But it is not intuitive that fear of these future losses should cause such turmoil in other credit sub-sectors. There have been few actual losses on the underlying loans – although there is no reasonable bid for bonds backed by them. Nor have there been any corporate defaults, so the speed with which the booming leveraged loan buyout phenomenon has run into investor intransigence –some would call it a restoration of plain common sense – has caught lending banks by surprise.
Investors have apparently decided that the trend of aggressive loan terms and leverage ratios should end. Having seen first-loss positions in ABS (sub-prime) CDOs wiped out, equity investors in CLOs have understandably become more cautious. It should surprise no one that risk managers at investment banks are scaling back warehouse lines for CLOs – there is plenty of evidence that buyers are wary even of triple-A rated bonds. One can see how US corporates, especially lower-quality credits, might be challenged by a long-term hit to US consumer confidence. The fact is that the connections between sub-prime and leveraged finance, or any other part of the market, rely on real economic effects and these take time to work their way through. No one knows what the final reckoning on sub-prime will be.
Why is it that the Crossover index – which measures sentiment for European sub-investment grade names – has become the bellwether for the wider European corporate sector and seems to be correlated with the ABX index? There is no doubt that the ABX/sub-prime weakness is manifesting itself in cash primary and secondary markets, with synthetic indices in the latter being the main driving force for what is happening in the former. Because of sub-prime there has been a reduction of liquidity, and banks have huge amounts of risk on their balance sheets. They need to hedge their positions – and the best way to do that is by selling credit indices, as it is the most liquid market.
In secondary markets, traders say that credit default swaps and the various indices are contributing to driving all spreads wider, if not leading the process. It is easier to short an index or buy protection on a CDS than it is to sell a bond.
Is it right that the influence of indices is so pervasive? Look at the ABX, where a lot of players might have substantial paper gains but can they close out their positions? If they do actually attempt to take profits they struggle to realize the full value of what their booked positions are.
In addition to a moribund ABS CDO market, and struggling CLOs, another feature of current markets is that the synthetic CDO market is slow. While in the past wider CDS and bond spreads triggered a frenzy of CDO-inspired buying – the CDO bid is remarkably absent. There is now a substantial positive basis between cash and CDS markets – in contrast to yesteryear.
For some time now, trading of cash bonds has been virtually dead. Single-name CDS and indices’ volumes are multiples of cash market secondary flows. A key question that needs answering is whether cash markets have actually been damaged by synthetic markets’ growth. Primary bankers increasingly believe that credit indices are instruments that exaggerate moves in both directions. A corporate might want to launch a deal and think it has a reasonable order book but if the Crossover opens substantially wider – on the back of further sub-prime fears – investors will say the market is in poor shape and demand a juicy new-issue premium. But what has really happened? The cash market might be just a beep wider. It has become a disturbing factor for some.
Financial innovation is generally a good thing, without CDOs and securitization the residential mortgage lending boom in the US would definitely have ended up as a banking crisis – there is a strong possibility that such a crisis will be avoided. But because of synthetic markets it is a lot easier to express a view without consequence of being caught short. And the connections and correlations between supposedly separate asset classes are much closer than many had once assumed.
