Risk is Back

Just a couple of posts ago, we complained about Bernanke talking up the stock market.

While that may indeed have been what he was doing (and we don’t approve of that), he may also have been trying to slow action in the credit markets, and that is a legitimate use of his power of the pulpit.

As readers may recall, we have been commented repeatedly on the fact that risk spreads have been at historically low levels, and that isn’t a good thing at all. As we have seen in the unwinding of the subprime market, what happens is that dodgy borrowers get money when they shouldn’t. Enough of them go into arrears or default to make lenders nervous. So creditors start making it harder for similar borrowers to get money (and that includes making it more expensive to borrow). That’s appropriate. But what often happens is that the lenders eventually overshoot, and get too stringent across the board. That leads to a business slowdown.

In this case, we have a second reason to be worried about increasing risk spreads, namely, hedge funds. Hedge funds have been active buyers of all kinds of risky credits, and many have done so with lots of leverage. The Financial Times in a January 19 story that we quoted, “The uneasy bubbling in today’s brave new financial world,” gave a sense of the extent and danger of leverage:

Last week I received an e-mail that made chilling reading. The author claimed to be a senior banker with strong feelings about a column I wrote last week, suggesting that the explosion in structured finance could be exacerbating the current exuberance of the credit markets, by creating additional leverage.

“Hi Gillian,” the message went. “I have been working in the leveraged credit and distressed debt sector for 20 years . . . and I have never seen anything quite like what is currently going on. Market participants have lost all memory of what risk is and are behaving as if the so-called wall of liquidity will last indefinitely and that volatility is a thing of the past.

“I don’t think there has ever been a time in history when such a large proportion of the riskiest credit assets have been owned by such financially weak institutions . . . with very limited capacity to withstand adverse credit events and market downturns.”….

He then relates the case of a typical hedge fund, two times levered. That looks modest until you realise it is partly backed by fund of funds’ money (which is three times levered) and investing in deeply subordinated tranches of collateralised debt obligations, which are nine times levered. “Thus every €1m of CDO bonds [acquired] is effectively supported by less than €20,000 of end investors’ capital – a 2% price decline in the CDO paper wipes out the capital supporting it.

“The degree of leverage at work . . . is quite frankly frightening,” he concludes. “Very few hedge funds I talk to have got a prayer in the next downturn. Even more worryingly, most of them don’t even expect one.”….

There is, for example, a credit analyst at a bulge-bracket bank who worries that rating agencies are stoking up the structured credit boom, with dangerously little oversight. “[If you] take away the three anointed interpreters of ‘investment grade’, that market folds up shop. I wonder if your readers understand that . . . and the non-trivial conflict of interest that these agencies sit on top of as publicly listed, for-profit companies?”

Then there is the (senior) asset manager who thinks leverage is proliferating because investors believe risk has been dispersed so well there will never be a crisis, though this proposition remains far from proven. “I have been involved in [these] markets since the early days,” he writes. “[But] I wonder if those who are newer to the game truly understand the impact of a down cycle?”

Another Wall Street banker fears that leverage is proliferating so fast, via new instruments, that it leaves policy officials powerless. “I hope that rational investors and asset prices cool off instead of collapse, like they did in Japan in the 1990s,” he writes. “But if they do, monetary policy will be useless.”

Not even six weeks later, and the scenario these writers worried about is starting to play out. Risk spreads rose sharply on Tuesday, and although they reversed somewhat today, it’s a pretty safe bet that we are beginning to see a repricing of risk. And that has widespread, and as yet unknown ramifications. If there is a dramatic enough move, it could lead to a downward spiral as leveraged players try to unwind their positions. As the Bloomberg story, “Bond Risk Falls After Bernanke Comments, Default Swaps Show,” indicates, Bernanke’s remarks soothed the credit markets, but the bigger story is the sharp move of the day before, and the likely continuation of that trend. As with the move in the stock market, the reversion in the default swap only partially offset Tuesday’s move:

The perceived risk of owning U.S. corporate bonds fell today after Federal Reserve Chairman Ben S. Bernanke said subprime mortgage losses weren’t “a broad financial concern,” according to traders of credit-default swaps.

The risk soared yesterday by the most since benchmark credit-default indexes were created three years ago after the global selloff in stocks. In Europe, risk rose for the second day amid the stock plunge.

Credit-default swaps based on $10 million of debt included in the Dow Jones CDX North America Crossover Index of 35 companies fell $8,710 to $129,760, according to CMA Datavision in London. The five-year contracts rose $24,160 yesterday to $138,470, the biggest move on record, CMA prices show.

The U.S. credit market retreated from a global rout that started yesterday in China when shares there had their biggest slide in a decade and continued in the U.S. as the Dow Jones Industrial Average had the biggest one-day drop since the first trading day after the Sept. 11, 2001, terrorist attacks….

In Europe, the slump was extended as the iTraxx Crossover Index of 45 European companies jumped as much as 37,000 euros to 239,000 euros, according to Lehman Brothers Holdings Inc. The index, which has increased from 179,500 euros on Feb. 26, fell back to 213,000 euros at the close of trading in London, Lehman and JPMorgan Chase & Co. data show.

“We’re seeing a repricing of risky assets,” said Jochen Felsenheimer, head of credit strategy at Unicredit SpA’s markets and investment banking unit in Munich. He expects the index to reach 250,000 euros within two weeks. “This isn’t a buying opportunity; the risk is that we’ll see further contagion.”

Investors are concerned rising delinquencies on the riskiest mortgages in the U.S. may spread to other parts of the home-loan market, hurting consumer confidence. Bank of America Corp. yesterday recommended investors sell corporate bonds as “housing-led weakness” spreads to the broader debt market….

A report today showed U.S. new-home sales fell last month by the most in 13 years, pointing to more weakness in the real estate market that limited economic growth last year…

In the U.S., credit-default swaps tied to the bonds of General Motors Corp., the world’s biggest automaker, fell $16,010 to $379,320 from a two-month high of $395,330 yesterday, CMA Datavision prices show.

Countrywide Financial Corp., the biggest U.S. home lender, fell $11,660 to $57,480. The contracts yesterday reached $69,140, the highest level since August 2003.

The cost to protect the debt of Turin-based carmaker Fiat SpA, Italy’s largest manufacturer, surged as much as 10,000 euros to 66,900 euros in the biggest two-day increase since June 2006.

The cost of credit-default swaps on London-based music producer EMI Group Plc, whose artists include the Beatles and Norah Jones, jumped 14,000 euros in the past two days to 190,000 euros, the highest level in more than a year, according to data compiled by Bloomberg.

An increase in credit-default swaps indicates worsening credit quality. Investors use the contracts, based on bonds or loans, to speculate on the ability of companies to repay debt.

“Are we buyers at this level? No,” said Vivek Tawadey, a credit strategist at BNP Paribas SA in London. Defaults by U.S. sub-prime mortgage holders may cause further selling, he said. “A U.S. slowdown does have a ripple through effect, starting with China and eventually Europe,” Tawadey said.

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