The Cruelty of Strangers

Unlike Blanche, companies (and taxpayers) sometimes find themselves at the mercy of people they don’t know, paying for something (like borrowing) that they didn’t do.

This week it was the junk bond market, and it’s going to cost Calpine an extra $26 million a year.  Did Calpine and the other companies paying wider spreads over LIBOR go on a borrowing binge over the Memorial Day holiday?  No. Did their business prospects all get much worse over the last month? Not exactly.

What happened was that there was a rally.

Huh?  I thought rallies were good for issuers.  Not always, as it turns out.  In fact, if you stay with me, I’ll explain how it was the rally in mortgage bonds that helped cost the mortgage lenders their existence.  And it was the “borrowing” by strangers that sealed their doom.

First, let’s be clear that it’s not a nefarious plot, except for when it is.  In fact, this week’s extra borrowing costs for a wide range of companies responding to the recovery by issuing bonds is simply due to market forces unleashed by the enormous junk bond rally earlier this year.

The dealers looked at their chance to sell into a market that had rallied, and they all came to the same conclusion at the same time.  They rushed to clear out their inventory of mezzanine CLO bonds.  Unfortunately for the borrowers pricing bonds now, mezzanine CLO bonds have embedded leverage.

If the mezzanine bonds being sold were 5% to 10% of the total principal, but subordinate to 80% to 90% of the CLO structure, the buyers were agreeing to take all of the credit exposure of the corporate bank loans in the collateral pool, at least until the principal of the mezzanine bonds was completely wiped out.

In other words, they were taking credit risk anywhere from $5 to $20 for every dollar they invested.  The $600 to $800 million of CLO bonds the dealers dumped could have had the credit market effect of up to $16 billion of unannounced junk bond issuance.  That’s a lot of credit exposure, especially when there isn’t a road show or other market preparation to absorb it.

As I shared with Jody Shenn when he posted the article on spread widening, this reminds me of the virtual vivisection of Askin Capital Management on March 31, 1994.  It was a derivative CMO hedge fund that got liquidated that day.

Even though it held less than $300 million in invested capital prior to the liquidation, the internal leverage of the CMO bonds he (David Askin) held created the effect of two quarterly refundings by the US government.  Because it was a complete surprise to the market, the effect was even worse than the government selling tens of billions in debt.  The 10-year Treasury dropped more than four percent in price that day, one of the worst days in bond market history.

Since no one knew that all the dealers were rushing for the exits as May drew to a close, the effect on junk bonds and bank loans to that same group of borrowers simply fell out of bed.

Even the AAA bonds from those CLO’s repriced 50 to 75 basis points wider over the benchmarks, which translates into Calpine having to pay 2% more than it was led to believe it would pay just a couple of weeks ago.

If you’re at Calpine, it’s pretty hard news to take when you are also hearing that the US Dollar is strong and US interest rates are coming down and likely to stay low for another year or more.

Oh well, I’m sure their dealers told them it was just “market conditions.”

For the conspiracy fans, I just need to point out that the handful of major Wall Street trading desks probably don’t (and don’t need to) send each other IM’s saying they’re going to look for higher rates.  The action in the broker screens tell any seasoned trader when the competition is unloading without anyone having to put it into words.

It get even more secretive and incestuous when it comes to CDS.  After all, 90% of the business is controlled by just five banks, and they still don’t have to tell anyone what rates they charge, not even the companies they write protection on.

Let that sink in for a minute.   Imagine, if you will, that you’re shopping for a new car or a home, and you haven’t borrowed any money for a while.  Imagine that you have a mortgage loan you’ve paid every month, even when it was tough.  Imagine that you paid your last car loan in full before you even thought about buying a new car.

When you go to get the car loan, all the banks tell you that they already have millions of dollars in credit written on your name, so they won’t be able to give you the loan you need. They offer to introduce you to their special situations lending team, as long as you understand the rate will be higher than you might have thought.

They were writing CDS, and the hedge funds that bought the credit protection on your name had no need to tell you that they had doubts about your future prospects while they took out credit insurance for millions of dollars you name.

Welcome to the world the mortgage lenders faced in 2007 and 2008 as the bond market for their securitizations shut down.  Part of the reason the credit bears were able to buy so much insurance was the fact that the MBS and CDO markets had rallied so far.

I’ll get a little technical here so you can see just how inexpensive it really was to buy all that insurance.

When Calpine and the other high-yield issuers borrow money, they pay LIBOR plus a spread.  When a credit bear “buys protection” on Calpine’s name, they only pay the spread.

In 2006, that meant a bond paying LIBOR plus 100 basis points like a typical MBS single-A bond was paying 6% + 1%, or 7%.  The hedge fund who was also using the market’s ability to absorb that same credit risk was only paying 1% per annum. If they did “the Magnetar trade” as well, they could collect 15% from the “equity” investment in the very same CDO, a front-loaded 15% return, to boot.  That paid for 15 times as much insurance as their investment, unless they really went for leverage, and bought insurance on the AAA bonds, which only cost 25 basis points…

Since the attempts to limit CDS protection purchases to buyers with legitimate “insurable interests” or the weaker “legitimate portfolio hedging” got stripped out of the financial system reform bills very early on, maybe a disclosure requirement would help, if only a little.

Now you can see why the European sovereigns are looking at the speculator community as throwing gasoline on their fires, and why Germany looked to ban some “naked CDS.”  I bet if you had to pay 20% to buy a car or house because other people (unbeknownst to you) used up all your credit, you’d like to ban that kind of trading, too.

I’m surprised corporate America isn’t at least demanding that they know whenever someone takes out insurance on their names, effectively using some of their ability to access the credit markets.

Too bad Michael Lewis and the hedge fund defenders didn’t think of that aspect when they decided these guys are the “good guys.”



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