Circular Reasoning - Helping Default Rates Rise

We've moved passed greed as the major motivator on Wall Street (trust me, it will be back, unchecked as ever), into basic fear. Trying to picture that the Michael Douglas character in Wall Street, if you remember that film – who touted greed – saying, “Fear, for lack of a better word, is good.” Just doesn't seem to fit the character. Hoarding capital and not lending it, investing in Treasuries producing an effective “negative interest rate” (you pay more to borrow than the interest you receive on the investment you make with the borrowing) – fear at its jolly best.

But it is near Halloween, and scary stuff is in vogue. So here’s another fun fact. As the market explores the depth and damage of the loan default insurance market (the lovely credit default swaps I've detailed in earlier blogs), the criteria for corporate borrowing just added one more variable. In addition to routine reviews of the company’s credit rating (which produces a formulaic interest rate based on the U.S. prime rate or the European equivalent – LIBOR), major lenders have added the cost and pricing of credit default swap (CDS) paper on the prospective borrower.

Today’s Washington Post’s Dealscape noted: “Tying the [credit] lines to swaps could leave corporate borrowers in the lurch since the derivatives are often used by speculators to bet on a default by those who don't actually hold the company's debt and aren't listed on any government-regulated exchanges.” So the non-kindness of strangers, trading your risk profile in unregulated derivatives (CDS paper), could cause your corporate interest rates to rise high enough to trigger the very default that the CDS paper is supposed to insure against.

Sounds really stupid until you realize that, according to Bloomberg, “Citigroup Inc., Credit Suisse Group AG and other banks are starting to shift away from basing the rates of $6 trillion in revolving loans solely on a combination of the borrower's debt rating and a mark-up to LIBOR.” And this has actually happened to food-processor Nestle SA, cellphone maker Nokia Oyj, and electrical power-generating FirstEnergy Corp.

I can see sympathy lacking in this issue. No tears. So let me add one more variable to the mix. Those credit lines fund payrolls! They keep people in jobs, who pay mortgages, and buy “stuff.” So the circle is indeed vicious.

Fear on Wall Street also arises as Congress drills down on this $20 billion set aside for Street traders and bankers – year-end bonuses the companies claim are essential to retain the best and the brightest (who caused this mess?) – in light of the taxpayers’ sacrifices in the bailout plan. Some Congressmen want to expand the coverage of salary reductions to the top ten highest compensated folks in any company (but in large investment banks, there could be hundreds receiving significant seven figure and even eight figure bonuses!).

I'll end this tirade with a letter from Henry Waxman, Chairman of the House Oversight Committee:

"While I understand the need to pay the salaries of employees, I question the appropriateness of depleting the capital that taxpayers just injected into the banks through the payment of billions of dollars in bonuses. Some experts have suggested that a significant percentage of this compensation could come in year-end bonuses and that the size of the bonuses will be significantly enhanced as a result of the infusion of taxpayer funds."

He’s Henry Waxman, and I approve his message.