Monday, March 10, 2008

Credit market meltdown

Well there's a title designed to catch your attention. "Credit market meltdown".

It's always interesting to talk about turmoil and disaster, especially when it's the kind of disaster that's happening right before your eyes, as opposed to the more usually seen and heard theoretical musings on potential calamity.

You know the kind; it usually sounds something like, "well, we could be headed for disaster as a result of x...".

Well now "x" is here. And today's "x" is a fallout in the credit derivatives market that's spreading to other parts of the global financial system and driving up the cost of available credit.

Here's more from FT, "Credit derivatives turmoil bites":

"Turmoil in the credit derivatives markets is having an increasingly brutal impact on the wider financial system as a vicious cycle of forced selling drives risk premiums on company debt to new highs.

The trend accelerated on both sides of the Atlantic last week as investors rushed to unwind highly leveraged positions in complex structured products. The cost of protecting US investment grade debt against default soared to a high of 188 basis points, from 80bp in January.

In Europe, the cost of insuring the debt of the 125 investment-grade companies in the benchmark iTraxx Europe index surged to a new high of 156bp, before closing at 146bp on Friday.

A move above 150bp would spark the unwinding of structured trades, according to BNP Paribas."

If you read the full article, you'll note that the high-risk appetite of recent years has now given way to risk-aversion, as banks and financial institutions try to get rid of structured credit instruments and cut their losses. Problem is, the unwinding of some of these positions are bound to have an effect on the rest of the financial markets.

"Liquidating structured credit instruments requires buying large amounts of protection using credit default swaps. This, in turn, drives the cost of protection higher, potentially triggering a chain reaction. "There is potential for some wild and possibly inexplicable price movements as the unwinds get bigger," said Mehernosh Engineer at BNP.

The markets are so illiquid that a few trades can lead to sharp movements, producing violent price swings and knock-on effects."

As noted in last Friday's "Features" post, these problems in the credit markets have already caused big problems for top-notch firms like Carlyle Capital, which stands to lose billions as a result of its overleveraged play in agency-backed mortgage securities.

More on this from Forbes:

"Until last month Carlyle Capital had a $21.7 billion portfolio of securities backed by government agencies Freddie Mac (nyse: FMC - news - people ) and Fannie Mae (nyse: FNM - news - people ). However, as risk aversion has spread well beyond subprime, the value of these assets has plunged, leading to increased margin calls from lender banks.

Carlyle Capital, which had borrowed 32 times its capital to fund its investments, like other heavily leveraged funds been particularly vulnerable. Its troubles are similar to those of Peloton Partners, a London-based hedge fund which collapsed last week after creditor banks withdrew their funding, forcing the liquidation of assets."

You can also add Blackstone Group to the category of firms suffering from the credit market rout. As Bloomberg reports, fourth-quarter profits at Blackstone fell 89 percent in the wake of a "credit market meltdown". And top Blackstone execs are not expecting a rosy outlook any time soon.

"``Credit market problems persist and if anything have gotten worse,'' Tony James, president of the New York-based company, said on a conference call with reporters today after the results were released. ``We're looking to 2009 before we see much of an improvement.''

Blackstone, which has lost 55 percent of its market value since the IPO, hasn't completed a takeover of more than $2 billion in five months as credit costs doubled and the LBO market shut down. Chairman Stephen Schwarzman, who owns 23 percent of the company, is struggling to close the $6.6 billion buyout of Alliance Data Systems Corp., the Dallas- based credit-card processor, announced in May.

LBO financing evaporated last July as banks and investors pulled out of the market amid the fallout from rising subprime- mortgage delinquencies. The value of deals announced in the second half of 2007 plunged two-thirds from the first six months, according to data compiled by Bloomberg.

``We're a proxy for the credit markets,'' James, 57, said at the Super Returns private equity conference in Munich on Feb 26."

So as each stage of the financial crisis unfolds and spreads to new areas, it becomes more apparent that we are sledding down the other side of that great mountain of risk.

And now as fresh worries surround subprime-beleaguered bank Bear Stearns, emerging market bonds are falling, as investors demand more yield premium for risky bonds.

"Emerging-market bonds fell, sending yield premiums over U.S. Treasuries to their widest since July 2005, on speculation Bear Stearns Cos. lacks sufficient access to capital, drying up demand for higher-yielding assets.

The extra yield investors demand to own emerging-market bonds over Treasuries swelled 7 basis points to 3.03 percentage points at 1 p.m. in New York, according to JPMorgan Chase & Co.'s EMBI Plus index. A basis point equals 0.01 percentage point."

What a difference a year makes.