The Great Credit Unwind
Credit default swaps market reveals just how antsy the financial markets are right now
By Aleksandrs Rozens March 17, 2008
Buying insurance against default in the credit default swaps market has become pricier despite the Federal Reserve's moves to shore up liquidity in financial markets.
The cost of insuring US commercial bank and brokerage debt fell slightly after the Fed's move last week, but has since risen because of concerns that what has become known as "The Great Leverage Unwind" still poses risk for many firms on Wall Street.
In recent weeks, several fund managers and a prominent mortgage lender have faced margin calls which have served as a reminder that financial markets remain fragile. Specifically, the funds have been forced to sell liquid securities such as mortgage bonds to meet margin requirements. This has brought about a cascade of other margin calls and spurred selling by not only investors but banks that have seized the collateral. The selling has pushed yield premiums of Fannie Mae and Freddie Mac mortgage securities to levels not seen since the mid-1980s.
Last week, Carlyle Capital Corp. announced that it was unable to renegotiate its borrowing arrangements with lenders and said that it expects its lenders to take possession of all of its assets, many of them agency mortgage bonds.
In its announcement to investors on Wednesday, Carlyle Capital said that within a seven-day period it received margin calls in excess of $400 million.
In addition to the leverage issue, the cost of insuring debt from brokerages and commercial banks has widened amid concerns about inflation and the US economy, particularly after a series of reports showed a softening in the US job market. Many commercial banks hold not only massive amounts of corporate debt, but loans to consumers in the form of mortgages, auto loans and credit cards. A slowing economy, the thinking goes, would only make it tougher for many firms to service this debt.
Early this month, the mortgage lending industry's trade group, the Mortgage Bankers Association, reported that foreclosures of home loans hit record levels while late payments were at a pace not seen since the mid-1980s. The trade group also found that the problem loans were not just in the subprime mortgage market. The credit issues had seeped into the prime and Alt-A home loan markets.
Also, credit markets have become increasingly aware of the change in US macro-economic conditions, notably the loss of 63,000 jobs in February, sagging consumer confidence and poor retail sales.
The widening in credit default swaps reflects concerns related to the massive unwinding of leverage that was used to amplify returns, according to a swaps analyst with a dealer firm who declined to be named. This credit cycle, he says, is one dominated by the unwind of leverage and not defaults.
"With banks [are] unable or unwilling to give credit ... repo funding has become incredibly expensive," according to a UBS report published last week. "Heavy unloading of securities ensued, as leveraged investors were forced to either pony up equity or sell," says UBS.
Early last week, Washington Mutual five-year credit default swap spreads were at around 700 basis points, but by mid-week had dropped to a range of 600 to 645 basis points. A year ago, WaMu credit default swaps were at about 45 basis points.
Bear Stearns, which has been caught in the middle of the credit maelstrom since last summer, has seen its five-year credit default swap spreads trade at around 680 basis points, compared with 35 basis points a year ago.
Lehman Brothers' five-year credit default swap spreads were at 410 basis points early on Thursday, compared with a range of 30 to 40 basis points a year ago.
Merrill Lynch has seen its five-year credit default swap spreads move out from 30 to 40 basis points a year ago to 325 basis points. Goldman Sachs' five-year credit default swaps are out from 30 basis points last March to 235 basis points.
Citigroup, JPMorgan and Wells Fargo, meanwhile, have not fared much better. Citigroup five-year credit default swaps traded at 12 basis points a year ago, but they are now at 235 basis points, while JPMorgan five-year credit default swap spreads -- at about 12 basis points a year ago -- were at 155 basis points last Thursday.
Wells Fargo five-year credit default swaps -- at a spread of 12 to 13 basis points last March -- were at 160 basis points last week.
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