Still More Grim News from the Credit Markets

Another day, another adverse development in the credit markets, or so it seems. Except now we are getting more than one troubling sighting a day.

The latest tidings: liquidity in the credit markets is falling to the point where the European Central Bank has announced it will inject new cash. The underlying cause is worry about the health of the banking system, which makes banks reluctant to lend to each other. This fear is producing other symptoms, as you will see later in the post.

Yet, not surprisingly, the disparity in reporting between the Wall Street Journal and the Financial Times was striking. “ECB set to pump cash into money markets” was the lead story in the FT, and its first sentence reads:

Fresh emergency action to pump funds into the money markets was announced on Friday night by the European Central Bank amid renewed fears that liquidity in the credit markets is again starting to dry up.

What was the headline in the Journal’s version? “ECB Reinforces Liquidity Policy.” That makes the operation sound routine.

From the FT’s coverage:

On Friday night, the bank said it would inject an unspecified amount of extra liquidity next week, noting “re-emerging tensions” – and would do so until at least the end of the year.

Earlier, Jean-Claude Trichet, ECB president, had pledged continuing action to keep short-term money market interest rates in line with its main policy rate.

The new promise of intervention came as three-month US interbank rates rose for the eighth day in a row to 5.04 per cent, more than half a point higher than the US Fed Funds target rate of 4.5 per cent.

Three-month money usually trades just above the Fed Funds rate which is 4.5 per cent. Europe and UK money markets are showing similar strains.

Continuing problems in the markets were highlighted again on Friday as key interest-rate indicators hit fresh highs while the dollar plumbed new lows against the euro, falling to a record low of $1.4966.

The credit squeeze is also showing signs of dragging down eurozone economic growth, according to a closely watched survey published on Friday…..

Mr Trichet hinted that he expected financial turmoil to result in structural changes, saying banks’ losses “may trigger a reassessment by some of them of the suitability of the so-called originate-and-distribute business model”, which relies heavily on loan securitisation.

Note the idea of moving away from securitization is heresy in the US.

In other bad-news sightings, Reuters (hat tip Alea) tells us that the first Constant Proportion Debt Obligation has blown up, leading to a 90% loss to investors. Many of these deals had been trading as if they were in trouble in September. The overall market is small (only $4 billion in total outstandings) but it is yet another dent in the rating agencies’ reputation.

From Reuters:

Investors in a structured deal sold by UBS that was backed by the debt of financial companies have lost around 90 percent of their investment, Moody’s Investors Service said on Friday.

Moody’s cut its rating on one tranche of a deal issued via UBS nine notches to “C,” one step above default, from “Ba2,” after unprecedented spread widening in credit default swaps on financial companies included in the deal hit triggers that required it to be unwound….

The downgrade impacts 11.5 million euros (US$17.04 million) of debt that was due in 2017. Forty one million euros of the notes were bought back and canceled before the cash out occurred, Moody’s said.

Moody’s has also placed under review for downgrade 340 million euros worth of debt from five CPDOs that are also exposed to financial companies.

Another source of stress is that trading in many types of normally highly liquid derivatives has fallen off substantially. The Financial Times reports in “Trading in derivatives slows to a trickle” that some participants have decided to sit out the rest of the year. This is very unusual; most institutional investors don’t go into hibernation until mid-December.

From the FT:

Liquidity in some of the world’s biggest derivatives markets has dried up this week amid increasing fears over the health of the international financial system.

Over-the-counter trading in derivatives of equities, credit and interest rates have all seen much lower volumes as problems in financial markets have prompted investors to sit on the sidelines.

Analysts said flows had slowed to a trickle this week – even lower than in the summer when the credit squeeze was at its peak – as investor appetite for risk had diminished amid talk of potential bank defaults.

Although Thursday is typically slow because of the US Thanksgiving holiday, bankers said the week had been unusually light because of the growing fears that a big bank could go under as a result of losses in the US subprime mortgage and structured finance markets.

David Brickman, head of European credit strategy at Lehman Brothers, said: “Generically, trading volumes [in credit derivatives] are a lot lower than they were in the summer.

“The theory is that if people can’t trade bonds, they’re going to go to CDS [credit default swaps]. But in an environment like this you can’t get liquidity on single-name CDS either. That just leaves the indices.”

Another credit analyst said: “A lot of people have written off this year and hung up their boots until the new year. There’s no big bond issues in the primary market or activity in the secondary market. You can’t make money when there’s no liquidity.”

