Where Are the Next Car Wrecks?

Howard Simons

"Give me a place to stand and a lever long enough and I will move the world."
-- Archimedes

History is silent on Archimedes' understanding of financial leverage, but it might be a fair bet that anyone who could describe such diverse problems as leverage and buoyancy would grasp the concept easily.

Whether Archimedes could extrapolate the shipping-based economy of his hometown of Syracuse to the modern credit-based economy, one wherein automobiles are manufactured as an excuse to make automobile loans, is more of a stretch: Like all ancients, he probably was a "show me the money" sort.

On the subject of buoyancy, stocks float on a sea of bonds. As discussed here last month, the relationship between corporate bonds and stocks is highly asymmetric. A stock can get hammered on all manner of silliness without affecting the bond, but if a corporation's bonds are in trouble, the stock will get dragged lower until and unless a suitor for the stock emerges.

Last Wednesday's pot-clanging bid by Kirk Kerkorian for General Motors(GM) was just the sort of event that could rescue a weak stock from the issuer's weaker bonds. So is any leveraged buyout situation.

Credit Risk by Sector

Standard & Poor's divides the market into 10 economic sectors. As is the case in all such taxonomy schemes, definitions can get a little arbitrary. The embattled automobile industry, for example, is included in the consumer discretionary sector and not in the industrial sector. General Electric(GE), which is as much of a financial firm as a manufacturing one, is in the industrials, not in the financials. But at least the classifications are consistent and known to all.

If we take the cost of a five-year credit default swap (CDS) for each member of each economic sector and construct a weighted average for that sector, we can depict each sector's relative credit health. The most striking development in corporate credit is the literally off-the-chart condition of the consumer discretionary sector, home not only of the auto industry, but of these stalwarts:

Home Depot(HD),

Time Warner(TWX),

Comcast(CMCSA),

Viacom(VIAB),

Disney(DIS),

News Corp.(NWS),

eBay(EBAY),

Target(TGT),

Lowe's(LOW) and

McDonald's(MCD)

.

Five-Year CDS Costs By Sector

Source: Bloomberg, Howard Simons

Two other sectors, health care and financials, have been flat-lining in recent weeks. Health care has had an interesting history over the past year; the CDS costs of Pfizer(PFE) and Merck(MRK) both jumped during their respective Cox-2 inhibitor travails, but as both companies are likely to survive in a form other than a plaintiffs' trust, their credit quality has improved.

The financials have been playing the roadrunner to everyone else's Wile E. Coyote; this is the sector everyone expects to get too smart for its own good, especially as the Federal Reserve continues to raise short-term rates and flatten the yield curve, but the credit markets are satisfied with their performance.

The Middle-Tier Risks

What about the remaining sectors, consumer staples, utilities, energy, materials, technology, industrials and telecommunications? All of them have seen a substantial increase in their CDS costs since early March. The increases have been most pronounced in the energy, utilities and materials sectors, and the level of CDS costs are now the highest in the technology sector.

This Trend Is Not Your Friend

Source: Bloomberg, Howard Simons

Energy and materials have been the stars of the market over the past year, with total returns for the sectors of 40% and 22%, respectively. Given the pattern in finance of success breeding excess, are there any members of these two sectors that have taken their leverage to excess as evidenced by their CDS costs?

In the energy sector, three firms have seen their CDS costs rise sharply since early March. Kerr-McGee(KMG) saw its costs rise after an April 14 announcement that it would sell $4 billion in assets to buy its own stocks. Valero Energy(VLO) saw costs rise after an April 25 announcement it would buy Premcor(PCO). And Devon Energy's(DVN) costs rose on a May 3 announcement it would retire convertible debentures.

Energy Sector CDS Increases

Source: Bloomberg, Howard Simons

The materials sector has only one dramatic increase, that of Weyerhaeuser(WY). This CDS jump came after Franklin Resources(BEN) announced on April 29 it had acquired 7.1% of the company and urged the company to make changes to "boost the value of the stock."

Materials Sector CDS Increases

Source: Bloomberg, Howard Simons

A common theme in all three announcements is that someone other than the bondholder is being rewarded by management. This is a downside of modern executive compensation: Anyone whose paycheck is linked to the stock price has an incentive to be aggressive on behalf of the shareholders, not the bondholders.

If we learned anything from the past decade's "Executives on Trial" extravaganzas, it should have been that a compensation level, once achieved, is not abandoned without a fight. Executives who have gotten a taste of mega-riches are going to do anything to maintain those riches at the expense of whomever.

If we are to remain in a difficult market environment and in a difficult management environment -- anyone want to sign their name to a Sarbanes-Oxley attestation of the financial statement? -- we are likely to see more and more firms go private in one way or another. That is bad news for the bondholders. But as we saw during and after the 1980s leveraged buyout boom, it is often bad news for shareholders as well; few managers know how to run a company for the sole purpose of paying off a note.

The jumps in CDS costs for firms that are going down these paths are warnings of difficulties ahead. Archimedes would have understood: Even though he probably wore a toga-like robe, the concept of lining one's pockets at the expense of others certainly would have been familiar to him.

---