If you had any doubts that the credit contraction was having real-world consequences (beyond, say, the ease of getting a mortgage in the US), consider this DowJones Newswire story (hat tip Michael Panzner). Banks are not only not willing to lend to each other, but because liquidity is scarce, they are trying to dissuade UK clients from borrowing. This is unprecedented.
Now admittedly, standby lines of credit to large corporations are not a profitable product on a risk adjusted basis even in normal times (they are the price of having those relationships). And funding of various supposedly off balance sheet exposures that turned out not to be so off balance sheet is eating up bank credit capacity at precisely the time when their equity bases are shrinking due to writeoffs.
There also appears to be an element of window dressing, of banks trying to avoid having audited year end balance sheets that spook regulators and investors. Not a pretty picture at all.
Banks have asked top U.K. corporate clients not to draw on lending facilities to which they are entitled in order to preserve their balance sheets as they approach the financial year end.
The banks are urging some of their biggest clients not to draw on standby credit facilities as the sub-prime crisis and squeeze on interbank lending have affected banks’ ability to fund themselves.
The problems started with the closure of the commercial paper market as a means of cheap funding for companies in the summer. Banks have to provide standby financing of up to 100% to backstop commercial paper programs. With banks struggling for their sources of financing through the interbank market, the drawdowns are having a direct effect on their balance sheets.
Several bankers have said Citigroup (C) is one of those most affected and that the bank was asking some clients not to use standby facilities, which are part of the normal relationship banking arrangements made between banks and companies.
A Citigroup spokesman said: “Citigroup honors its commitments to its clients but, as part of our normal business, we discuss with clients the potential use of our balance sheet. This is standard industry practice.”
Simon Allocca, head of non-French corporate origination at BNP Paribas ( 13110.FR), said: “By the end of the summer, the principal problem facing banks was not U.S. sub-prime or collateralized debt obligation exposure but the drawing down of standby loans and bilaterals. In some cases banks are seeking to avoid further balance sheet capital pressure by asking clients not to use their standby facilities.”
Standby financing is typically for 364 days and when undrawn has a zero risk weighting. When it is drawn, the risk weighting goes to 100%. This makes the sums involved significant. If a company is unable to tap the markets for commercial paper to the tune of, say, GBP4 billion (EUR5.6 billion), banks may have to provide that amount in standby financing.
In the past week equity markets worldwide have begun a rally on the expectation that accommodation by the global central banks will be more successful on its second try and that the dollar may end its free fall and foreign buyers, no longer attracted by securities, may purchase instead the assets underlying them.
These hopes will be in vain and the market fall will resume when the rally has been exhausted, probably sometime after the coming round of central bank accommodations.
Something useful can be learned from the reaction of the various segments of the derivatives market to these events. The ABX and CMBX markets have disdained the rally and continue to feed on the bottom. The interest rates swap markets have begun what is until now a perfunctory retracement without much enthusiasm. The credit derivatives market, by contrast, has reacted strongly. Domestic CDX indices exhibit gains in single digits, while international credit indices and credit futures have performed like equities on crack cocaine. From the Thanksgiving extreme, iTraxx Europe Crossover has gained about 13%, but still lags several Asian indices such as the iTraxx Asia ex-Japan which is up about 19%, as is the Credit Derivative Futures contract. Many CDS spreads have also tightened significantly.
From such indications as are available, it appears that these big swings have taken place with little actually being traded. What will happen in these markets on the next major fall in the equity markets? The answer is obvious: to put it plainly, spreads will blast off into orbit at an altitude where the credit derivatives markets will be untradeable. In other words, the many sizable global credit derivatives markets will cease to function. This raises the question of how counterparties to these transactions will determine their profit and loss in the absence of a market. The daily marks of the Markit Corporation are based on the input of the contributing banks. Do these banks then create Level 3 accounting models for these derivatives in the absence of a functioning market? Do the counterparties accept this and pay up? Or, what is far more likely, do trillions of dollars notional fall through to years of litigation?
Although the comment of a well known financier that derivatives are weapons of mass destruction is not accurate at least for this class of derivatives, in fairness it should be noted that such things were not current when the remarks were made. It might be better to describe credit derivatives as weapons of mass litigation. The effects may still be fatal to many but the pain will not be instantaneous or soon ended.
Banks will experience double jeopardy. As the major participant in this market, they are at far greater counterparty risk than appears to be discounted in the OCC reports. In addition some of the collateral they hold in these transactions may be at risk of discounting in the ongoing credit crunch. By the way this raises an interesting question. How do they value collateral submitted by other firms and is it consistent with how they value their own assets?
It is an irony that credit derivatives, designed to provide insurance and stability, are in fact accomplishing the opposite.
When the financial system is restructured in coming years, the credit derivatives business will still have a function to perform but it will need to be transacted in public markets in a manner similar to other commodities. This will not magically provide liquidity in times such as we are experiencing, but it will make possible better risk management, and prevent the same sort of debacle we are witnessing in this market.
This deal seems to be pumping for global monopoly of synyhetic risk:
Markit Group, a provider of independent data, portfolio valuations and OTC derivatives trade processing, has acquired International Index Company and has agreed to acquire CDS IndexCo in a transaction it expects to complete by the end of the year, bringing two series of widely-used credit derivative indices under common ownership.
IIC owns the iTraxx Europe and iTraxx Asia credit derivative indices as well as the global family of iBoxx bond indices. CDS IndexCo owns the CDX credit derivative indices and the synthetic structured finance and loan indices ABX.HE, CMBX and LCDX. Both businesses are currently owned by overlapping consortiums of international banks.
The iTraxx and CDX credit derivative index families, created by the merger of dealer-owned indices in 2004, are credited with revolutionising the credit derivative markets. They have increased the transparency and liquidity of these markets, and provide investors with an efficient, rules-based tool to gain or hedge exposure to the underlying credit markets.
The iBoxx bond index family was the first comprehensive suite of independent, transparent, multiple-contributor priced bond indices when it was launched in 2001.
‘The acquisition of IIC and CDS IndexCo will put us at the very heart of the global credit and rates markets,’ says Markit chief executive Lance Uggla. ‘By bringing the indices together, we will create the next generation of credit benchmarks and stimulate innovation in trading across the entire fixed income market.’
IIC is currently owned by ABN Amro, Barclays Capital, BNP Paribas, Deutsche Bank, Deutsche Börse, Dresdner Kleinwort, Goldman Sachs, HSBC, JPMorgan, Morgan Stanley and UBS.
CDS IndexCo is owned by a consortium of 16 investment banks licensed as market-makers in the ABX, CDX, CMBX and LCDX indices, comprising ABN Amro, Bank of America, Barclays Capital, Bear Stearns, BNP Paribas, Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JPMorgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, UBS and Wachovia.