Counterparty risk aversion leads to tough margin calls

Global credit and equity markets have recovered somewhat after the central banks around the world pumped in billions of dollars to boost liquidity, but counterparty risk aversion has become acute and pervasive, according to a new report on capital markets.

The Institute of International Finance (IIF), a top global financial services association, said in its "Capital Markets Monitor" report that the heightened concerns about counterparty risk have led banks and other financial institutions to enforce stringent margin calls and raise haircuts on a wide range of securities, not only mortgage-related securities.

"Since last summer, haircuts on collateral have been increased by three to five times. Even haircuts on US Treasuries were reportedly hiked from 0.25 per cent last summer to three per cent – reflecting higher volatility in US rates and counterparty risk concerns," it said.

Generally, financial institutions have tried to reduce exposures to each other, and in extreme cases, these pullbacks become "liquidity runs" on perceived weak players, such as in the case of Bear Stearns and several hedge funds. Consequently, financial institutions have built up significant liquidity pools (of cash and liquid assets) as precautionary measures, sometimes equivalent to 20-25 per cent of their balance sheets. This precaution has curtailed the efficiency of credit intermediation in the financial system, not to mention curbing the profitability of the financial sector for some time to come.

The report found tension in term inter-bank market still exists, which is reflected in spreads between interbank rates and expected overnight rates remaining wide. In fact, spreads for sterling funds continue to rise, approaching the previous peaks.

The report said wide spreads are "perplexing and worrisome" as major central banks have added a substantial volume of term liquidity, including through newly-increased and longer-term facilities. In fact, the results of the latest Term Auction Facility (TAF) auction by US Federal Reserve on March 24 showed a decline in the bid-cover ratio to 1.78 and a very low Libor-stop-out spread of only four basis points – as demand for liquidity has become less intense.

As part of its market stabilisation measures, the Fed has injected almost half of its $880 billion (Dh3.2trn) balance sheet to take in a wider range of non-Treasury securities as collateral and to provide support to a wider range of financial institutions, including primary dealers. The Fed also took an exceptional step in staving off the collapse of a major non-bank financial firm.

The IIF stated that though these measures provided immediate relief as credit spreads have narrowed and equities recovered, many market participants attributed the recovery to "short covering" and it is not clear that the improvement can be sustained in the long run.

"The financial market increasingly expects some form of government 'buyer-of-last-resort' support for the US sub-prime mortgage market to arrest ongoing deterioration in asset values," the report said.

It also found that a parallel development to counterparty risk aversion is strong preference for safe and liquid assets.

"Demand for US Treasury securities has increased, pushing yields down quite sharply at the short maturities – three-month Treasury bill [T-bill] rates fell briefly below one per cent, causing the TED spread [Libor minus T-bill rates] to widen despite the 300 basis point reduction in the Fed funds rate. Demand for US Treasuries has also led to a shortage of those securities and an increase in Treasury fails in repo transactions [failure to deliver or receive Treasuries in repos]," it said.

So far this year, the average weekly amount of Treasury fails has increased to almost $500bn, compared to the average of about $350bn in the past five years.

"Any signs of tension in the repo market on top of prolonged tension in the term inter-bank market would be serious for the financial system," IIF stated.

However, IIF warned investors to gear up for another wave of writedowns as banks begin to release first quarter financial reports. According to preliminary estimates, major banks and securities firms have reported mark-to-market losses of $209bn and credit losses of $26bn so far since the beginning of 2007.

These figures do not include losses reported by other financial institutions such as insurance companies and credit guarantors.

Besides ongoing deterioration in residential and commercial mortgage markets, consumer credit markets, and leveraged loan market, banks are now faced with concrete signs of deterioration in the corporate debt market, especially for high-yield borrowers.

In particular, credit default swap (CDS) spreads for Asian high-yield debt have risen sharply in recent months to be higher than European and US high-yield spreads – reflecting rising concerns about the ability of Asian high-yield borrowers to refinance in the more difficult credit environment and the relatively more illiquid nature of the Asian corporate bond markets.

More specifically, in the US high-yield corporate bond market, the proportion of high-yield bond issues in distress (trading at or below 70 per cent of par value) has risen sharply.

There is now $70bn in debt from more than 100 issuers trading at distressed levels, compared with only $3.6bn in distressed debt from 14 issuers last June (see chart 5). Historically, rising levels of distressed debt lead to higher default. Consequently, the high-yield default rate is expected to increase sharply from the record low in the last quarter of 2007 to more than five per cent this year – another area of credit losses for banks and other financial institutions.

Meanwhile, signs of tension continue to increase in certain markets outside major financial centres. In particular, CDS spreads on the three major Icelandic banks have increased to record highs as investors expect these banks to face increasing funding difficulty after their balance sheets increased significantly in recent years – the banking sector's combined assets have risen from 96 per cent of GDP in 2000 to more than eight times GDP in 2006 – and probably more by now.

The Icelandic krona has also weakened by more than 20 per cent against the euro since the beginning of this year, leading the central bank to hike its policy rate to 15 per cent last week to defend the currency.

Iceland's weak economic fundamentals (current account deficit of 16 per cent of GDP, inflation more than 81 per cent) have also undermined sentiment. Several countries and banking systems, including the Baltics, Kazakhstan, Romania and Bulgaria have also exhibited signs of tension.

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