Market Risk: Will the CDO Machine Destroy Public Equity? November 27, 2006
Market Risk: Will the CDO Machine Destroy Public Equity?
With the cost of dollar debt well-below the cost of equity, and credit spreads at all time�lows, the Sell Side has been piling deal upon deal, taking public companies private�with borrowed money and selling the debt to the hedge fund community via collateralized debt obligation or "CDO" deals.� And who can blame them?� Dealers exist, after all, to do the deals at hand, not to worry about whether transactions actually make economic sense.
But then a question comes: When the credit derivative markets are telling you that the risk premium for many issuers is zero or even negative, does that make you sleep better at night?� Perhaps this is why Fred Barnes, writing in the latest issue of The International Economy magazine, reports that former Goldman�Sachs chief and now Treasury Secretary Hank Paulson believes "a financial crisis is long overdue -- a serious crisis that would be a body blow to the US economy."
Consider
the warning signs.� In the credit derivative swap or CDS markets, General
Motors (NYSE:GM)
closed last week at 430 basis points for five-year�protection. GMAC, the finance unit which will shortly be majority-owned by private equity�investors, closed at just 140 basis points.
Ford (NYSE:F)
and Ford Motor Credit closed Friday at 560 basis points and 340 basis points, respectively, illustrating the fact that the markets still view F as an inferior credit to GM.� Both credits are junk, however, as illustrated by their profiles in the IRA Basel II C&I Credit Obligor tool:
Though CDS spreads for
F�and GM are�near the�tightest
levels of 2006, there is a growing sense in the credit markets that the party is�over.��Both F and GM are still�trading "negative basis," which means that is cheaper to buy default protection on debt issued by�these names than the yield on the bonds, but other names are widening in�CDS�as the year-end approaches.�
For F, by
way of illustration, five-year credit default insurance
is trading�inside�the yield on five-year F unsecured debt.� This means
that you can buy the F debt, purchase CDS coverage, and lock in a risk-free
spread of almost a point�on the trade -- even if�the automaker�were to eventually file
bankruptcy.�
As our friend John Dizard of the Financial
Times notes, such seemingly
irrational�market
relationships�may help an enterprising trader pay for
a summer house�in the Hamptons, but bode ill for the health of the global
capital�markets.� One senior risk manager told us months ago that
the�existence of negative basis trades in the CDS market is attributable
to�sheer avarice on the Sell Side and stupidity on the Buy Side.� That
is,�too many�CDO�deals using too much leverage to fund too many
going private transactions bought by too many hedge funds.�
But what does this imply for
the future of public equity markets?
It seems that the volatility obsessed hedge fund community has for many months now believed
that�buying CDS protection against a long�CDO or just plain vanilla equity trade�amounts
to a valid correlation hedge.��And the major private equity houses,
aided and abetted by their former colleagues in
the dealer community,�use this fact to finance a succession of LBO deals to take public
companies private.� Best of all, these�companies taken private today�eventually will�come back into
the public markets as IPOs at even higher valuations!
As�debt
and�equity markets�rallied during
2006, spreads for CDS tightened inexorably, creating what one trader describes�as�a "black hole" effect,
sucking equity out of the public markets into
private hands.��Fact is, CDS spreads don't�reflect credit quality
and are�merely a function of CDO production or hedging
equity�trades.���Since may of these CDO deals involve debt used to
finance going private transactions, the net effect is to push valuations for the
remaining body of public equities higher and CDS spreads ever
tighter.
In the past, we described this situation as the equity markets
wagging the credit
market
�doggie, but somehow even
that metaphor seems inadequate.� We hear from the trenches
that with the VIX index hitting a 13-year low and the Sell Side's
CDO machine visibly slowing, the days of printing money to
line the pockets of the dealer�and�fund communities via negative basis CDS
trades�are drawing to a close -- at least for
2006.� But hope remains as the backlog�of new going private transactions builds for
2007.
One trader tells The IRA: "Any stock out
there, regardless of size, trading below a 14 P/E, is a candidate for an
LBO.� This includes most of the energy sector.� Even giant names like
Exxon Mobil (NYSE:XOM) are not beyond the realm of
the possible."� Another�trader opines that most names traded in the
the CDS market, representing more than half of the market capitalization of US
equity�exchanges,�could eventually be taken private via the CDO
machine.
Ponder that,
Secretary Paulson, as you wait for your long overdue macro market risk
event.
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