then watching the market yesterday can only lead one to believe that breaking windows is the new window dressing. If PM’s want to own the hottest stocks when the market is on its way up then maybe they used yesterday to off load the dogs they had on the books.

Last Friday, along with news that consumers were saving more than they had at anytime since 1993 as the personal saving rate was reported by the Commerce Department to have risen to 6.9% came the release of the University of Michigan/Reuters Consumer Sentiment Index rising to 70.8 breaking through the previous high of 70.3 set in September of last year.

Yesterday’s release of Consumer Confidence by the Conference Board contradicted last Friday’s number and not only declined from the previous post of 54.9 but fell short of expectations by 6 points or roughly 10.8%.

Contradiction seemed pervasive in June as headlines like “Corporate Bonds Are Signaling Growth” were countered with others reading; “Summertime, and the Credit Ain’t Easy”.

A look at the CDS indices shows a similar pattern. On the investment grade side the index closed at 138.0 on the last day of May and at 131.4 on the last day of June. Had you Rip Van Winkled it would appear to have been a quiet month with a slight improvement in credit spreads; something not unexpected during what are usually those “Lazy, Hazy, Crazy Days of Summer”.

As New Yorkers are all too well aware June was not hazy and lazy but the weather was crazy as it was supposedly the wettest June since records have been kept. The credit markets were a bit more stormy than the opening and closing quotes would lead you to believe as within the sixth month IG spreads were as low as 120.6 on 6/5/2009 and as high as 145.8 on 6/22/2009. Slicing and dicing those numbers shows that the range for the month (25.2pts) was just about four times the movement for the entire month (6.6pts).

High Yield spreads started June at 1036.7pts; broke through the 900pt level on 6/12/2009 to close at 896.4pts and then made their way, right quick like, to 1065.1pts in just six trading days. Winding up the month at 948pts the HY index improved by 88.7pts or 8.55% over the month but ranged 168.7pts in the meantime. The movement to range ratio was just under 2 on the high yield side but reasonably mind bending when you experience an 8 and a 10 handle on the index within the same month.

The debate as to whether the green shoots are growing or wilting seems destined to be fought in the media. With low summer volumes and lack of conclusive evidence as to which side is winning, the forecast is uncertain at best but with the rain in NY continuing into July and the kind of volatility seen in June keeping your powder dry and yourself seems to be the most prudent way to approach the new month.

Enjoy the short week,

Jim Delaney