Credit where credit is due

Goldman Sachs, Merrill Lynch, and Bear Stearns all saw their credit rating upgraded by S&P on Friday. I've made no secret that I like brokerage bonds (here and here), and will disclose right now that my clients own various issues from all three of these firms.

Why the upgrade? All three companies are making money hand over fist despite the inverted yield curve that was supposed cause them so much trouble. In the last 5 years, the list of events that could have hurt the brokerage business are many:

1. Bear market in stocks in 2000-2002.
2. "Research" scandal.
3. Post-bear market weakness in IPO market.
4. Argentina default in 2001.
5. Post-depression records set in corporate bond defaults in 2001 (source: S&P). 2002 was #2 and 2000 was #3.
6. Deflation scare in 2003.
7. REFCO collapse in 2005.
8. Inverted yield curve in 2005-2006.

But the fact is, the big brokers continue to reap impressive profits. The ratings agencies are finally getting the clue that the brokerage business is more diversified than it was 20 years ago. That the increased leverage these firms are taking on is appropriate, given their ability to manage risk. Could something happen? Some sort of contagion event? Sure. But the same could be said for any company.

A lot is made about the world being more linked together today than in years past. An economic event in Asia or Latin America is no longer a local issue, but has worldwide implications. One thing that isn't talked much about, is the flip side of that statement. That because investors are involved in situations all over the world, that risk has become more spread out. For example, whereas once banks owned most of the risk in the consumer mortgage market, today that risk can be securitized or sold off in the form of CDS. So now, various investors will suffer a small amount if consumer mortgages go bad, rather than the pain being concentrated among a smaller number of financial intermediaries. Contagion risk is lower than most people think.