The cost of credit is going up for banks as corporate bond yields for financial institutions rise above industrial companies.
For the first time in at least a decade, the world’s biggest financial institutions are paying more to borrow in the corporate bond market than industrial companies.
Bonds of banks, brokerages and insurance companies yield 1.49 percentage points more than U.S. Treasuries, matching a record high set in October 2002, according to indexes compiled by New York-based Merrill Lynch & Co. The average industrial bond trades at a yield premium of 1.34 percentage points.
Investors are demanding extra compensation for the risk of owning Citigroup Inc., Merrill Lynch and Barclays Plc on concern that the $50 billion in losses already reported from subprime mortgages will increase. The total damage may reach $400 billion worldwide, Deutsche Bank AG analysts said this week in a report, and Wells Fargo & Co. Chief Executive Officer John Stumpf said the housing market is the worst since the Great Depression.
My Comment: $400 billion is just a down payment on the writeoffs to come. No one has yet to factor in the losses that will come when commercial real estate cracks wide open. For more on the problems in Commercial Real Estate please see Commercial Real Estate Heads South and Commercial Real Estate Black Hole.
Investors two days ago punished Citigroup for its $17 billion in credit-market losses, driving yields on 10-year notes the company sold to the highest in the bank’s history.
Borrowing costs for financial companies are more than just an added expense. The companies’ ability to make money on trading and lending depends on them being able to access financing at low interest rates. To compensate, banks need to increase the amount they charge their customers, potentially raising costs throughout the economy.
My Comment: The Fed’s solution will of course be the same one they throw at every problem, cut interest rates. Anyone who believes the Fed when they claim this is just a “Rough Patch” is smoking some pretty powerful stuff. The Fed is hoping to fool the market by pretending these problems don’t exist. For more on this please see Goldman Sees “Substantial Recession” Risk.
“The pricing of risk is going to cost a lot more,” said Peter Plaut, an analyst at New York-based hedge fund manager Sanno Point Capital, which doesn’t disclose its assets under management. “Certain issuers won’t be able to access the capital markets, which presents higher default risks going forward, which also has an implication on real economic growth.”
Citigroup said this month it provided $7.6 billion of financing to SIVs it runs after they were unable to pay maturing debt.
“Further write downs, further transfers of assets from the SIVs to the banks will draw down capital further,” [said Kevin Murphy, head of investment-grade corporate bonds at Boston-based Putnam Investments].
My Comment: Plaut and Murphy are both correct. Furthermore, drawdowns in capital will inhibit banks ability to lend. Banks will tighten standards and not just for real estate. All lending will be affected.
Citigroup paid 1.90 percentage points more than Treasuries of similar maturity to sell $4 billion of 10-year notes on Nov. 14, its biggest premium, according to data compiled by Bloomberg. Citigroup is rated Aa2 by Moody’s Investors Service, the third- highest level, and AA by S&P.;
The same day NStar, the Boston-based electricity provider with ratings two levels below Citigroup, paid a premium of 1.40 percentage points in the sale of $250 million of notes due in 2017.
My Comment: This shows how out of whack things are. It’s not that Citigroup’s debt is priced to high, NStar’s is simply too low.
The cost of protecting European bank bonds against default rose above the premiums for non-financial company debt for the first time in at least three years this month. Europe’s iTraxx Financial Index of credit-default swaps on 25 financial companies including London-based Barclays and UBS AG rose 2.5 basis points to 52.5 basis points today, according to JPMorgan Chase & Co. prices. The index has more than doubled the past month.
“Until credibility can be restored, the banks are going to have to pay prices to investors that they thought were unthinkable until six months ago,” said John Atkins, corporate bond analyst at research firm IDEAglobal in New York. “But they have little choice as they need to keep the capital taps open.”
My Comment: Be prepared for “unthinkable” conditions to be with us for quite some time, as in years not months. This unprecedented global lending spree far exceeded the credit boom that preceded the Great Depression in terms of lending standards and malinvestments. It will not be resolved any time soon. In addition, credibility is hard to come by when the Fed pretends such problems don’t exist.
Credit-default swaps that are tied to the banks are trading at the widest levels in at least five years. The contracts, a gauge of investors’ perceptions of risk, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements. A rise in the contracts signals a reduction in investor perception of credit quality.
Citigroup contracts earlier this month reached the widest in at least five years, while Merrill Lynch touched the highest in at least six years, Credit Suisse Group data show. A basis point on a credit-default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.
“It’s a bit bizarre,” said Gunnar Stangl, head of index and bond strategy at Dresdner Kleinwort in London. “We’re in a state of exaggeration on the risk of banks compared to non-financials.”
My Comment: In a sense Stangl is right. The Fed would not easily let Citigroup fail but it could languish with impaired balance sheets for years, unable or unwilling to lend. Alternatively Citigroup could be broken up into pieces and sold. The former is the Japanese deflation scenario, especially if the situation spreads beyond Citigroup.
On the other hand, the Fed is not apt to be bailing out non-financials, which lends credence to the notion things are “a bit bizarre”. However, as I said earlier, It’s not that Citigroup debt is priced to high, it’s that risk of default elsewhere is priced way too low.
Here’s the big question: Is the system so messed up that central banks everywhere will not really be able to bail out anyone? I think so. It’s the price we have to pay for the most reckless global financial experiment in world history. Confidence in the Fed’s (and central banks in general) ability to reflate is going to be shattered in due time.
Mike Shedlock / Mish
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