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The bond game changes

Investors who bought into the bank hybrid argument are unlikely to do so again in a hurry.

Spare a thought for bondholders. In the first phase of the crunch, credit markets were crushed mainly because of mark-to-market volatility – as illustrated by the rating agencies’ actions. Standard & Poor’s downgrades in the financial sector this year amount to $1.2 trillion – outweighing the number of upgrades by a factor of 20 to 1.

This financial crisis is also widely known as the sub-prime crisis but at the moment the real losses, of the kind that arise through a bond actually defaulting, have been relatively limited. The losses in sub-prime RMBS and their resecuritization into ABS CDOs will be substantial. S&P estimates sub-prime RMBS and ABS CDO losses will amount to $378 billion but that is projected losses not defaults.

The demise of Lehman and WaMu has clearly had a dramatic impact on the actual number of defaults that investors have suffered – losses of $150 billion – with who knows what likelihood of recovery.

Ever since the Enron/WorldCom debacle, investors in high-grade bonds had thought that buying regulated bank assets would protect them from jump-to-default risk. To some extent the market had priced in the likelihood that Lehman and WaMu could default.

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