Housing Bets Sink Goldman, Merrill Bonds to Near Junk

Housing Bets Sink Goldman, Merrill Bonds to Near Junk
Morgan Stanley, Lehman Brothers, and Bear Stearns bonds also trade lower

After windfall profits in 2006, the nation's major investment banks are now seen as a big risk, according to their own traders, reports Bloomberg. And their near-junk status has a lot to do with the housing bust.

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Prices for credit-default swaps linked to Goldman Sachs, Merrill Lynch, and Morgan Stanley bonds are trading at levels equal to debt ratings of Baa2, according to Moody's Investors Service. That's five levels below their official Aa3 ratings on senior unsecured notes and two rungs above non-investment grade or junk status, points out Bloomberg.

Credit-default swap prices tied to Lehman Brothers and Bear Stearns equate to debt ratings four levels below their official A1 ratings, also two levels above junk.

Credit-default swaps act like insurance on bonds. Traders buy them to hedge against a default. When prices for the credit-default swaps go up, it means that the underlying bonds have become riskier.

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Morgan Stanley and Goldman Sachs were among the top five traders of credit-default swaps in 2005, according to a report by Fitch Ratings. The top five traders represent 86 percent of the market. Lehman Brothers, Merrill Lynch, and Bear Stearns were in the top 12. So, in effect, as the price of credit-default swaps rises, it's actually the investment banks' traders that are valuing the banks at close to junk status.

The slump in the housing market and the precarious subprime lending market are upping the risk of credit defaults, according to Bloomberg.

Since 2005, Merrill Lynch has financed two mortgage lenders that have since failed and purchased a third, First Franklin Financial Corp., for $1.3 billion.

In an instance of "pot meet kettle," Merrill's equity analysts recently cut their recommendations on Goldman, Lehman, and Bear Stearns, Deutsche Bank, and Credit Suisse Group to "neutral" from "buy" because they anticipate earnings weakness tied to the housing sector.

Bear Stearns holds about 13 percent of the firm's "tangible" equity in non-investment grade mortgage securities, according to CreditSights. Lehman holds 11 percent. Goldman, Merrill, and Morgan Stanley don't disclose the level of junk mortgage securities that they hold, but CreditSights estimates it's in "the low- to mid-teens."

[Editor's Note: Sir John Templeton first warned of housing crash – Read More Here]

CreditSights says the investment banks also risk losses from trading in mortgage bonds and the derivatives tied to them.

"These guys have made a lot of money securitizing mortgages over the years in a mortgage boom time," Richard Hofmann, an analyst at bond research firm CreditSights Inc, explains to Bloomberg. "The question now is what is the exposure to credit risk and what are the potential revenue headwinds if they're not able to keep that securitization machine humming along."

David Munves, director of Moody's credit strategy research group, points out that 22 percent of companies that had similar gaps between their official ratings and the credit-default swap implied ratings had their ratings downgraded. However, 87 percent of the companies outperformed their peers on a one-year horizon, he added.

Editor's note:
Sir John Templeton first warned of housing crash – Read More Here
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