Tuesday, October 28, 2008

leverage rules, the Libor disconnect

in june 2008, a total of 45bln of credit securities were issued in the USA

in sept, 18bln, a multiyear low, of debt was issued. this month it's to be even lower.

in the world of credit, debt needs to get refunded. if companies don't sell new debt, they cannot roll over bonds coming due. many large companies like ATT, Comcast, GE, etc, issue bonds to pay for long-term assets.

normally any quality company can simply issue new debt and no one in the stock market even knows it happened. when it's not available, the shareholders are first in line to pay for it. dividends will be at risk, etc. it's a completely new kind of risk that's going to face non-financial companies (so far, we've only worried about banks, etc... GM could be next to go...)

I have observed that if a bond falls 10%, the same company's stock will fall 20-30%.

I am sure some official economist/credit expert somewhere knows the exact level... what that means is, when a company's debt comes due, management HAS to find a way to pay that money back. if they don't, it's chapter 11.

what I fear is that many industrial companies and others operate with small amounts of cash and require bank lines for working capital, etc. this environment will be brutal, and companies will be forced to raise capital and accept much lower earnings multiples.

this economy benefitted from 25-30 years of falling interest rates. that allowed a continuous process of multiple expansion... that era is over. deleveraging is how it will end.

THE LIBOR DISCONNECT

by becoming more reliant on the capital markets, the banks have added a new element of risk. they decided to become reliant on capital markets and to sell bonds. now that these bonds are blowing up, how can anyone expect the banks to deal with each other?

if a company's long-term debt is trading like junk, how can anyone expect it to operate as a steady, reliable bank? why would other banks ever want to deal with it?

then the Fed goes and drives short-term rates lower. using the period of "normal" spreads, a bank like BAC would issue 3yr floating rate debt at about 5-10bp more than Libor. at the time, libor was about 5.25-5.50.. that means the cost of their credit risk is about 5.5% ... more or less all of their bonds yielded this.

suddenly, the Fed cuts rates. now, Libor "should" go lower. with fed funds of 3%, libor "should" be about 3.20%. why?

the interbank market is being affected by credit risk in the capital market.

if you now see Bank of America's 5-10 year bonds yielding 7-10%, you might be willing to accept 5% for the overnight risk on the name. but why should you accept something like 3.2?

but that's what the Fed is asking you to do. "ben and ted's unexcellent adventure"

because Libor is set by the market, it is the instrument that reprices. it's like ben bernanke came along and said "you WILL agree to lend to washington mutual for 2.5%, because the FOMC says so."
and the market answers back "no you won't. I will just refuse to bid on loans until Libor reaches the correct level." and then ben bernanke says "oh yeah, I forgot about Libor."
Libor is now around 3.40, and that's after some declines. the Fed needs to accept that Libor is a rate set by the market. somehow people have used this market to express an opinion. this is why they markets exist, after all.

in 2002, fed funds was 1%. something like 10yr bonds by jpm or citi back then would have yielded something like 4.2-4.5% -- at the most. and libor then would have been about 1.30%.

so, the normal spread between 10yr yields and 3 month yiedls was about 300bp.

now the yield on those long-term bank bonds is 8-9%.... using the old logic from 2002, libor should be somewhere closer to 5-6%. and, in 2002, there wasn't a debt crisis, so if anything it should be higher now....

this is why I am starting to fear the government's solution of insuring bank debt. it won't end well. this is why the only answer is for the govt to buy long-term debt.. ABS and corporates.

No comments: