Tribune filed for bankruptcy today. This, by a very smart man who sold his $12 billion commercial and residential real estate portfolio at the very tippy top of the CRE bubble, only to be sucked into another bubble bursting. The Tribue Cos. And affiliates have sold off a lot of assets, fired a lot of professionals and cut back on a lot production – in essence, they are much lesser a producer of actual original content and will shrink further as time goes on.
Considering “As investment banks cut back, the serious blogs take the forefront“, there is a strong current of trenchant, need I say “superior” analysis coming from blogs, and the ability for bloggers to transform that analytical ability into most nutritious fodder in the form of being able to quickly analyze news events not only as they happen but to perform the type of investigative analysis that is probably too expensive and (in this environment) too intensive for a reporter who is not a specialist – I think even the most ardent of the old school must come to face the music, “A Change is gonna come!“
This popped into my mind as I had to spend even more money to upgrade my servers for the fourth time since starting this blog about a year ago. I also had to hire customer service for subscribers, since I couldn’t handle it on my own. I hate to say it, but this nascent new media business that I discovered by mistake by just trying to publish my financial and analytical thoughts to the world is actually growing (knock on wood) while the mainstream media and the investment bank analyst model are floundering. I now can count several major central banks as subscribers, much of what’s left of the Wall Street broker/banks, all sorts of small, medium and brand name hedge funds, commercial banks and even the IMF.
If I may make a suggestion to the main stream media, I believe the advertising model (as it stands) is flawed with the advent of free flowing information on the Internet and extreme cycles in our economy that are bound to introduce significant volatility in ad spending and revenues (I’m sure Mr. Zell can attest to that). I believe it is time to retool in order to create content that people are willing to pay for, but that content has to be A) truly useful and value added, or B) truly entertaining, and not a bunch of stereotypical fluff.
People are still willing to pay for things, even with the Internet in full boom. They pay to go to the movies, they pay for my blog, some of us even paid to get Bush out of office. People will pay if they believe they are getting true value for their dollar. I have paid for Calculated Risk (well, actually their newsletter – my condolences goes out to the personification of the high quality blogger – Tanta, who recently passed away at a very young age) and Roubini’s site, and ignore the ads. I pay, not to see flash animations, but because I believe they offer quality content that is worth more than I am paying for – and one of those sites charges a lot…
If I were a MSM (mainstream media exec) I would be pursuing successful blogs to imitate, or outright purchase, ASAP. The only problem is that the maverick nature of blog creators would probably cause them to refuse such overtures.
If you haven’t noticed, I have started dumping some real resourced into the blog in an attempt to make it a true, “go to” resource for those interested in the investment and financial space. Their will be a FAQ coming online soon to help answer questions.
Well, back to the Tribue story. If you have read the “Butterfly Effect” as well as the other installments of the asset securitiziation crisis, you know that I believe this is just the tip of the iceberg. We will be seeing a deluge of bankruptcies coming down the pike very soon. A quick recap of relevant links:
- · Counterparty risk analyses – counter-party failure will open up another Pandora’s box (must read for anyone who is not a CDS specialist)
- · More on the banking backdrop, we’ve never had so many loans! and Capital, Leverage and Loss in the Banking System – Tribune had $12.9 billion in debt and listed assets of $7.6 billion, who do you think is left holding the $5.3 billion bag? I’m sorry, I mean leveraged (about 13x) bag? Well, JPMorgan Chase & Co. was listed as the biggest creditor, representing lenders owed $8.6 billion. JPMorgan is the biggest holder of that debt, with $1 billion. I am short JPM because they are the financier/counterparty for many an overleveraged entity. Remember Bear Stearns and Lehman Brothers. There are enough bones in that closet to start a fertilizer factory.
- · Continued Deterioration in Global Lending, Government Intervention in Free Markets
The Butterfly Effect: part 2, the public edition In the Butterfly Effect (a piece that cost me a lot of time and money to put together, thus part one was for paying subscribers only), I explicitly warned of what we are seeing now. The government does not have the capacity to resurrect ALL of the walking dead! For those that are buying into these sharp and violent bear market rallies, I strongly suggest you hold on to your dentures, the trip down will be harsh. Some of you may actually be buying bankruptcies on a rallying high!
For those who want to read the story via MSM, here is the Bloomberg version. For those who don’t remember the early warnings from the Butterfly Effect, here is a repost of a small excerpt. Paying subscribers are urged to read the entire document if you have not already done so: The Asset Securitization Crisis Part 27: The Butterfly Effect. It gives the global macro argument of what is going down in the US in the hear and now. We are the first to get hit, but we are definitely not the last, we will not get hit the hardest, either.
Tremendous growth in leverage loan market in 2007
When the US economy started to show signs of a recession in 2007, the supply of lower-rated loans increased exponentially as the lure of high returns attracted many high-risk investors. According to Mark Gilbert, a Bloomberg news columnist, private equity firms declared a record US$736 billion of LBO deals globally in 2007 compared to US$696 billion in 2006 and US$270 billion in 2005. The huge success of LBOs, particularly before the credit crunch set in, created a lot of companies with the potential to go bankrupt. Due to a large number of buyers for a single company, the deals were finalized at much higher multiples of EBITDA. Deals priced at five or six times EBITDA were bought at nine times EBITDA. These inflated prices led to the downfall of several companies as it created unnecessary risk.
In 2006, 62% of new leverage loans in the US and 70% in Europe were sold in the form of collateralized loan obligations (CLOs). CLOs are a pool of bank loans divided into various tranches, providing investors with diversified exposure to leverage loans. In view of the current problems related to structured credit’s exposure to the subprime sector in the US, concerns have emerged about the CLO market, since it carries the same risk. Most of the deals closed in 2007 in the industrial sector were utilized to fund working capital needs and, in some cases, expansion plans. If the default on these loans increases, industrial companies would be in trouble.
Market plummets in 2008
The leverage loan market in the US has changed considerably since 2007. The US economy is at a more advanced stage of the economic cycle and is under increased stress. The auto and airline sectors were the first victims of the economic slowdown, followed by the housing market due to defaults on subprime debt. US companies have seen their leverage multiples rise. The debt ratio of an average leverage loan deal, measured as a debt multiple of cash flows, has gone above 6.5% from the historic levels of 4.5% in 2001.
The graph above represents historical prices vis-à-vis volatility of the DLJLVAL Index, a prime leverage loan index in the US. There was a sharp dip in the price and volatility metrics during December 2002 due to the debt crisis. In 2007, the 10-month historical volatility went up to 6.4% with the price touching 275 levels as many capital-intensive sectors raised loans from leverage markets. In 2008, prices and volatility have dropped as fewer loans are being raised and lower volumes are being traded in the secondary market. This trend is expected to continue during the coming months of 2008 and the first half of 2009 as leverage loans dry up. Therefore, capital intensive companies in the industrial sector face a high risk of going bankrupt due to credit unavailability and heavy exposure to leverage loans. Servicing these high interest loans in the tough market environment would be a challenging task for industrial companies.
Leverage loan issuance subsides in FY 2008
Negative macroeconomic factors, which include declining GDP, escalating inflation, higher default rates, and soaring interest rate in the economy, have weighed on the leverage loan market as reflected by decreased loan issuance. The negative macroeconomic environment worsened with the collapse of a number of financial institutions, mounting write-offs in leveraged loan portfolios, total rate of return (TRR) CLO unwinds, tightening liquidity, a sizable loan overhang and negligible new issuance.
