Greenspan Was Right
26, Jul 2006 13:30
The former chairman of the Federal Reserve has been saying since 2002 that derivatives -- financial agreements used to bet on everything from bond prices to weather patterns -- actually reduce risks by making financial markets resilient to shocks. He told a Bond Market Association gathering in New York in May that derivatives are the most significant change on Wall Street ``in decades.''
At a time when oil prices are above $70 a barrel, the Mideast is exploding and more than two dozen central banks have raised interest rates since May, derivatives are allowing companies to borrow a record $607 billion and obtain relatively cheap financing.
By bundling more than 10 percent of that into so-called collateralized debt obligations, bankers are able to provide more cash to companies, especially those that need it the most. Defaults fell to the lowest since 1997 as sales of CDOs rose 63 percent to $177 billion in the first half, according to the Bond Market Association, a New York-based trade group of dealers and underwriters.
Derivatives ``help explain why the default rate has remained this low as long as it has,'' said David Hamilton, director of default research at New York-based Moody's Investors Service, the bond rating company founded in 1900. We are ``seeing a historic shift.''
Eastman Kodak Co., the world's largest photography company, and cable-television operator Charter Communications Inc., which both reported losses of more than $1.6 billion over the past six quarters, had an easier time raising money because of CDOs.
Kodak got $2.7 billion of loans in October, including $1.2 billion that paid 2.25 percentage points above the benchmark London interbank offered rate. As recently as three years ago, borrowers with similar ratings had to pay an interest margin of more than 3 percentage points above the dollar Libor rate.
The Rochester, New York-based company was able to borrow even after Moody's lowered its ratings three times since the beginning of 2005 in part because its debt and credit-default swaps --another type of derivative used to insure against bond losses --are contained in more than 150 CDOs, according to CreditSights Inc., a New York-based bond research firm.
Access to capital means Kodak has more time to return to profitability. Kodak had 51,500 employees as of December 2005, and 63,900 at the end of 2003.
David Lanzillo, spokesman for Kodak, declined to comment.
Lower Default Rates
``The broader implications of all of this from a fundamental point of view is to provide an extension of the time that corporations have to access capital at very attractive rates,'' said Jeffrey Rosenberg, head of credit strategy in New York at Banc of America Securities LLC. The additional lending ``has helped postpone the increase in default rates.''
Raymond Kennedy, head of the high-yield debt group at Newport Beach, California-based Pacific Investment Management Co., said demand from CDOs explains why high-yield loan rates are so low relative to government debt. Pimco manages $562 billion in fixed-income assets, including $21 billion in high- yield debt.
U.S. companies rated two or three levels below investment- grade paid an average spread of 1.59 percentage points more than Libor to borrow in April, a record low, according to S&P. The premiums, or spreads, have narrowed by half since 2003.
Banks create CDOs by packaging bonds and loans and funneling the interest payments to investors. The first CDO was set up in 1987 by now-defunct Drexel Burnham Lambert Inc. for Imperial Savings Association, according to S&P. Sales of the securities totaled $249 billion last year, up from $157 billion in 2004, according to the BMA.
Corporate-bond yield spreads would have widened 0.03 percentage point to 0.05 percentage point more since May without demand from CDOs, according to Edward Marrinan, head of North American credit strategy at New York-based JPMorgan Securities Inc. Based on the $5 trillion corporate-bond market, investors have been spared $2.5 billion in losses.
CDOs have ``helped limit the damage,'' Marrinan said. CDOs act as ``a shock-absorber.''
Company debt of all ratings yields 1.50 percentage points on average more than Treasuries, Merrill Lynch & Co. index data show. The spread compares with an average of 2.34 percentage points over the past five years, and comes even as sales of bonds and loans surged 42 percent during the first half of 2006, according to data compiled by S&P and Bloomberg.
Access to capital helped Charter weather a cash shortage. St. Louis-based Charter's 2005 earnings of $1.9 billion weren't enough to pay $1.5 billion of interest and $1.1 billion of capital expenses, according to bond research firm Gimme Credit Publications Inc.
Charter, controlled by Microsoft Corp. co-founder Paul Allen, in September persuaded investors to exchange $6.8 billion of debt at a discount for new bonds with longer maturities to improve its ``financial flexibility.''
The move triggered a so-called technical default because Charter violated the terms of its borrowing arrangement. S&P said at the time it was considering lowering a Charter unit's CCC+ ratings. By April, Charter had refinanced $6.5 billion of debt and even got a new $350 million loan.
