Goldman's CDS / Equity Level Disconnect

Ever since Matt Taibbi informed us that Goldman Sachs (GS) was actually “a great vampire squid wrapped around the face of humanity,” the press has pressed the issue with numerous articles and a chronicling of their every move including and possibly most notably, their nominally record compensation pool for this year. I say nominally because on a percentage of net revenue basis it has actually been higher in the past. But hey, that’s not a headline!

The bubble that Mr. Taibbi would like to place complete blame squarely on Goldman’s shoulders for inflating actually took complicity from the entire vertical of participants from the law makers right down to the folks whose yearly income was 1/300th of the purchase price of the real estate they acquired, as was profiled in a WSJ article on the Indy Mac collapse earlier this year.

One of the key pumpers in the bubble machine were the rating agencies putting AAA marks on paper that, as it turns out, was not quite of that quality but demand being what it was, got the better of supply and the fees for stamping the highest quality seal on dreck were, it seems, too good to pass up.

In their effort to point enough fingers outward that there aren’t many left to point back, congress recently called on Moody’s to respond to allegations that its Moody’s (MCO) Investor Service unit continues to inflate ratings after Eric Kolchinsky, a former analyst for the firm, made allegations of his own that his former employer was still in the business of rating paper as they hoped it would be but not necessarily how it was.

Insurance regulators are now considering alternative sources for determining ratings as the entities they regulate hold a combined $3TN of paper and they figure it would probably help to figure out what the quality of that debt really is.

“We just need to take stock of this reliance on a system that allows that kind of shock and evaluate if there are other alternatives. We’re under quite a bit of pressure to respond,” was the way Hampton Finer, New York Insurance Department Deputy Superintendent, put it recently.

Enter into the fray BlackRock (BLK), who is in talks with the National Association of Insurance Commissioners about lending their risk assessment capabilities to the group to assist NAIC in their quest to find out just what the quality of the $3TN in debt the companies under their egis hold among which are 18,000 bonds backed by residential mortgages totaling more than $366BN. I say “lend” here but that in no way is meant to describe a “rate” that is anything less than usury.

Needless to say Larry Fink has built himself quite a franchise over the years and given that when he first joined Blackstone Group as a partner in 1988 he did so along side former Carter Administration White House aide Ralph Schlosstein there are the government ties that now seem a necessity for success on Wall St.

It all seems a bit too close for comfort but like some of the new proposals for securitization, if BlackRock had to hold a portion of every bond they helped rate, maybe there would finally be a true assessment of risk.

The CDS/equity combination for GS presents an interesting conundrum. GS’s stock peaked on 10/14 at $192.28 and closed last night at 178.61. The CDS hit one of its lower highs on 10/12 at 115bps after having reached its low for the year to that point at 87bps on 9/16 when the stock closed at $179.87. The interesting thing is that from mid-September to mid-October both the CDS and equity rose in positively correlated fashion and both have similarly fallen since. GS’s CDS touched 89bps on 10/26 just 2bps off its mid-September low close.

This positive correlation is evident in a number of names within the CEC Strategy universe at the moment and as such long positions are continuously being cut as the market trades off but due to the disconnect between CDS and equity there haven’t been a lot of shorts to take their place.

At the index level the CDX IG broke above the 102bps level yesterday to close at 104bps. There seems to be no real resistance until the 110 level seen on 10/1 is reached. This would suggest that at the index level the negative correlation is still evident.

These past two years have seen a number of strange occurrences in the CDS/equity relationship. The disconnect between the CDS levels and equity prices at the individual name level appears to be another one.