These markets are usually highly liquid, turning over huge volumes every day. Outstanding contracts in equity, credit and interest rate derivatives amount to $400,000bn, dwarfing the $60,000bn in the value of share trading on the world’s 10 biggest stock exchanges, according to the latest figures from the Bank for International Settlements.

Nino Kjellman, head of equity derivatives Europe at Deutsche Bank, added: “Liquidity has severely declined. In the current environment, appetite for risk is rare. Either people are sitting on the sidelines waiting for more visibility or, approaching year-end, they are reluctant to bet on risk.

“We see that investors are increasingly prepared to lower their risk exposure, which creates an imbalance and causes liquidity to dry up.”

Significantly, equity derivatives volumes have risen on the exchanges, such as Liffe and Eurex. Analysts said this was because exchanges tend to be used for hedging rather than speculative bets.

A contract at an exchange also has no links to the beleaguered banking sector; unlike a bilateral over-the-counter trade, when investors could lose all their money if the bank were to default, even if they were on the right side of the trade.

Interest rate derivatives volumes, including swaps and options where traders take positions on the monetary policy outlook, have also been sharply lower this week. The darkening mood was reflected in the underlying money markets and stock markets, too.

The Financial Times reports that it isn’t just derivatives or highly levered alphabet soup paper that is being trashed; even well established, conservative fixed income investments are taking a hit. The latest casualty is covered bonds. As Paul Davies and Joanna Chung explain:

Volatility is virtually unknown in the near 240-year-old market for Pfandbrief – or covered bonds as they are now more commonly named.

These mortgage and public sector loan backed bonds are seen as ultra-safe because of strict rules about the quality of their collateral and because investors also have recourse to other assets on the issuers’ balance sheets.

So when the industry’s governing council suspends market-making obligations between banks due to the rapidity of spread widening on such debt – as it did this week – observers are bound to fear the worst.

Jim Reid, credit strategist at Deutsche Bank, called the suspension of trading in the roughly €2,000bn market a “rather frightening spectacle” and said it was “cast-iron proof that we are in a credit crunch”….

Now it seems nervousness about over-inflated housing markets and the negative news around mortgage businesses and complex debt products generally is finally hurting a market that so far has been mostly resilient to these problems.

Jose Sarafana, analyst at SG CIB, says: “The resultant selling had a marked impact on spreads, with only a few investors or marketmakers wanting to increase their covered bond exposure. UK covered bonds suffered in particular, Cédulas (Spanish deals) less. In contrast, [the French] Obligations Fonciers and [German] Pfandbrief spreads remained almost stable.”

Early September saw jitters hit covered bonds after deals from HBOS and Nationwide of the UK priced at much wider levels than expected and set off a repricing of outstanding issues.

The dislocation in trading and lack of communication from some of the biggest marketmakers seen then are what led the European Covered Bond Council to create the committee that took the decision to suspend interbank market-making obligations on Wednesday.

However, there are many who do not believe that concerns about the strength of the underlying mortgage credit is the problem. Sofia Kwon, analyst at ABN Amro in Frankfurt, is among those who think the strictures and inefficiencies of the market- making regime are the cause of volatility and it is time to think about a change.

“The trading system has been a major force behind the recent spread widening, spread volatility, price discrepancies and lack of market transparency,” she says. “Marketmakers’ obligation to quote tradable two-way prices at fixed-bid offer spreads to competitors has caused many market distortions, with mid prices far from reflecting fair value.”

The other issue weighing on the market is the prospect of an overwhelming supply in coming months from issuers who typically raise funds from other areas such as securitisations.

“Normally, the big high street banks would have had perfectly good liquidity from their traditional short-term funding sources or the mortgage securitisation markets, but now they need to go into covered bonds to get funding,” Mr Kemmish says.

As a result, some analysts estimate that UK issuance, which averaged €20bn a year, could reach about €100bn next year. That is “a disaster scenario”, Mr Kemmish says. “Such a glut of supply will have enormous repercussions. The covered bond market has never seen anything like this before.”

While many of those investors who are traditional buyers of covered bonds – the massive Norwegian pension fund and Asian central banks for instance – remain flush with cash, it is far from certain they will swallow all that extra supply.

The big worry for large lending banks is that these disruptions will cut liquidity to the covered bond market, which may have been their final hope for getting the books straight ahead of the year-end.