Total syndicated loan issuance in the US declined 60.5% y-o-y in 2Q 08 to US$229.6 billion. This slowdown indicates that investors are hesitant to buy new loans due to weakness in the secondary market. However, syndicated loan issuance increased 38.4% q-o-q in 2Q 08 from US$165.9 billion in 1Q 08, thereby showing some signs of improvement. The total leveraged loan issuance in the US was US$84.1 billion in 2Q 08, down 61.6% from US$219.0 billion in 2Q 07 but up 39.2% from US$60.4 billion in 1Q 08. The sharp y-o-y drop in US leveraged loan issuance was largely due to the steep decline in LBO and institutional issuance as the credit crisis continued to tighten its grip on capital markets. Merger & acquisition (M&A) issuance in the US totaled US$50.3 billion in 2Q 08, up 47.5% from US$34.1 billion in 1Q 08. LBO issuance in the US was just US$7.9 billion in 2Q 08, up only slightly from US$6.5 billion in 1Q 08.
Institutional issuance (including refinancing and new money) declined 86% in 2Q 08 to US$20.0 billion from US$143.4 billion in 2Q 07, while second lien issuance fell 77% to just US$3.5 billion during the same period. New issuance during 2Q 08 was led by industry sectors including healthcare, utilities, oil & gas, beverage, food, and tobacco, although surprisingly automotive and automotive-related borrowers were one of the largest issuers of new facilities. The automotive sector borrowed these funds mainly out of financial necessity and liquidity needs as the sector continues to experience rising raw material costs, labor issues, and softening demand.
In line with general expectations, Moody’s considers the US construction industry to be the most vulnerable followed by the industrial sector. According to Moody’s index, which uses market prices to assess how much of the speculative-grade market is at distressed levels, the debt of 21.3% of borrowers was trading at junk levels in April 2008, up from just 1.3% in June 2007. The recent weakness in the US loan market is likely to dampen the growth of industrial companies. The key loan index in the US saw its implied spread widen from 105 basis points to 295 basis points on a y-o-y basis in June 2007.
Rising default rates in leverage loan market
The number of borrowers defaulting on their debt obligation is gradually going up as expected by a few credit rating agencies such as Moody’s and S&P. As the latest figures show, default rates, which were as low as 0.2% in August 2007, have gone up almost 13 times to 3.3% in August 2008. Insiders say this is just the tip of the iceberg, with default on bigger loans anticipated. According to sources, companies in the real estate and auto sectors accounted for more than half the defaults this year, closely followed by the gambling sector. Moody’s expects that this rate would rise to 5% by the end of 2008 and 6.1% by 1H 09 as loan issuers anticipate the economy to slow down further and loan recoverability from lower-rated companies to reduce.
The last period of high default rates was December 2000 (see chart above) after the leverage loan boom in 1998 and 1999. With the dotcom bust, most telecom companies that had taken these loans, crashed and defaulted on their payments. Furthermore, the graph shows an upward trend from almost no defaults in December 2007 to about 3.0% in 1H 08, indicating a steep rise in the number of defaulters. This increasing trend is expected to continue until the end of 2009 as most of the loans would mature by the end of 2008 or 2009. Manufacturing and industrial companies are expected to be the worst hit as majority of them would default due to falling margins with the slowdown, rising input costs, and falling consumer confidence. In addition, increasing interest rates would lead to higher borrowing cost, negatively impacting the margins of companies.
The S&P/LSTA Index shows the trend in all kinds of loans in the US market for the last 11 years. The level of B loans, also known as subprime loans extended to borrowers with tainted or limited credit histories, took a hit during the dotcom bust in 2002-03. Since then, there was a surge in demand for all types of loans before the retraction that started in December 2007. This trend is seen to continue into the next year.
Fractured deals and broken structures
The leveraged loan market showed signs of panic recently, following the failure to syndicate US$14 billion of debt used to finance the US$30 billion buyout of Harrah’s Entertainment. Another instance of panic was when the group of banks assisting buyers Apollo Management and Texas Pacific Group were having problems with selling the LBO debt to third parties. In fact, every deal made in the past few months is trading well below 90 cents on the dollar, with most market watchers concluding that the bottom is still out of sight.
