Trouble in Financials

Another rough day on Wall Street yesterday, led by the financials. Just when you think the worst is behind you, rumblings of new writedowns and increased risk due to Collateralized Debt Obligations resurface. You have to wonder at this juncture, with many financial institutions hitting 1991 lows, how the private-equity guys who invested a fresh chunk of capital several months ago are feeling today. Yes, the Sovereign Wealth Funds have made big-time investments in these guys, but they have billions on their books and the percentage of these investments in their portfolio is much smaller -- not necessarily the case for the big private equity guys. If they're feeling the pain, where will fresh funding come from if the banks need to shore up the books even further?

Yesterday, we heard about layoffs from the likes of Goldman Sachs and Citigroup in their investment banking divisions, specifically mergers and acquisitions for Goldman. No surprise there. But in the past week we have also heard about possible continued deterioration in the credit markets and further writedowns. Gary Crittenden, Citigroup's CFO, hinted about that on a call with Michael Mayo last week. Yesterday, Bank of America made a call on Merrill Lynch's further exposure and talked about writedowns and a huge revision to their 2008 eps forecast. How much worse will it get? Unfortunately, nobody knows. This isn't about transparency as much as it's about the freezing up of liquid assets and the inability to mark those assets. The credit rating downgrades of MBIA and Ambac makes matters worse. Take a look at this snippet of an article from my colleague David Gaffen at the Wall Street Journal written last Thursday.

“Thursday, Moody’s cut shares of Ambac by three notches, to Aa3 from AAA, and MBIA by five notches, to A2, a greater move than expected, though MBIA pronounced itself “baffled” by the company’s analysis.

The downgrades are having a ripple effect in the markets, as the CDOs and various asset-backed securities that are held in the CDOs are going to be forced to be re-rated as a result of the downgrade of the monoline insurers. “Anything wrapped by these bond insurers can’t have a rating higher than the wrap,” says K. Daniel Libby, senior portfolio manager at Sands Brothers Select Access Management Fund. “At every marginal notch down, certain policies flare up that force [holders] to sell.”

That will only get worse if the insurers are downgraded further in the months to come, he notes. Equity shares of MBIA and Ambac are down 7.6% and 2% in trading today. The cost of the company’s insurance protection is ridiculously high, meanwhile, at about $3.65 million to protect $10 million in MBIA bonds against default over the next five years — along with a $500,000 annual payment. Markit’s index of high-grade credit-default swaps was traded at 124.5 basis points, or $124,500, costliest since April 16, says Tim Backshall, chief credit derivatives strategist at Credit Derivatives Research.

As for the brokerages, their CDS have also widened. It costs $220,000 to insure Merrill Lynch’s debt, compared with $195,000 prior to the news. Morgan Stanley’s CDS’s are at $260,000 from $249,000 before the news.

If that doesn’t seem like much movement, Mr. Libby says that a “lot of it may already be imputed into the spreads, but my expectation is that they’ll continue to widen more…together with expectations of further declines in home price appreciation, banks are making noises that other sectors besides mortgages are coming under distress. It just paints a picture of a worsening credit market.”

A lot has been said about the discount window. Without the Fed opening the discount window to the broker-dealers, things could be A LOT worse. Last week on Michael Mayo’s conference call, he talked about further consolidation. Perhaps JP Morgan going after Wachovia Bank? One colleague of mine called me immediately after and said bad trade. Why wouldn’t a Goldman Sachs consider buying a Wachovia Bank? They’re not that expensive and Goldman has the cash. More importantly, if Goldman were to purchase Wachovia or a smaller regional bank, they would continue to have access to that discount window. Keep in mind the discount window, where banks can borrow cash from the Fed, is usually only open to commercial banks. Several months ago the Fed opened it up to the broker dealers to help re-liquify the markets and shore up the balance sheets where needed. It was only opened as a temporary measure and word is the discount window will be closed to broker dealers this fall. Will that now change? Or will this environment force consolidation?