An article in today’s Financial Times is useful, albeit sobering, for attempting to give more of a calibration of the negative sentiment sweeping credit markets. Pretty it isn’t.
Note also that the FT isn’t big on stories with emotional content.
From the Financial Times:
A palpable sense of crisis pervades global trading floors. Not since the meltdown of the Long-Term Capital Management hedge fund in 1998 have interest rate and derivative markets suffered such a breakdown in confidence.
In the past decade the scale of bond and derivative trading has expanded enormously, as global banks have provided easy access to trading for hedge funds and other investors.
That source of cash has dried up as banks seek to protect their deteriorating balance sheets amid writedowns of impaired assets. Big banks have pulled back from lending to clients for trading, starting a vicious downward spiral across the mortgage, interest rate swap, municipal bond, corporate debt and global credit derivative markets.
As investors have purged mortgages from portfolios, interest rate swap spreads – a barometer of bank credit risk – have surged more than a percentage point above Treasury bond yields.
In the credit derivatives market, the cost of buying insurance against corporate default has hit highs in the US, Europe and Japan.
The Federal Reserve’s response on Friday – a boost in short-term lending for banks this month to $100bn (€65bn, £50bn) from $60bn – provides more cash for banks in return for posting mortgages and other assets as collateral. But there are fears the benefit will not percolate beyond a small circle of banks.
“As the nation’s financial risk and lending has become concentrated in ever fewer money centre banks, the Fed finds itself more powerless than ever to control the spreading conflagration in the credit markets,” said Bill O’Donnell, strategist at UBS.
Banks have tightened lending standards in the repurchase market, where cash is borrowed against assets by hedge funds and others. This has forced some funds, such as Peloton and Carlyle Capital, to sell assets bought using borrowed funds. As assets are sold, prices fall further, prompting banks to keep tightening lending standards.
Many expect the turmoil to go on for much longer than the 1998 crisis.
“LTCM was such a transitory event compared with today,’ Mr O’Donnell said. “This is not just about the collapse of one entity, this is about millions of homeowners who are underwater.”
Until home prices stop falling and foreclosure rates cease rising, investors will keep shying away from holding mortgages. On Thursday, Citigroup said it planned to reduce its US mortgage assets by $45bn during 2008.
Unlike past housing crises, the banking sector is far less well equipped to cope with the fallout because of the wave of banking consolidation in the last decade, said Mr O’Donnell. This means the pain has become concentrated among a small handful of institutions, all of whom play a crucial role in keeping all markets liquid.
“As each of the mega-banks begins to suffer from housing-driven balance sheet stress, they simultaneously pull credit lines from other fully-functioning markets,” he said.
Note that in the wake of the LTCM crisis, it took swap spreads, a measure of market perceptions of risk, a full year to return to their former levels.