The current dismal conditions have dragged the markets back into the price finding mode. Due to these conditions, underwriters are cutting back, modifying, or in some cases, delaying loan offerings that showed much promise during 2003-07, when the markets were on an upswing. Many industrial companies have postponed their issues as a majority of the investors expected higher returns than the company’s estimates or there is no more investor confidence left in the market for these companies. Some instances where deals have been modified or postponed are AllteF’s loan syndication, which was downsized in early November 2007 from an original target of US$6 billion to US$3.2 billion. Chrysler Automotives’ US$4 billion loan and Energy & Industrial Utilities’ US$425 million loan were also postponed. These are just some of the industrial companies whose deals collapsed.
Leverage loan volumes declined in the European region in 1Q 08
The European leveraged loan market opened its doors to non-bank participants in 2003. Since then, the market in terms of outstanding loans has grown dramatically as investors were lured by high-yield bonds. Demand for leverage loans has been very high with most corporate borrowings being executed in the loan market. This strong demand was matched by increasing supply in the form of private equity sponsors financing the recent LBO boom. Against the backdrop of this strong growth, a number of recent developments have been the cause of increasing concern for the market as leveraged finance issuance nosedived to €11.1 billion in 1Q 08 from €89.4 billion in 1Q 07. The decline in demand for these products is due to the greater underlying risk. Besides, due to huge writedowns during the current credit crisis, investors expect riskier assets to default.
Signs of rising default risk in the European market
Default risk in the European leverage loan market has been low historically. However, in the current credit crisis, defaults are likely to surge once lenders and sponsors shy away from companies that need capital for financial restructuring, according to S&P Ratings Services. In its recent report, S&P listed 52 global publicly rated companies that defaulted (from June 2007 to June 2008), driving up the TTM speculative-grade default rate to 1.8%. This compares with only 22 publicly rated companies globally for the whole of 2007, with a record low default rate of 1.0%. Among the 52 companies, the only rated European company to default was the French drinks manufacturing company Belvedere S.A., which voluntarily filed for bankruptcy in July 2008.
In Europe, as more activity takes place in the unrated private leveraged loan market, it would be inadequate to review defaults of only high-yield issuers that are publicly rated. S&P’s private credit estimate database of 648 entities (as of June 2008), comprising mainly private leveraged loans held in institutional investors’ portfolios, says a different story. Over the 12-month period until June 2008, 10 defaults were recorded in Europe, representing a default rate of 1.5%. Going forward, S&P’s analysis suggests that the private European leveraged loan default rate is likely to reach 5.8% by mid-2009, and majority of the defaulters would be in the industrial and consumer goods sectors.
According to Moody’s, FMCG companies are likely to be the most risky in the European region. With the latest figures showing retail sales dropping 1.6% in March 2008 in the region, most retail companies, which were LBO targets, look increasingly vulnerable. For instance, Coltrane CLO Plc held an auction to sell €394 million of loans. Nine banks paid an amount totaling 86.7% of face value for the securities, according to KPMG LLP. Deutsche Bank AG said recently that it bought about a third of that debt. With the European leverage market showing signs of a slowdown due to rising default rates particularly in the industrial sector, it would become more difficult for industrial companies to raise capital.
The industry-wise breakup of leverage loans made in Europe shows a gradual rise in leverage loan transactions from 2003 until 1Q 08, with the biggest of around €230 billion recorded in 2007. In 2003, no particular sector/ industry held the highest share of loans taken. With the telecom boom, most of the loans from 2003-06 went to the telecom sector. However, in 2007, the general manufacturing industry accounted for the highest share of leverage loans made on a y-o-y basis. According to Reuters, in 1Q 08, borrowings were highest in the real estate (€1.5 billion), telecom (€1.1 billion), and general manufacturing (€0.8 billion) sectors. With huge loans on their capital and slowdown in the European economy, most of these leveraged manufacturing companies are likely to default on their repayments. Defaults would increase as the companies would be under increasing pressure to refinance their loans, which has become difficult due to stricter lending practices and higher interest rates.