``When you have a credit market that is willing to a take a lot of risk, they're willing to provide additional financing for these companies and push out a chance of default,'' Pimco's Kennedy said. ``Charter is a great example of a life-extension deal.'' Pimco owned Charter loans in at least one of its CDOs.
Charter added 1,700 employees in 2005, bringing its total to 17,200 as of Dec. 31. It was the first time since 2002 that the company had increased its headcount.
``Charter's very pleased with the results of the refinancing of our credit facility earlier this year,'' said Anita Lamont, a company spokeswoman.
Billionaire Warren Buffett, called ``the world's greatest investor'' by biographer Robert Hagstrom, described derivatives in an annual report to shareholders of his Berkshire Hathaway Inc. as ``financial weapons of mass destruction.''
Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates.
``The range of derivatives contracts is limited only by the imagination of man or sometimes, so it seems, madmen,'' Buffett said in the 2003 letter to shareholders.
Not so, according to Greenspan, who says derivatives help spread risk.
``The use of a growing array of derivatives and the related application of more sophisticated methods for measuring and managing risk are key factors underpinning the enhanced resilience of our largest financial intermediaries,'' Greenspan told a banking conference sponsored by the Chicago Fed in Washington on May 8, 2003. ``The benefits of derivatives, in my judgment, have far exceeded their costs.''
The growth in the market has outpaced banks' abilities to keep up with the paperwork.
Regulators led by the Federal Reserve Bank of New York demanded last September that Wall Street firms improve their handling of credit derivatives after discovering 150,000 unconfirmed or unsigned trades on default swaps. The banks said last week they are still working through the backlog.
``One of the big questions in the markets is whether credit derivatives are going to ultimately live up to their billing in terms of providing market efficiency, or simply are providing excess liquidity to the debt markets,'' said Hamilton at Moody's.
The securities that go into a CDO are typically selected and monitored for a fee by managers such as Pimco and Blackstone Group LP, co-founded by former U.S. Commerce Secretary Peter Peterson.
Pimco's Kennedy estimates that a manager can receive fees of $1.5 million on a $400 million CDO. Pimco manages $10 billion of CDOs, according to S&P.
By year-end, the number of CDO managers will top 200, more than double the amount in 2004, Fitch Ratings estimates.
CDOs can be rated as high as AAA, the highest level, because they can include debt from hundreds of borrowers. They also may hold more collateral than the face amount of the CDOs, reducing the risk should some of the securities go bad. The manager of a CDO often slices them into pieces with varying degrees of risk and yields, which typically offer higher returns than comparably rated corporate debt.
It is ``really just about trying to put certain types of risk profiles into the best hands to hold them,'' said Bryan Mix, a managing director in the structured credit department of New York-based Goldman Sachs Group Inc., the fifth-biggest underwriter of corporate bonds.
Blackstone on May 25 sold the $500 million Prospect Park CDO Ltd., named after the park in Brooklyn, New York, and backed by high-yield loans. Companies in Blackstone CDOs include Dallas-based luxury retailer Neiman Marcus Group Inc. and satellite operator Intelsat Ltd., according to an April S&P report.
Intelsat, based in Bermuda, sold $2.9 billion of bonds in June to help pay for its $6.1 billion takeover of rival PanAmSat Holding Corp.
CDOs are ``creating more appetite for credit in general,'' said Wilmer Stith, who helps manage $2 billion in bonds at MTB Investment Advisors in Baltimore.
Investors are pouring money into CDOs even as economists predict rising interest rates and gasoline prices at about $3 a gallon will slow growth, according to a Bloomberg News survey.
Gross domestic product will expand at an annual rate of 2.9 percent this quarter and 2.8 percent in the last three months of 2006, according to the median forecast of 51 economists surveyed by Bloomberg from June 30 through July 10.
Both forecasts are down 0.1 percentage point from last month's median, and compare with an annualized growth rate of 5.6 percent in the first quarter.
The global high-yield default rate held at 1.8 percent in June, less than half its 5 percent average since 1979, according to Moody's. In May of 2005, the firm predicted the rate could be 3.3 percent by now and this month forecast the default rate will end 2006 at 2.1 percent.
Level 3 Communications Holdings Inc. on March 9 announced it had persuaded owners of $692 million of its notes to exchange their bonds for ones maturing at a later date to help the company avoid a cash crunch. That didn't prevent the Broomfield, Colorado-based company from selling $700 million of bonds since March. Level 3 employed 4,800 people as of Dec. 31, up from 4,500 in January 2005, according to company filings.
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Last Updated: July 25, 2006 00:17 EDT