Significantly, and against the norm, the price of insuring banks from default has recently increased above that of corporations the financial institutions themselves lend to. This is seen through market credit default swaps of banks that have recently risen to over 150 basis points, above that of a similar corporate index.
Traditionally the cost is less for banks than investment grade corporates as investors perceive bonds sold by banks to be less risky than corporates.
Problems in the financial institutions are forcing counterparties to examine more carefully both existing exposures and also potential deals. In fact, the international financial funding market is still under severe pressure with institutions reluctant to take on new exposure.
Instead, most are still battening down their hatches and ensuring their own balance sheets are liquid and comfortably funded. This is despite the large and concerted effort of central banks around the world to increase financial liquidity through pumping in billions of dollars into the system.
Large problems are surfacing with increasing frequency. Creditor banks of a fund of Carlyle Capital Corporation, the world’s second- biggest leverage-buyout firm by assets, forced the sale of some holdings and the group received significant margin calls and additional default notices from lenders.
Creditors of Carlyle plan to seize the assets of its mortgage-bond fund after it failed to meet more than $400 million of margin calls on mortgage-backed collateral that plunged in value. It has now defaulted on around $16.6 billion of debt.
Carlyle Capital’s plea for refinancing on residential mortgage-backed securities failed as the basis on which lenders are willing to provide financing against the company’s collateral has changed so substantially that a successful refinancing was not possible.
Carlyle failed to meet margin calls, prompting creditors to seek immediate repayment. The specific Carlyle fund used excessive leverage to buy $22 billion of AAA rated mortgage debt. It joined a list of firms that have had to sell securities or close due to losses stemming from the sub-prime mortgage crisis.
Peloton Partners, another well-regarded hedge fund, also hit huge problems and was forced to unwind. There are likely to be more hedge funds that will hit big problems.
Not only is plain vanilla bank to bank lending being squeezed but financial institutions are cutting lending to hedge funds substantially. Rising US mortgage foreclosures and loan defaults increase the likelihood that many more financial firms will face increasing pressure over the course of 2008.
Margin calls and increased collateral requirements can quickly deplete a firm’s liquidity and impair its capital.
The effect of the US sub-prime mortgage market collapse has reduced the value of previously high-rated residential mortgage-backed securities severely. Carlyle’s counterparties use repurchase agreements to lend money and require securities be put up as collateral.
As the perceived credit-worthiness of asset-backed bonds declined, the amount of money that can be borrowed using them as collateral fell. A downturn in market moves in price lead to mark-to-market losses, which in turn lead to margin calls and forced selling. The scenario is an increasingly vicious circle.
Investors remain sceptical that the move by the US Federal Reserve to inject funds into weakening credit markets would convince banks to loosen their grip on cash and solve the fundamental problems faced by credit markets.
The recent move by the Federal Reserve, and by the Bank of England, will certainly not end the volatility. Moreover, it is highly likely that the low point in the downturn has note yet been reached.
A US recession is highly probable, if not happening already. Weaker economic data, such as the recent sharp decline in jobs, the biggest monthly fall in five years, adds to concerns. Write-downs are still occurring. Banks and securities firms have to date disclosed more than $190 billion of asset write-downs and credit losses since the beginning of 2007.
Despite the effort of the Federal Reserve through the injection of further liquidity as well as raising the size of its credit auctions, markets have continue to show weakness. The 28-day term repurchase operations allow primary dealers to borrow against any type of securities, including agency-backed mortgages.
The credit auctions will be done via the Fed’s Term Auction Facility, which allows banks to borrow from the Fed at lower interest rates than those offered at the discount window. The US central bank also said it would conduct these auctions for at least the next six months.
Other market signals are also worrying. The US auction rate market is still largely closed, financial stock prices are still falling, debt spreads continue to widen, and interbank rates are still very high. High investment graded sovereign borrowers are also facing difficulties in the debt markets.
Major financial institutions have imminent result announcements. Even the mighty Goldman Sachs is expected to report first quarter earnings of about half what it earned in 2007. Forecasts have come down sharply for all the big banks, as the credit crunch spreads across almost every market. Moreover, share prices continue to be hammered. Goldman is down 28 per cent this year alone.
With around $200 billion of high risk corporate loans and few buyers, bank lenders have sought to sell loans at steep discounts in recent weeks. Goldman has about $42 billion of leveraged loan commitments on its books at the end of its fiscal year in November 2007; write-offs of $2 billion at the bank could be written.
Another potential source of trouble is Goldman’s variable interest entities, vehicles that keep assets off the books by issuing short-term debt. Goldman has $62 billion in variable interest entities holding mortgage securities, real estate and other assets.
Goldman also carried $12 billion of corporate and real estate investments on its books at the end of November. These values are expected to come down in a period when markets around the world slumped.
The market in general and investors specifically, fear conditions could worsen as hedge funds, banks and other financial institutions come under pressure to cut their losses before conditions deteriorate further. The markets are so illiquid that a few trades can lead to sharp movements, producing significant price swings and knock-on effects.
The current poor market condition is causing heavy losses in the banking system, eroding banks’ capital and reducing ability to lend. The credit spread widening is so severe that borrowing rates are rising across the board.
The market is very concerned about counterparty risk and how stable positions are as they are marked to market as prices keep falling.
The connection and link between institutions in the current negative climate and the focus on risk aversion is also feeding off one another. The hedge fund industry is suffering significantly as banks are demanding more money pledged to support outstanding loans.
Over the past month, at least seven hedge funds, totalling more than $5.6 billion, have been forced to liquidate or sell holdings as their lenders raised borrowing rates by as much as 10-fold with new claims for extra collateral.
While lenders are most concerned by exposure consisting of real estate and consumer debt, bankers are now attempting to raise the rates they charge on Gilts and Treasuries because of the price fluctuations in the bond market.
The credit squeeze is the worst to hit the hedge fund sector since Russia’s debt default in 1998 and the bailout of Long-Term Capital Management. Hedge funds are being forced to sell assets to meet banks’ margin calls, resulting in the meltdown of the funds.
Banks are reducing exposure anywhere they can. Prices keep falling, with yields on mortgage-backed debt issued by agencies rising to the highest level relative to US Treasuries since 1986.
Costs to protect corporate bonds from default are close to a record high. Given such a predicament, lenders have no choice but to ask clients to stump up more cash.
For AAA rated residential mortgage backed securities, banks have raised haircuts 10-fold in the past year to 20 per cent. On AAA asset-backed securities, banks are demanding a 15 per cent haircut, up from 3 per cent last year. Corporate bond haircuts have gone to 10 per cent from 5 per cent.
Some banks have raised Treasury haircuts, which range from 0.25 per cent to 3 per cent, depending on the length of the loan and the creditworthiness of the borrower.
The falling dollar, the soaring gold price, volatile stock markets, and interest rate derivatives highlight concern is increasing among investors that central banks are losing ground in their effort to stimulate banks to lend. Markets could well be on the edge of a precipice.
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