Negative impact on industrial/ manufacturing units
With the current scenario looking extremely gloomy, industrial and manufacturing units in the US, Europe, and around the world are likely to find it exceptionally difficult to keep up with their capex projections. The market turmoil in the US, expected global economic slowdown due to the credit crisis, rising input costs, and dwindling consumer spending would adversely affect the capex plans of these industrial companies. The option of internal funding is looking grim as companies’ reserves are depleting due to diminishing profit margins resulting from the slowdown. Moreover, higher borrowing rates are keeping companies away from banking institutions. Lastly, leverage loans are getting out of their reach as investor confidence declines with rising default rates. As the credit crunch plagues the industry making credit availability difficult in the light of worsening macroeconomic conditions, demand is set to decline. Going forward, we believe the impact of the failure of financial companies and ongoing credit crisis would trickle down to the real sector and negatively impact industrial and manufacturing companies.
Default risk of companies continues to rise as depicted by rising CDS spreads
The notional outstanding value of credit default swaps (CDS) grew at an exponential pace from US$900 billion in 2000 to US$45 trillion in 2007 and US$62 trillion in 2008, which is more than four times the US GDP. The recent cataclysmic events in US financial markets changed the face of Wall Street as two of its investment banks evaporated in the heat of the credit crisis. The bankruptcy of Lehman Brothers (Lehman), fire sale of Merrill Lynch, and nationalization of AIG has seen CDS spreads rise not just in financial sectors. Though AIG was bailed out, Lehman’s bankruptcy would have a far-reaching effect on the CDS market as settlement issues surface in the near future. The worst fears on Wall Street have come true as distrust among financial institutions has frozen credit markets in the last few days. Central banks across the globe are injecting liquidity to soothe financial markets.
The spike in CDS spreads reflects the rise in perceived risk and loss of investor confidence as the strain in the financial sector continues. The rise in insurance cost reflects the increased probability of default by companies, further dampening the credit situation. The rise in default rates would send ripples across the financial system as more companies are anticipated to be in trouble and possibly fail in the near future.
The US Government two-year note rates declined 31 basis points from September 15 to 19. This is the highest decrease since February 2008 as investors opted for the safer government debt. The bankruptcy of Lehman and nationalization of AIG, Fannie Mae, and Freddie Mac have made financial markets skeptical about the safety of corporate bonds. With investors hoarding safe treasury bonds, the CDS of corporate bonds skyrocketed in the past week.
The financial turmoil in mid-September 2008 led to a surge in the CDS spread of financial giants as liquidity froze and perceived credit risk increased. The fact was evident in the case of AIG as the credit spread of the five-year bond began to increase since the start of September 2008. This spread increased 529.2 points to 902.5 basis points on September 12, 2008, from 373.3 on September 1. This was the time when the company declared its business was in trouble. As AIG’s requirement of US$40 billion came to light, spreads increased to 3500 basis points on September 16, 2008. Subsequently, the insurer was bailed out by the Federal Reserve, which provided US$85 billion of bridge loans for an 80% stake in the company. Washington Mutual, which has written down losses totaling up to US$14.8 billion and is looking to save itself from liquidation, has seen its spread rise. The CDS spread for a five-year period soared 88% as of September 17, 2008, since September 1.
CDS spreads widen mainly in banking and industrial sectors
The US dollar-denominated CDS year-to-date (YTD) movement until July 2008 showed that all industries reported wider spreads except the building & materials sector, which expanded more than 400% in 2007. The worst-performing sectors were transportation, automotive, insurance, gaming, banking & finance, lodging & restaurant, and broadcasting & media, with the spread of each widening by greater than 90%.
The banking and finance sector bore most of the brunt of the credit turmoil as around 40% of outstanding CDSs are held by this sector. Top investment banks saw their spread rise in the last few months as they reported increasing losses led by asset writedowns and increase in provision. As losses mounted for these institutions, the CDS spread also gained as the risk of default rose. The spread of Bank of America, which has written down US$21.2 billion in the current credit crisis until September 11, 2008, increased as the company acquired Merrill Lynch. The spread increased by 99 basis points to 223.3 points on September 17, 2008, from September 1. This rise indicates that as the riskiness of companies’ increases, the CDS spread also moves upward, reflecting greater default risk. The spike in CDS spreads is an indicator of the deteriorating health of financial institutions. Goldman Sachs’ CDS spreads also rose considerably to 443.3 basis points on September 17, 2008, from 129.6 on August 1, 2008.
