An article in Bloomberg, “Credit Swaps Thwart Fed’s Ease as Debt Costs Surge ,” focuses on a noteworthy phenomenon, but does a lousy job of explaining it. I’m posting it nevertheless in the hopes that a reader in the relevant markets might shed some light.
The story tells us that corporate borrowers, even AAA ones like General Electric, are facing borrowing costs that seem inappropriately high due to the impact of correlation models for credit default swaps, which are no longer working properly.
The article states that as CDO prices fell, banks that owned them attempted to hedge them. OK, I get that part. They then began use indices to hedge the exposures. I get that too. But apparently they were using indices on corporate bonds like the the Markit CDX North America Investment-Grade Index.
Huh? A corporate bond index to hedge exposures that are significantly if not primarily real estate related? Presumably the use of an index from a completely different asset type was used to hedge CDOs based on the famed correlation models mentioned in the article.
But guess what? Markit was founded in 2001. Any models based on its indices have so little history as to be the functional equivalent of garbage, which is what we are seeing now.
The article is also not clear how the CDS prices are distorting the price setting for new bond issues. I assume it is because price formation no longer takes place in the cash bond market but in the CDS market (that’s been true for some time for secondary trading, since a lot of corporate bond issues don’t trade very much, if at all).
Credit trading models used by Wall Street have gone haywire, raising company borrowing costs even as Federal Reserve Chairman Ben S. Bernanke cuts interest rates.
General Electric Co. is one of five U.S. companies rated AAA by both Standard & Poor’s and Moody’s Investors Service, making its ability to repay debt unquestioned. Yet when the Fairfield, Connecticut-based firm sold 2.25 billion euros ($3.35 billion) of five-year bonds last week, its annual interest payment was $17 million higher than on a sale nine months ago.
Borrowers from investor Warren Buffett’s Berkshire Hathaway Inc. to Germany’s HeidelbergCement AG face the same predicament. Yields on $5.12 trillion of corporate bonds tracked by Merrill Lynch & Co. average 2.05 percentage points more than U.S. Treasuries, the most since at least 1997.
The higher costs are an unintended consequence of securities that allow investors to speculate on corporate creditworthiness. So-called correlation models used to value them have become unreliable in the fallout from the U.S. subprime mortgage crisis. Last month some showed the odds of a default by an investment- grade company spreading to others exceeded 100 percent — a mathematical impossibility, according to UBS AG.
“The credit-default swap market is completely distorting reality,” said Henner Boettcher, treasurer of HeidelbergCement in Heidelberg, Germany, the country’s biggest cement maker. “Given what these spreads imply about defaults, we should be in a deep depression, and we are not.”
The problem started in the second half of last year when subprime mortgage delinquencies started to rise, causing investors to retreat from complex instruments such as synthetic collateralized debt obligations, or packages of credit-default swaps that became hard to value. The swaps are contracts based on bonds and used to speculate on a company’s ability to repay debt.
As values of CDOs began to fall, banks that had sold swaps underlying the securities started to buy indexes based on them instead, a method of hedging their losses on portions of the CDOs they owned. The purchases are driving the cost of the contracts higher, raising the perception that company bonds tied to the swaps are suddenly riskier and leading investors to demand higher yields throughout the corporate debt market.
The Markit CDX North America Investment-Grade Index, a gauge of credit-default swaps on 125 companies from Wal-Mart Stores Inc. to Walt Disney Co., has more than doubled since the start of the year. It jumped as much as 21.5 basis points today to a record 186 basis points, according to Deutsche Bank AG. The index dropped to a low of 29 in February last year…
Banks bought more contracts on indexes containing GE’s swaps after CDO pricing models broke down, sending the so-called default correlation to more than 100 percent last month from 60 percent in July, according to research from Zurich-based UBS.
The programs, which computed the value of the highest-rated portions of CDOs, implied that all companies in the CDX index would default if just one did. Banks often hold these senior tranches after arranging the CDOs for investors.
“The banks that have been using correlation to calculate their risk will have to go back to scratch,” said Janet Tavakoli, president of Chicago-based Tavakoli Structured Finance. “By using correlation models as the main means of risk management, the engineers threw out sound banking practices.”….
The mathematical breakdown is compounding the decline by creating a vicious circle. As the cost of the swaps on the CDX index increases, the models signal a greater risk of defaults, and vice versa. A bank holding $100 million of the highest-rated portion of a swap-based CDO now has to buy $60 million of swaps to maintain its hedge against losses, JPMorgan said. A year ago, it would have had to buy $10 million.
“The recent unwind and activity in that market is also causing activity in our name,” said GE spokesman Russell Wilkerson. Swaps linked to GE’s financing unit are included in 67 percent of European CDOs, more than any other company, according to S&P.
Before the subprime collapse, the burgeoning CDO market had the opposite effect. Increasing demand for the underlying assets helped lower U.S. corporate bond yields to 1.28 percentage points over similar-maturity government notes in February 2007, the smallest spread since 2005, indexes from New York-based Merrill show. Synthetic CDOs pool swaps, while others package loans or bonds.
“It’s the key factor that brought spreads to irresponsibly tight levels up to the end of the second quarter of last year,” said Nigel Sillis, director of fixed-income and currency research at Baring Asset Management in London. “Now we’re seeing the reverse, except that the impact is far more negative than it was ever positive.”
One way to make the models useful again is to reduce the amount banks expect to recover from defaulted bonds to 30 percent of face value from 40 percent, according to analysts at UBS and New York-based Citigroup Inc. Banks would still have to buy more default protection though, keeping the pressure on borrowers.
“The unwinding of structured credit is eating away at the fabric of the corporate bond market,” said Suki Mann, a credit strategist at Societe Generale SA in London. “The increase in credit-default swaps is making it far too expensive to borrow.”