Credit derivatives 'performing poorly' in crisis

Section:

Credit Insurance Costs Soar to Record

By Stacy-Marie Ishmael and Gillian Tett
Financial Times, London
Monday, July 30, 2007

http://www.ft.com/cms/s/041c1122-3ed1-11dc-bfcf-0000779fd2ac.html

The cost of insurance against credit defaults hit record levels on both sides of the Atlantic on Monday amid concerns that some investors were being forced to sell assets to cover losses on subprime mortgages.

Investors rushed to buy contracts that would protect them against corporate credit defaults after it emerged that more European institutions had suffered losses following the crisis in the US subprime mortgage market.

IKB, a German lender specialising in providing credit to smaller companies, and Commerzbank, the country's second-biggest bank, both warned they would be hit by losses from risky US home loans to borrowers with poor credit histories.

In spite of the heightened risk aversion in credit derivatives markets US stocks rose. The S&P 500 was up 1.2 per cent in late trade, after a sharp tumble on credit market concerns last week. The safe haven of government bonds also gave up some of last week's gains with the yield on the 10-year bond 5 basis points higher at 4.81 per cent.

However, heightened risk aversion in credit derivatives markets on Monday failed to stop US stocks from rising. The S&P 500 was up 1.2 per cent in late trade yesterday, after a sharp tumble on credit market concerns last week. The safe haven of government bonds also gave up some of last week's gains with the yield on the 10-year bond 5 basis points higher at 4.81 per cent.

Investor fears were displayed in the derivatives markets, which have become increasingly active in recent days. The iTraxx crossover index, which tracks the cost of protecting a basket of risky European companies against default, rose more than 60 basis points yesterday to trade above 500 basis points for the first time.

That means it now costs E500,000 ($685,000) to insure against the default of E10 million of bonds. Last week it would have cost less than E400,000. This was the largest one-day move yet seen, leaving the index at more than double its level in June.

Similar dramatic swings occurred in US credit derivatives, where the CDX index of investment-grade bonds was quoted 20 basis points higher to cross 100 basis points for the first time on Monday, before settling at 87 basis points.

Analysts warned that the financial markets could stay jittery in coming days, since the credit turmoil could force more financial institutions to offload troubled assets.

"At a minimum, credit travails are apt to create a higher volatility environment across all asset classes for much of this year," said Alan Ruskin, global strategist at RBS Greenwich Capital. "Credit derivatives liquidity and risk management characteristics are finally being tested in a crisis and are performing poorly."

The speed of the swing in the credit derivatives markets has shocked many investors, particularly since it has not come amid a sharp deterioration in the macroeconomic background. Some traders consequently blame price swings on hedge funds that may have been rejigging their portfolios before the end of the month.

However, there are also mounting concerns that some investors are being forced into liquidations because prime brokers are trimming credit lines to groups with heavy exposure to subprime mortgages.

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