Morgan Stanley (), one of the last two independent US based investment banks, is (was) in merger talks with Wachovia Corporation. Morgan Stanley registered further losses of US$1.3 billion in 3Q 08 to record total losses of US$15.7 billion. As illustrated in the charts below, the CDS spreads of both Wachovia and Morgan Stanley widened considerably in the past week. The CDS spread of Morgan Stanley increased to 997.9 basis points on September 17, 2008, from 225.1 basis points as of August 1, 2008. Similarly, Wachovia Corp., which wrote down assets worth US$22.7 billion as of September 19, 2008 (Source: Bloomberg), saw its spread increase to 756.7 basis points as of September 17, 2008, from 108.3 basis points at the start of the year. The tremendous increase in the perceived risk of the asset in 2008 led to the rapid widening of its CDS spread.
The turmoil in the financial markets is spreading across the general economy as the perceived risk has increased and chances of corporate failures are on the rise. Spreads have widened across the industrial and manufacturing segments as investors believe the likely recession in the US economy would lead to more bankruptcies. Tight credit market conditions, rising inflation and unemployment, declining consumer confidence, flagging consumer sales, and increased interest burden would cause distress among industrial and manufacturing companies.
In the transportation sector, airlines such as AMR Corporation, JetBlue Airways Corp., and Continental Airlines, Inc. were the worst hit. Trucking companies YRC Worldwide Inc. and USF Corp. saw their spreads almost double to 912 and 957 basis points YTD, respectively, through July 2008. Since production has declined due to falling consumer demand, the transportation sector’s profitability has dropped, increasing the CDS spread for these companies.
Among auto manufacturers, the worst performer was General Motors Corp as its CDS spread increased to 2486 basis points as of September 18, 2008, from 726.6 basis points at the start of the year. Due to the bleak outlook for the auto sector, it is not surprising to see spreads of companies rise. General Motors has been in trouble as its losses have been mounting. The company reported a net loss of US$15 billion in 2Q 08 as sales in North America decreased 20%. This decline mainly increased the CDS spread raising the company’s perceived risk.
The average spread on CDSs increased in all but one industry in 2008. This factor indicates that the market may be bracing for more corporate defaults. Fitch Ratings said spreads have widened the most this year in industries badly hit by the housing and subprime crises. These industries include banking, insurance, transportation, gaming, and media. Of the 23 business segments that Fitch covers, only one sector – building and materials – has seen spreads tighten. Spreads in this sector dropped almost 50% to about 504 basis points through July 2008. Spreads in the construction-related sector had skyrocketed in 2007, rising around 400%. Surging spreads make it difficult for many companies to refinance debt. Increasing spreads raise the perceived risk, pushing the insurance cost higher. This in turn is expected to further increase borrowing costs in the bond and loan markets.
Wider spreads across the board indicate that the market would be preparing for a rise in defaults. According to Fitch, the high-yield corporate default rate rose to 3.1% at the end of June 2008 from 0.5% at the end of 2007. One can expect greater defaults in the future as spreads increase and investors seek greater reward for taking on credit risk.
Major CDS indices are falling as credit market turmoil touches nadir
The current credit crisis has resulted in an increase in spreads across regions. The rise in asset writedowns, surging global inflation, and deteriorating macroeconomic conditions have worsened the outlook for the economy. The rise in input prices led to an increase in cost of production, slowing down growth in companies. As a result, there is greater pressure on companies across sectors, leading to increase in credit spreads. Furthermore, considering the crumbling financial sector, large number of bankruptcies, and a few companies looking for a suitable buyer, the spread is bound to increase. Overall, the situation ahead looks challenging and murkier for companies.
The US CDX NA IG index spread widens at a rapid pace by over 200 basis points from April 1, 2008, to 469.2 basis points as of September 16, 2008. This index’s spread could rise further as an increasing number of financial institutions, including Washington Mutual and Morgan Stanley, are looking for a possible buyer. The US financial system, which looked resilient until now, seems to be crumbling as investors are wary of the current turmoil.
