It’s All About the Spread… The Coming Bank Credit Crunch… More Thoughts on Fannie and Freddie… Who Is Holding the Old Maid?… When is the credit crisis going to end? How will we know?

The credit crisis is getting ready to enter its second phase. This week we examine what that means, and what the economic environment will look like over the coming quarters. We also (sadly) re-visit Freddie (FRE) and Fannie (FNM) and examine the risks that they put into the markets. Risks, by the way, that were sanctioned by regulators and encouraged by a Congress that took in hundreds of millions in campaign contributions and lobbying fees. We (the US taxpayer) have taken on a huge risk and potential loss for that paltry few hundred million. Sadly, those who encouraged that risk will by and large be voted back into office rather than ridden out of town on a rail (an old US custom, rather barbaric, but one which should maybe be revived for this purpose). It should make for an interesting letter as we count down the last days of summer.

But first, last winter I mentioned that I am looking for private equity and venture capital funds and investment professionals who specialize in those deals, and asked those who would be interested in looking at the potential deals I see from time to time to write me. I had a nice response, but my filing system is somehow inadequate to the task and I seemed to have misplaced about half the respondees. If you have not heard from me lately and would like to be “at the table,” just drop me a note at this email address. And now, let’s jump into the letter.

It’s All About the Spreads

Credit spreads have been increasing and getting ever more volatile. We are going to look at them in detail this week, as one of the signs that the credit crisis is waning will be when spreads start behaving more normally.

Briefly, when we talk about credit spreads we are generally talking about the difference between a benchmark cost of a bond or index and the higher cost for another unrelated loan or bond. As an example, as of Wednesday, a high-grade corporate bond yielded 3.15% more than US Treasury bonds, based on a Merrill Lynch index. Very roughly speaking, in finance terms that means a typical corporation paid 315 basis points more than a similar longer-dated US Treasury. Thus we talk about the spread being 315 basis points or bps. (A basis point is 1/100 of a percent, which means that there are 100 basis points for each 1% difference in interest rates.)

To see how much credit spreads have moved over the past year, let’s look at a few charts (I apologize for some of the fuzziness, but I had to resize them). The data is from www.investinginbonds.com . First, let’s look at the cost for a typical US financial firm. The cost has gone from 70 bps to 390 bps! That is over a 500% move - a big hit to margins and profitability.

Merrill Lynch US Financials Index

And it can get much worse for some banks. In the “for what it’s worth” department, Iraq’s bonds are now considered safer than those of many US banks. The country’s $2.7 billion of 5.8% bonds due 2028 have gained 45% since August 2007, according to Merrill Lynch & Co. indexes. Investors demand 4.84 percentage points more in yield to own the debt instead of Treasuries, down from 7.26 percentage points a year ago. The spread is narrower than for notes of Ohio banks National City Corp. and KeyCorp, suggesting Baghdad may be safer for bond investors than Cleveland. National City and KeyCorp, based in Cleveland, have debt ratings of A and spreads of 959 basis points (9.59%) and 7.55 basis points (7.55%), respectively. Iraq debt has no ratings. Clearly the market is ignoring the rating agencies which give the banks an “A” rating. Their debt is priced at the junk level. Go figure. (Source: Bloomberg)

Utilities, which you would think would be somewhat immune to the economic crisis and the recession, have seen their borrowing costs rise by almost 300%.

Merrill Lynch US Utilities Index

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