Calling for Another Dangerous Go-Round

Until this past year, many in the mainstream media seemed to think that the stock market was the only true barometer of which way the financial winds were blowing.

In contrast, the fixed-income market, despite its much larger size and its absolutely critical role in greasing the wheels of a credit-dependent economy, was often ignored, unless there was a big move in yields in response to unexpected economic data or the Fed had stepped up the pace of its monetary interventions.

However, it has been the credit markets that have correctly anticipated and delineated the tsunami of financial destruction that has reverberated throughout the financial system and the economy.

Based on the following report from David Gaffen at the Wall Street Journal's MarketBeat blog, "Write-Downs, Right Down to the Ground," it looks like the coupon-clipping types are calling for another dangerous go-round -- like we saw a few months ago -- in the period ahead.

Is it March all over again?

Most investors thought that, after the blow-up of Bear Stearns Cos. as the winter ended, the credit markets would finally recover, owing to the various creatively-named Federal Reserve facilities (TAF, TSLF, et. al.), and the risks yet to be confronted would pale in comparison to the Bear debacle.

It hasn’t turned out that way. While the strain in the credit markets still falls short of the explosive environment of mid-March, the current malaise is in a sense, more depressing, as it can be attributed directly to broader U.S. economic problems.

The CDR Counterparty risk index has risen to levels not seen since March. (Source: CDR)

As a result, a key index of the health of the banking companies suggests more concern than at any time since late March, the aftermath of the Bear situation. An index of 15 counterparties (made up of banks and brokerages) formulated by Credit Derivatives Research that tracks the credit-default swaps of those firms is at its widest level since the end of March.

This index has been steadily rising since the middle of June, and of late was traded at 147.8 basis points, according to Dave Klein, manager of CDR Credit Indices. That figure refers to the average cost of insuring $10 million in bonds against default for five years, so it would theoretically cost $147,800 to insure a bond that represented all of these banks. (The financial institution with the highest cost is currently Lehman Brothers Holdings Inc., at $280,000; HSBC Holdings Inc. was the cheapest, at $68,000.)

“In the middle of June the credit spreads tightened up and there was a lot of talk, certainly about the names in the counterparty risk index, that the worst was over,” says Mr. Klein. “In the last week people have really backtracked on that. The sentiment now is that there is no light at the end of the tunnel.”

Why the despair? Part of it has to do with the slow, steady wave of rising mortgage delinquencies, and the erosion of the value of assets backed by those mortgages. In addition, the loss by bond insurers MBIA Inc. and Ambac Financial Group Inc. of their key triple-A credit ratings has forced banks and brokerages to revalue the assets those firms backed.

“That’s triggering some forced selling and delevering,” says Mirko Mikelic, portfolio manager for Fifth Third Asset Management in Grand Rapids, Mich. “People are getting rid of structured product and corporate [bonds] across the board, and that continues unabated…dealers don’t want to hold onto any inventory.”

Mr. Klein says credit-default swap spreads also tend to widen when earnings approach, as investors brace for the latest spate of write-downs from major banking firms. Several Wall Street analysts expect more than $4 billion in write-downs from Merrill Lynch & Co., while some analysts estimate Citigroup Inc. could write down as much as $9 billion in assets.

“Our expectation was that write-downs would be done by the second quarter but it looks like it’s going to be another quarter or two,” says Mr. Mikelic.

Comments

[roger]

the mainstream media seemed to think that the stock market was the only true barometer of which way the financial winds were blowing.And for decades people believed that the economie was under control with the manipulation of interest rates LoL LoL LoL

[Jes]

The counterparty risk graph looks almost like the opposite of the Dow for the last few weeks...
I was thinking it was credible we could have another Bear-Sterns this week.

[CJ]

I was reading this, and I just glanced at the 2Y swap quote on my bloomberg terminal. It's at 99.4.

We made a big deal of > 100 before, right before the BSC collapse - and now we are here again.

3Y's at 111, 4Y's at 109.

Jes, I think you are right.