"Fresh credit market turmoil"

It is truly amazing how disconnected credit instruments are from other tradeable financial investments. The Fed released the minutes from its latest Open Market Committee meeting, which lowered the growth forecast and increased the inflation forecast. That shouldn’t be cheery at all; the stagflationary 1970s were a terrible time for equity valuations, but the US stock market perked up, commodities showed even more zip. Overnight, the Nikkei is up nearly 400 points, and the yen, a barometer of risk perceptions, has fallen to a three week low, signaling a reduction in worry.

Yet the Financial Times tells us the debt markets are in a funk. There was a further flight (if such a thing is possible) from structured products and a spike up in the price of insuring against corporate defaults.

From the Financial Times:

Credit markets were thrown into fresh turmoil on Wednesday as the cost of protecting the debt of US and European companies against default surged to all-time highs.

The sharp jump, which rivalled the sell-off at the height of last summer’s credit market turmoil, came as traders rushed to unwind highly leveraged positions in complex structured products.

The sell-off was triggered partly by fears of more unwinding to come as investors rushed to exit before conditions worsen. As losses have snowballed, further unwinding has been triggered.

“There’s a domino effect taking place,” said Mehernosh Engineer, credit strategist at BNP Paribas.

The cost of insuring the debt of the 125 investment-grade companies in the benchmark iTraxx Europe rose more than 20 per cent to as high as 136.9 basis points, before closing at 126.5bp. That compares with a level of about 51bp at the start of the year, according to data from Markit Group.

This means buyers of protection through so-called credit default swaps are paying €126,500 ($185,780) annually to insure €10m worth of debt over five years.

In the US, the situation was just as bad with the investment grade CDX index hitting a record wide of 165.5bp in morning trade – more than double its level at the start of the year.

The iTraxx Crossover index, which covers mainly junk-rated European debt, bust through the 600bp barrier – up from 343bp at the start of the year. The moves are expected to affect the cost of raising new debt in the bond markets. Credit default swaps act as a proxy for the amounts real companies have to pay to borrow in the bond markets.

The way CDS spreads influence real borrowing costs has been illustrated this week by the situation at Credit Suisse.

Investors who had agreed to buy a bond from the Swiss bank the day before it announced unexpected writedowns are already looking to renegotiate price terms after the news sent its CDS contracts higher.

One funding manager at a different European bank believes the influence of CDS prices is a case of the tail wagging the dog.

“We feel we’re being unfairly penalised by the CDS market right now. It directly influences your cost of borrowing because investors up till now have wanted a return over CDS for any bonds issued,” he said.

The opacity of credit derivatives markets has contributed to problems. While most analysts and traders believe unwinding is taking place, few are sure of how much or by whom.

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  1. Anonymous

    Denial. The globe is in collective denial, which is really not that amazing since this whole mess was all about collusion and a lack of realistic collateral (or control) from anyone, everyone.

    We are in a massive casino where the game continues on while an epidemic spreads from player to player, yet, new players enter, just as crispy fried players exit. Perhaps this game is played even as the casino burns down and is re-built, as if the game of synthetic derivatives shifts from virtual reality to tent cities, where a desperate need to gamble is fueled by endless streams of cheap cash infusions.

    What is value and how do you measure that, when all our future value is synthetic? Why not play the game and ignore reality, drink more vodka and take greater risks!! Take on more debt and cut a deal for longer payments, because you will have greater cash flow in the future, bet on it!

    Thus, what we see now is the coping and the groping and the comrades weaving themselves together into new webs of financially engineered bridges, from which they will launch new and improved risk-free derivatives — using this very aspect of denial as a PR effort to establish a motive for cost averaging and making your bets less risky and potentially more rewarding, bet on it!

    Re: Collins et al. [18] found that those participants dealing with the Three Mile Island incident who reported greater use of emotion-oriented coping experienced fewer symptoms of emotional disturbance and stress than those participants using problem-oriented coping and denial, which is a form of avoidance. Hence, when stress is chronic, and the sources of stress are not easily changed, reappraisal-based emotional management appears to be the most effective strategy in reducing the psychological and behavioural consequences of stress. Future research should compare traumatic events that differ on degree and perceptions of controllability (e.g., natural disaster vs. MVA) on the type of coping strategy used. It seems likely that those traumatic events (perceived to be) under one’s control would be more amenable to problem-oriented strategies whereas those that are not are probably more amenable to emotional-oriented and avoidant strategies such as denial.

    See also: Every time Europe looks across the Atlantic to see the American eagle it observes only the rear end of an ostrich.” — H.G.Wells

  2. a

    With all the European and US orders sent to Japan overnight, Japan often follows trends set the previous day. So “Japan up” or “Japan down” is not always a good way of judging current market sentiment.

  3. Anonymous

    S&P 500 is 4.121% overvalued, based on 10 year treasury @ 3.763%, while S&P yield is at 7.884% (including divs) thus fair value is around 1293 for SPX. Bond yields continue to fall with earnings thus current value paid for future value is unrealistic in terms of gaining future value! Let the buyer beware, and IMHO as the recession kicks in and earnings begin to decline, the dis-connect between market valuation and reality will be driven by very pure economics and people will simply not have cash to burn on overvalued assets/securities!

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