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Goldman Sachs et al Downgraded To “junk” March 16, 2007

Posted by newyorkscot in Markets.
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I noticed that Moody’s Investor Services has *implied* that the credit ratings of Goldman Sachs, Merrill Lynch and Morgan Stanley were only two levels above “junk” based on the Credit Default Swap (CDS) market. Specifically, prices for credit-default swaps linked to the bonds of Goldman Sachs, Merrill and Morgan Stanley last week traded at levels that equate to debt ratings of Baa2.

This could be because CDS traders are more bearish than bond traders and have been more concerned about the slowdown in the housing (see blog posting) and global equity markets, and therefore Goldman & Co’s exposure to these markets through their massivley successful mortgage securitization businesses (which includes significant exposure to subprime mortgages).

The size of the CDS market is now an enormous $26 trillion (twice the annual economic output of the U.S.)!! According to Bloomberg, Goldman and Morgan Stanley have $171.6 billion and $168.5 billion respectively in bonds outstanding.

But what happens to their credit risk (and revenues) when these markets tank ? Since a Credit Default Swap is an insurance policy on a bond,  the buyer of the insurance pays a premium and gets a nice pay-off if the bond defaults. This is great for financial institutions in an environment of low corporate debt default rates.  Recently, interest-rate spreads above Treasuries on high-yield corporate debt were very low by historical standards. Some of this seemed ok since surging corporate profits have kept default rates on corporate debt very low. But since the credit quality of bond issuers has deteriorated in recent years, clearly the market has been out of sync with reality/history.

So, there are a few problems coming together here to potentially make a mess and really hit bank profits. If the housing market tanks and default rates increase, it is going to cost the banks a lot of money. During the recent sell-off, credit spreads have been widening and so the cost of insuring against corporate bond default (via CDS)  will continue to rise. And, if the actual ratings of these banks do drop to these implied ratings their borrowing costs will rise.

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