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With the cost of dollar debt well-below the cost of equity, and credit spreads at all time lows, the Sell Side has been piling deal upon deal, taking public companies private with borrowed money and selling the debt to the hedge fund community via collateralized debt obligation or "CDO" deals. And who can blame them? Dealers exist, after all, to do the deals at hand, not to worry about whether transactions actually make economic sense.

But then a question comes: When the credit derivative markets are telling you that the risk premium for many issuers is zero or even negative, does that make you sleep better at night? Perhaps this is why Fred Barnes, writing in the latest issue of The International Economy magazine, reports that former Goldman Sachs chief and now Treasury Secretary Hank Paulson believes "a financial crisis is long overdue -- a serious crisis that would be a body blow to the US economy."

Consider the warning signs. In the credit derivative swap or CDS markets, General Motors (NYSE:GM) closed last week at 430 basis points for five-year protection. GMAC, the finance unit which will shortly be majority-owned by private equity investors, closed at just 140 basis points.

Ford (NYSE:F) and Ford Motor Credit closed Friday at 560 basis points and 340 basis points, respectively, illustrating the fact that the markets still view F as an inferior credit to GM. Both credits are junk, however, as illustrated by their profiles in the IRA Basel II C&I Credit Obligor tool

Though CDS spreads for F and GM are near the tightest levels of 2006, there is a growing sense in the credit markets that the party is over. Both F and GM are still trading "negative basis," which means that is cheaper to buy default protection on debt issued by these names than the yield on the bonds, but other names are widening in CDS as the year-end approaches.

For F, by way of illustration, five-year credit default insurance is trading inside the yield on five-year F unsecured debt. This means that you can buy the F debt, purchase CDS coverage, and lock in a risk-free spread of almost a point on the trade -- even if the automaker were to eventually file bankruptcy.

As our friend John Dizard of the Financial Times notes, such seemingly irrational market relationships may help an enterprising trader pay for a summer house in the Hamptons, but bode ill for the health of the global capital markets. One senior risk manager told us months ago that the existence of negative basis trades in the CDS market is attributable to sheer avarice on the Sell Side and stupidity on the Buy Side. That is, too many CDO deals using too much leverage to fund too many going private transactions bought by too many hedge funds.

But what does this imply for the future of public equity markets?

It seems that the volatility obsessed hedge fund community has for many months now believed that buying CDS protection against a long CDO or just plain vanilla equity trade amounts to a valid correlation hedge. And the major private equity houses, aided and abetted by their former colleagues in the dealer community, use this fact to finance a succession of LBO deals to take public companies private. Best of all, these companies taken private today eventually will come back into the public markets as IPOs at even higher valuations!

As debt and equity markets rallied during 2006, spreads for CDS tightened inexorably, creating what one trader describes as a "black hole" effect, sucking equity out of the public markets into private hands. Fact is, CDS spreads don't reflect credit quality and are merely a function of CDO production or hedging equity trades. Since may of these CDO deals involve debt used to finance going private transactions, the net effect is to push valuations for the remaining body of public equities higher and CDS spreads ever tighter.

In the past, we described this situation as the equity markets wagging the credit market doggie, but somehow even that metaphor seems inadequate. We hear from the trenches that with the VIX index hitting a 13-year low and the Sell Side's CDO machine visibly slowing, the days of printing money to line the pockets of the dealer and fund communities via negative basis CDS trades are drawing to a close -- at least for 2006. But hope remains as the backlog of new going private transactions builds for 2007.

One trader tells The IRA: "Any stock out there, regardless of size, trading below a 14 P/E, is a candidate for an LBO. This includes most of the energy sector. Even giant names like Exxon Mobil (NYSE:XOM) are not beyond the realm of the possible." Another trader opines that most names traded in the the CDS market, representing more than half of the market capitalization of US equity exchanges, could eventually be taken private via the CDO machine.

Ponder that, Secretary Paulson, as you wait for your long overdue macro market risk event.

Source: Will the CDO Machine Destroy Public Equity?