Title Credit Markets woes published to cocoa-touch.
Report sent to cocoa-touch. about Credit Markets woes
This article is located at cocoa-touch.
With the financial system bailout plan derailed by the House of Representatives on Sept. 29, the resulting plunge in equities made headlines around the world. But while the stocks gyrate, it's important to keep one thing in mind: The big problem for financial markets is still the credit crunch. So as bad as equities have looked -- and during the big Sept. 29 sell-off, they looked pretty bad -- the true indicators investors should be watching are obscure measures such as credit default swaps, TED spreads, and commercial paper volume (all explained below)
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These names may sound wonky and insider-y, but they are nonetheless vital to understanding just how difficult, costly, and fearful the credit markets have become. They're the reason the stock market, in general an indicator of investor sentiment, plunged on Sept. 29 after the bailout failed. Without the plan, the markets recognized that the credit markets, the lifeblood of American business, will get worse before they get better. "The market understands the lack of liquidity that exists and the repercussions it will have on companies big and small," says American Capital CEO Malon Wilkis.
The credit default swap market is generally divided into three sectors: corporates, bank credits and emerging market sovereigns. CDS can reference a single credit or multiple credits. Multi-credit CDS can reference a custom portfolio of credits agreed upon by the buyer and seller, or a CDS index. The credits referenced in a CDS are known as "reference entities." CDS range in maturity from one to 10 years although the five-year CDS is the most frequently traded.
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Start with credit default swaps (CDS), which act as insurance on bonds and other debt. They've gotten a bad name amid the troubles at American International Group (NYSE:AIG - News), which was a big factor in the CDS market, but they're very good at one thing: measuring fear in the credit markets. And swap spreads, as measured by the CDX, an index of the most commonly traded CDS, rose to 163.7 at the end of last week according to CreditSights, levels unseen in five years and a sign that the credit markets are afraid. Very afraid.
Hunker-Down Mode
So scared, in fact, that investors are scooping up Treasuries, driving prices up, and yields down to 0% when adjusted for inflation. In other words, investors are willing to make nothing on their money as long as it's safe.
"Everyone's in a hunker-down mode," said Joseph Patterson, president of fixed income manager Patterson Capital Management. "They're trying to preserve capital."
What does this mean for everyone else? For starters, as Treasury rates fall, the rate at which banks lend to each other, known as the London Interbank Offered Rate, or LIBOR, has gone up. The three-month LIBOR, a short term rate, opened on Sept. 29 at 3.88%, the highest level since January. Three-month Treasury bills traded at the passbook savings-like rate of 0.66%. The difference between the two, known as the TED spread, is the highest it has been in five years. Essentially banks are paying more to borrow and are turning around raising rates for their customers.
If, that is, the banks are making loans at all. The amount of commercial paper -- loans of nine months or less used to fund operations for the companies that borrow under them -- outstanding fell to $1.7 billion on Sept. 24, a drop of 3.5% from the previous week, according to Federal Reserve data. And that was before Lehman Brothers, one of the largest commercial paper dealers, declared bankruptcy. If companies can't get funding in the commercial paper market, they won't be able to make to take care of basics, such as meeting their payrolls.
Stalled Cities
"The failure of Lehman cratered the commercial paper market," says risk analyst Chris Whalen of Institutional Risk Analytics. "All short-term lines of credit have been pulled."
Municipalities, too, are having trouble raising money. Cities are usually considered good bets to pay off their debt, but right now even they're having trouble. New York recently had to pay an interest rate of 9% on a $75 million short-term debt issue -- up from 1.25% at the beginning of September. Other cities, including Denver, have faced similar situations.
The freeze-up of lending has serious implications for the broader economy. Credit is the lubricant for the U.S. economic engine. If loans don't get made, businesses don't expand, orders don't get placed, workers don't get hired. A garden-variety economic slowdown can turn into a deep recession.
When will the credit crisis get better? Market confidence is a fragile thing, and with the rush of negative headlines credit market players are sticking to their guns. "It'll be a while," Patterson says.
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Characteristics of Credit Default Swaps
Unlike total return swaps that provide protection against the loss of credit value irrespective of the cause, credit default swaps provide protection only against previously agreed upon credit events. Below are the most common credit events that trigger a payment from the risk "buyer" to the risk "seller" in a CDS.
The settlement terms of a CDS are determined when the CDS contract is written. The most common type of CDS involves exchanging bonds for their par value, although the settlement can also be in the form of a cash payment equal to the difference between the bonds’ market value and par value.
How Has the Credit Default Swaps Market Evolved?
The CDS market was originally formed to provide banks with the means to transfer credit exposure and free up regulatory capital. As the credit default swaps market became more standardized and gained credibility, particularly following smooth credit event settlements in high profile cases such as WorldCom and Enron, more investors entered the market. While banks-through broker-dealers and reinsurance companies-are still both the largest buyers and sellers of credit default swaps, investment management firms are following closely.
Today, CDS have become the engine that drives the credit derivatives market. According to the British Bankers’ Association, the credit default swaps market currently represents over one-half of the global credit derivative market. The growth of the CDS market is due largely to CDS’ flexibility as an active portfolio management tool with the ability to customize exposure to corporate credit. In addition to hedging event risk, the potential benefits of CDS include:
A short positioning vehicle that does not require an initial cash outlay
Access to maturity exposures not available in the cash market
Access to credit risk not available in the cash market due to a limited supply of the underlying bonds
Investments in foreign credits without currency risk
The ability to effectively ‘exit’ credit positions in periods of low liquidity
The performance of credit default swaps, like that of corporate bonds, is closely related to changes in credit spreads. This sensitivity makes them an effective hedging tool that can assume exposure to changes in credit spreads as well as default risk. Credit default swaps also have given rise to new arbitrage opportunities, particularly in global markets that do not have the transparency or efficiency of the U.S. credit markets.
Conclusion
The event risk embedded in bonds and other credit assets was very difficult to reduce prior to the evolution of credit default swaps. In the brief decade since their inception, credit default swaps have become not only a tool that effectively hedges event risk but also a flexible portfolio management tool that far exceeds that single benefit.
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