Some Semblance of Calm Returning to Credit Markets

If credit default swaps prices are a valid indicator, the fixed income markets are regrouping. Prices, which spiked up earlier this week on panic buying of risk protection, have eased off. However, while this decline is a good sign, note that it does not equate (yet) to an improvement of liquidity in the riskier sectors of the market, which have largely seized up.

Later in this post, we also excerpt the astute but usually worried Gillian Tett of the Financial Times, takes comfort from the blow up of German lender IKB, arguing that it is sign of how far subprime risks are spread (although as she observes, it is also proof of how weak German financial institutions are at assessing and managing complex securities.

First, from Bloomberg:

Prices to protect corporate bonds against default fell for the first week since June as global financial markets stabilized.

Credit-default swaps on 10 million euros ($13.7 million) of debt included in the iTraxx Crossover Series 7 Index of 50 European companies dropped 5,000 euros to 390,000 euros at 11:40 a.m. in London and are down 52,000 euros for the week, according to JPMorgan Chase & Co. The contracts used to speculate on credit quality rose to the highest in at least three years at the start of the week.

The declining prices signal that traders have already accounted for the risks of the U.S. real-estate recession spreading to other parts of the global economy. Stocks in Europe are heading for gains this week and U.S. indexes rose three of the past four days. General Electric Capital Corp. raised $2 billion yesterday in its first U.S. sale of 30-year fixed-rate bonds since 2002.

“There was panic buying of credit protection earlier this week,” said Suki Mann, a strategist at Societe Generale SA in London. “Perhaps some sense of proportion is starting to prevail,” said Mann, who recommends investors increase holdings of corporate debt.

Credit-default swaps gyrated during the week, with the iTraxx Crossover, Europe’s benchmark indicator of corporate creditworthiness, peaking at 507,000 euros on July 30, the highest since the index began trading in 2004. The weekly decline reduced the cost to protect bonds for the first time since June 15.

Swap Gyrations

Less volatility may mean companies will have an easier time raising money after more than 50 borrowers from Tyco Electronics Ltd. in Berwyn, Pennsylvania, to Moscow-based OAO Gazprom postponed or reworked debt offerings in the past six weeks. Bond sales dropped to $193 billion in July, the slowest month in two years, from $483 billion in June, according to data compiled by Bloomberg.

Traders says they’re still concerned about credit quality deteriorating after American Home Mortgage Investment Corp. said yesterday that it will close and Accredited Home Lenders Holding Co. said it may need to seek bankruptcy protection. IKB Deutsche Industriebank AG required a bailout in Germany as its investments in U.S. subprime mortgage securities soured.

“Even though we have seen a calmer day in credit, we are not necessarily out of the woods yet,” said Jim Reid, head of fundamental credit research at Deutsche Bank AG in London.

Losses on AAA

Losses from U.S. mortgage defaults are spreading to higher rated securities. U.S. subprime-mortgage securities with the top AAA credit ratings from Standard & Poor’s are becoming riskier, based on the rising cost to protect the notes using credit- default swaps. An index of credit-default swaps linked to 20 securities rated AAA and created in the second half of 2006 fell 2.6 percent to a new low of 89.69 yesterday, according to London-based administrator Markit Group Ltd.

“Once the higher rated tranches start to be affected, a whole different investor group is exposed to the sub-prime fallout,” Reid said.

Credit-default swaps were designed to protect creditors against losses. Prices fall as the perception of credit quality improves and rise as creditworthiness deteriorates. The contracts pay the buyer the face value of the debt protected in return for the defaulted notes or the equivalent in cash.

The CDX North American Investment-Grade Index closed yesterday at $74,000 per $10 million of debt, down from $89,000 at the start of the week and a highpoint of $103,000 on July 30, according to Deutsche Bank AG.

And from Tett at the Financial Times:

How do you say “yikes” in German? That is a question many investors might ask right now when they look at IKB, the specialised German lender.

At the start of the week, IKB startled markets by admitting it had racked up vast losses on its credit portfolio – a move that prompted KfW, the German state bank, to underwrite around €8bn ($11bn) of IKB-owned securities. But, yesterday, it emerged that IKB’s exposure to the subprime sector had somehow ballooned to €17bn – many times the total market capitalisation of the group.

And that is not the worst of it. These staggering problems emerged a mere 10 days after IKB issued an upbeat trading statement in which it hailed “a successful start to the financial year” – and denied that it faced subprime problems. Perhaps this information oversight simply emerged because IKB’s own management did not know the scale of their own losses. After all, as we have written extensively on these pages, the value of complex credit instruments has fluctuated so wildly in recent weeks that even experienced hedge fund managers find it hard to measure their losses.

However, woes of this scale certainly do not crop up in a matter of just 10 days, even in turbulent times…. No doubt politicians would also be demanding a public inquiry given that public money is now being used to clean up this mess, via KfW.

Perhaps this will occur. If so, IKB could yet end up being truly good news for Deutschland AG. For it is a peculiar irony of Germany’s business world that while the country produces hordes of sophisticated, ultra-smart engineers, it is notably poor at churning out the type of sophisticated bankers it also needs.

As a result, many German financial institutions are woefully ill-equipped to handle complex derivatives risk (or indeed, capital market risks at all). That is troubling, given that many of these have been quietly shuffling into complex finance in recent years to boost returns.

But the lessons of IKB go further than German banking. In some respects, investors should consider it reassuring that US subprime losses are now cropping up all around the world. For this shows that financial innovation is enabling bankers to distribute risk more widely than ever before.

And that could potentially be a thoroughly good thing for financial stability right now, since if risk is spread around, it is less likely to cause a devastating shock to any single part of the financial world. The silver lining to the IKB cloud, in other words, is that it shows that American institutions are not the only ones reeling under subprime pain. The risk of large-scale American bank collapses is thus reduced. But one downside of spreading risk around in this manner is that it is fiendishly difficult for regulators to actually see where it is going, or to anticipate where problems are building up. After all, how many global investors – or policymakers – had even heard of IKB a week ago?

Worse still, what the subprime saga shows is that as risk has been passed around in recent years, it has not just ended up in the hands of people well-suited to manage this (such as hedge funds) – but those who are not. IKB was one of those lacking appropriate risk management skills. But I doubt it was alone. The shocks from this subprime saga probably have further to run.

* Meanwhile, if investors needed any more reason to feel uneasy, look at the extraordinary saga unfolding around AXA’s two troubled mutual funds (see opposite). Two months ago, it was widely presumed that anything carrying the tag of “money market fund” was a stodgy, safe-ish bet. But AXA’s two “dynamic money market” funds have apparently lost over 20 per cent of their value in a month, while being invested in securities with an average credit rating of A.

AXA is now fighting to restore its reputation with an unprecedented bailout. But the bigger question now is how many other surprises now lurk in other, supposedly dull “dynamic money market funds”?