Traderbill’s Financial Markets Weblog

 

…”there is junk and then there is junk,” that is what a former junk bond trader, that TB worked with used to say. The year was 1987 and the firm was L.F. Rothschild (incidentally the stock symbol was ‘R’, which has now morphed to Ryder Trucks…unfortunately the firm didn’t). Every time a junk bond issue would be posted on the board…yes, we did that in those days…somebody would come over the squawk box with some unflattering comment on the issuer to which he would utter the aforementioned quote.

 

That was then, now ”junk” is “high yield” is a popular fixed income option…less popular than it was a year ago but still an option. Since August, we have seen turmoil in all things quirky. First were the subprime derivatives which in turn affected the rest of the mortgage market…if people aren’t refinancing, or selling homes, that extends the life of mortgages, especially given the lower interest rate levels in 2002-2003, when the drop in rates lowered the average coupon significantly while extending the duration (time to average cashflow). High yield and other corporate bond rates appear to have put in a top and are now declining…thus raising the value of the bonds. Much has been written on the assumptions in credit defaults necessary to justify the prices…but haven’t we heard similar but opposite in stocks?…and where have they gone?

 

Yesterday, the talk was Citi trying to dump…oops, unload…$12 billion in leveraged loans. These are loans to private equity firms to buyout companies…where they raided the liquid assets and replaced them with debt…to the consternation of bond holders who saw credit quality fall…hey, not their problem! Then in the last quarter commitments to make these loans were balked at by the banks…on any number of reasons (excuses), as there were billions of these and the banking system is not only bleeding capital but paying dearly to put a bandage on the wound thus diluting earnings and impairing future lending. Now here is the weird thing: the buyer is rumored to be Black Rock…at about 90 cents on the dollar. The question is how are they going to fund it. Essentially though by buying it back at those prices they got an interest free loan for the past couple of years…so perhaps this is better than trying to buy companies in this environment, and to the extent they are loans to other PE firms gives them leverage in their deals, plus they will have to provide financials of some sort. Meanwhile, Citi trying to get a Texas judge to toss out the lawsuit for their balking to fund the loan commitment. So that is one kind of loan, but there are others. Recently there has been a lot of talk about senior collateralized notes trading cheaper than junk bonds…oops, high yield…of the same issuer even though the recovery rate in the event of default is much higher on the notes since they are senior to all other debt.

 

We also know of the problems in the auction rate securities market which are improving as rates are declining and after the tax date TB thinks there will be less pressure to redeem the securities. The proportion of failed auctions had been declining but is surging again albeit at lower rates. Now Mark Gilbert writing on Bloomberg notes that there are about $9 billion of perpetual callable notes issued by European banks. Dubbed LT2’s, they have a final maturity but with a ’call’ that if not exercised has a significant penalty (see where this is going? Like the ARS in the US to not call them is the ‘unthinkable’)…but the penalty for weakening credits might be the only option.  Then there are perpetuals that also have call dates, which have been seen historically as the same as ‘put’ dates since there is a heavy penalty if they do not exercise the call. You can compare these to the bond fund type of 7 and 28 day paper that currently has no liquidity except as the fund graciously decide to let you put them back, while the maturity date paper is similar to the muni type of ARS that at least has a date you get your money back as opposed to interest only to perpetuity…like the UK government issued.

 

Like borrowing from the Discount Window no bank wants to miss the call date…besides the penalty rate there is the stigma…unless  that is your only option and once one bank does that it makes it easier for others. Gilbert points to Italy’s Credito Valtellinesse Scrl which is not calling its notes on April 30, and instead opting to pay a penalty of 160 basis points BUT that is over money-market rates. but with those being low they can probably do so at less than it would cost to refinance. So once again, the debt holders become the lender of last resort and with deteriorating credit quality the ‘bid’ for similar notes plunges, regardless of the quality of the issuer. Mark points out that there are 8 billion euros of LT2 paper with calls this year…and where is it? Where do you think?…in structured investment vehicles (SIV’s)! So once again a bank buys a long term obligation…that is even longer than he had planned, then funds it thru an SIV, which is in turn a longer obligation than the short term investor thinks it is and is ultimately a liability of the issuer who was able to do all of this off balance sheet! We also know that 25% to 50% of capital in SIV’s is not uncommon for French and German banks.

 

The last point Mark makes is that since banks are subject to regulation, the regulators could refuse to allow the banks to call the notes because doing so could weaken the capital structure of the bank! TB pointed this out after reading prospectuses for not only Citibank preferred trusts, but on FNMA/FHLMC which clearly discloses that OFHEO may not allow them to pay the dividend even though they have the funds for it. As these two issuers get weaker it should come as no shock that they might be told to cut the dividend on the common (or suspend it), and possibly omit it on the preferred. While some scoff at this notion, TB sees it this way: if we are guaranteeing the debt in an undercapitilized company and thus protecting shareholders capital they should be willing to forego all or at least some of the dividends. Just an opinion…comments?

 

So if debt is weakening doesn’t it follow that stock prices on financials should be lower? Not to mention, retailers (WMT missed by a penny this morning but raised forecast…uh huh), and especially homebuilders…now that it looks like they will be cut out of the homeowners bailout…fortunately! 

TB

 

 

Trader Bill thinks it is clear to anyone reading these missives that they are merely commentaries…as he sees it…and do not necessarily reflect the views of anyone other than his own. Information is gathered from sources he has found reliable, but no guarantees of accuracy are implied. These are merely observations of events in the marketplace offering in an attempt to offer a non-mainstream viewpoint. Hope you find it useful.
Copyright TBD Capital LLC April 10, 2008