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Minyan Mailbag: Three Reasons Credit Levels Will Stay High


People's fear is that there are several reasons that may suggest credit may never trade down to levels where they would feel enticed, and consequently won't get paid.


Editor's Note: The following is an email exchange that began when Prof. Katz read Minyan Peter's letter "A Bird's-Eye View of the Credit Conundrum".

Minyan Peter,

With respect to the potential for banks being forced to move loans back onto their balance sheets and shore up $60-80 bln in liquidity, my understanding is that Goldman Sachs (GS), as one example, assembled a distressed fund and raised $20 bln for it in about a week.

I cannot imagine it is alone and have to believe that others are not sitting back waiting for their flagships to come unglued without some new storied distressed guy sitting around waiting to take advantage of the blood in the streets. Am I getting those issues confused, or couldn't those distressed funds buy and provide liquidity for exactly that kind of fall out?

Prof. Katz,

There is no doubt that there is a rapid move underway from "sell side" focus to "distressed buy side" among the banks. I think the issue is one of timing. My guess is that the distressed teams have their hands full right now with just the available subprime paper in the market.

If you go back to the RTC days, the distressed teams waited until the government took the bad loans from failing institutions and then sold them at a discount. And my guess is that we are too early for many of the distressed teams to act.

I would also add that Goldman's $20 bln is not comparable to the $60-80 bln figure I presented. I doubt that Goldman will be able to leverage the fund 10:1 the way the banks can. Then again, I have seen more crazy leverage of late than I ever imagined.

Minyan Peter,

When I talk to friends in the distressed market, they are indeed twiddling their proverbial thumbs. Their fear is that there are several reasons that may suggest credit may never trade down to levels where they would feel enticed, and consequently won't get paid. The three reasons I get for this are:

i) Fed will bail out the credit markets (although I think people are kidding themselves when they think that a FF rate cut will help – this issue in subprime in my mind is that the lies a lot of people told to get the loans in the first place would never be accepted today as 'evidence' of one's financial ability to repay). Getting a loan based on your 'stated income' is a thing of the past. Obviously their revised debt to income ratios will not help them either.

ii) Opportunistic hedge funds will front run the distressed guys and pay higher prices than the distressed funds would – we've already seen some evidence a la Citadel/ Sowood. Most of my distressed friends saw that as being a very risky and premature bid by Citadel given what's been transpiring.

iii) Lastly, there is so much money bet against the credit markets right now. Credit derivatives are supposedly 8x the size of the entire credit markets. ( I'm getting that from people who are much smarter and more in touch with that market than myself). Prof. Succo has done a great job in pointing out the inherent counterparty/credit risk in this equation, but I believe one has to respect the potentially contrarian nature of a bet that size, and the incentive by the banks to defend certain asset pricing levels… otherwise, someone is going to be left without a seat in this game of musical chairs.

The reason I'm pointing out the GSCO distressed fund is because I do believe they very well can get that kind of leverage. In April of this year, the margin rules on institutional accounts changed: funds are now able to obtain margin based on the net exposure of the portfolio as opposed to having margin requirements on individual positions. It's the reason we've seen some betas at large, global macro funds, skyrocket… because some of them were indeed using leverage in the neighborhood of 10-1. We've seen funds up 30% gross on the year that were actually up more like 3% on their invested assets. So a 5% reversal in invested assets crushed them. It's a big bone of contention right now among institutional investors who have been doing a better job educating themselves about how the hedgies eek out their results and how they do or don't manage risk.

Now based on the current environment, I believe to a certain extent you are probably right and they won't get the leverage that they were getting as recently as three months ago, but they will still get to leverage that money beyond 2:1. It's one of the revenue streams by the big IBs that is at risk and I don't hear anyone talking about: their margin lending revenue. Anyway, I am tremendously grateful for the contributions that are offered from members of the community such as yourself. Thank you for pointing out where the rubber is meeting the road in consumer spending. It is one of the biggest wild cards right now and your example on Target (TGT) was some of the first "apples to apples" empirical evidence that I've seen about the quality of the consumer's dollar and the pitfalls in earnings quality of some retailers.

Minyan Peter has positions in SPY, TGT, SKF and COF.

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