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Markets jittery over Goldman Sachs charges

CREDIT markets became jittery again overnight as a US regulator filed civil fraud charges against storied Wall Street firm Goldman Sachs.

The Securities and Exchange Commission said Goldman had failed to disclose to investors vital information about a synthetic collateralized debt obligation, or CDO, based on subprime mortgage-backed securities. In particular, the agency was interested in the role a major hedge played in selecting the assets included in the CDO, which the hedge fund then bet against.

"Credit markets are seeing a sizeable impact from the Goldman news," said Bill Larkin, a portfolio manager at Cabot Money Management, in Salem, Mass. "The question is, has the SEC discovered what may have been a common practice across the industry? Is this the tip of the iceberg?"

Investors will rush to "safety," Larkin added, noting that "this is impacting all markets across the globe."

The cost of protecting Goldman’s debt rose sharply before backtracking a little by late afternoon. The bank’s credit default swaps or CDS were quoted at 124 basis points after Thursday’s close of 90 basis points, according to administrator Markit. The level had widened to 136 basis points earlier in the day.

Investors tried to figure out whether other firms or other structured finance products will be affected. They are concerned that the SEC’s action may create a domino effect affecting other firms and other structured finance products. There’s also the worry that this regulatory move may rattle the recovery and bring uncertainty back to the market.

The cost of protecting the debt of other financial firms also rose. Citigroup Inc.’s (C) cost of protection rose by 17 basis points to 140 basis points. Bank of America’s (BAC) rose 19 basis points to 116 basis points.

"The entire space is wider but much more resilient than expected," said James Camp, managing director of fixed income at Eagle Asset Management. "This is the beginning I hope of the recalibration of risk," he said, adding "the financial space is overcooked in terms of debt valuation."

Key credit derivatives indexes have weakened. The benchmark investment-grade credit derivatives index, the CDX IG14, weakened 4.5 basis points to 86.5 basis points, while its high-yield counterpart fell 0.90 basis points to 100.55, according to administrator Markit.

The SEC’s move marks "an escalation in the battle to expose conflicts of interest on Wall Street," said Chris Whalen of Institutional Risk Analytics in a note to clients. "Once upon a time, Wall Street firms protected clients and observed suitability…This litigation exposes the cynical, savage culture of Wall Street that allows a dealer to commit fraud on one customer to benefit another."

The Goldman news punctuated an otherwise run-of-the-mill day for corporates, which saw negligible primary market activity and average trade volumes.

Goldman "has traders and everyone else preoccupied, no question," said Chris Towle, high yield portfolio manager at Lord Abbett. "I think it’s going to rein in risk-taking spirits a bit."

 In the high yield market, Allbritton Communications Co. said it will offer $455 million of 8-year senior unsecured notes. Proceeds, along with borrowings under ACC’s revolving credit facility, will be used to refinance the company’s 7.75 per cent senior subordinated notes due 2012.

Foreign investors were net sellers of $12 billion in U.S. corporates in February, according to Bank of America Merrill Lynch, which is an improvement from the record outflow of $24 billion in the first month of 2010, though it is the ninth consecutive monthly outflow. Bank of America Merrill Lynch said the outflows "highlight the prolonged lack of foreign demand for U.S. corporate bonds."

Geographically, Europe remained the largest seller of U.S. corporates at $13 billion, while Japan and China were net sellers of approximately $500 million each, Bank of America Merrill Lynch said.

High yield mutual funds had a net inflow of $282.1 million for the week ended Wednesday, Lipper FMI, and eighth consecutive positive weekly inflow.

Agency mortgages retracted a bit from their wider levels earlier in the afternoon. Risk premiums are now 1.5 basis point wider at 128.5 basis points over comparable Treasury yields. Earlier, they had weakened to 131 basis points on selling, and lack of support to counter the rally in Treasurys following the SEC’s charges against Goldman. Buyers entered at the weaker levels, helping these bonds regain some ground.

Treasurys rallied Friday as investors sought safety in low-risk government debt after the SEC’s complaint against Goldman and the ongoing worries about debt-laden Greece.

The duo sparked investors to buy Treasurys as stocks deteriorated, pushing the two-year yield further under 1 per cent and the 10-year yield further away from the key 4 per cent level, which it breached last week for the first time since June. Investors typically seek safety in Treasurys when there is troubling news on the economy or on financial markets.

Treasurys posted weekly gains, with the five and seven-year notes outperforming. The price of the five-year was up by 14/32, to yield 2.471 per cent, and the seven-year was up by 18/32 to 3.192 per cent. The two-year note was up by 4/32 to yield 0.959 per cent, the 10-year was up 20/32 to 3.768 per cent and the 30-year was up by 28/32 to 4.671 per cent.