The popular index in Europe, know as Itraxx Europe index, which covers 125 investment-grade entities from six sectors – auto, consumer, energy, financials, industrials, and TMT – has seen its spread widen in the last one month. The Itraxx Europe index rose 43.8% to 143.75 as of September 16, 2008, from September 1, 2008. With the rise in the number of companies defaulting, the credit spread is increasing rapidly as revealed by the index. This could raise the insurance cost as well as the default risk of companies.
The US financial crisis has impacted the entire globe, widening the CDS spread in all markets. The spread of the Itraxx Asia index rose, leading to increased default risk. The index rose 25.7% to 699.61 as of September 16, 2008, from September 1, 2008.
Japan’s economic health has deteriorated as indicated by its GDP, which fell 3% (annualized) in 2Q 08. The Itraxx Japan index spread expanded by 49 basis points to 179 basis points as of September 16, 2008, from April 1, 2008. Furthermore, the increasing spread increases the probability of default, which is rising worldwide.
CDS spread widens in Europe
Following the trend in the US, the spread of companies in the European banking and finance sector more than doubled in July 2008. The financial crisis impacted the banking and insurance industries the most, as reflected by the increasing spreads in these sectors. In 2008, other than these two sectors, the retail, automotive, and transportation sectors had the highest average spread levels in absolute terms, while the spreads of automotive, broadcasting & media, and building & materials sectors widened the most on percentage terms. While all companies in the transportation sector had greater spreads this year, the high average value is largely due to Scandinavian Airlines. This company’s spread rose to 529 basis points, whereas that of British Airways jumped to 395 basis points, up 167 and 242 basis points, respectively, from the start of the year. Spreads of retail companies widened substantially during 2007. The trend continued in 2008, with the spread increasing by an average of 119 basis points to nearly 225 basis points YTD through July. The spreads of most companies widened, with some underperforming considerably. On a nominal basis, DSG International’s spread increased the most, expanding 338 basis points from 122 basis points to 460 basis points as of September 18, 2008. Stalwarts such as Tesco Corp and Carrefour SA saw their spread widen by 43 basis points to 73 basis points and 41 basis points to 71 basis points, respectively, as of September 18, 2008, from the start of the year. The increase in the CDS spread of all these companies indicates the rising default risk. Consequently, the extra charge for the insurance of the debt is rising.
Industrial/ manufacturing companies, which had not witnessed a large increase in spread, have begun to feel the pressure of rising spreads. All companies in the automotive sector performed poorly. On a small scale, auto parts suppliers fared the worst, with spreads of Continental AG and Valeo SA widening by 219 basis points to 252 basis points and 201 basis points to 236 basis points, respectively, as of September 18, 2008, from the start of the year. Two companies led the rise in spreads in the Broadcasting & Media sector. SEAT Pagine Gialle S.p.A.’s spread rose 1028 basis points to 1375 basis points YTD, the highest spread in the industry, while ITV Plc’s spread widened 198 basis points to 308 basis points. The increase in the CDS spread has increased the default risk. This is because borrowing cost increases with the CDS spread, making debt refinancing costlier. As industrial production decreases (as shown by the Index for Industrial Production), industrial companies are likely to feel the pinch of a higher cost of borrowing. This situation is likely to result in the closure of many companies.
Bankruptcy of Lehman to raise settlement issues in the CDS market
The CDS market has grown at an extremely fast rate but the rules governing it have not kept pace. The default of one party to the transaction increases the potential risk to the entire financial system. The default of Lehman, which has led to an increase in the CDS spread of all financial players in the system, makes this clear. To avoid a similar situation, Bear Stearns was bailed out by the Federal Reserve. The complete failure of Bear Stearns would have impacted the entire financial system, compelling the Federal Reserve to intervene and save the company from bankruptcy. However, since Lehman has filed for bankruptcy, the effect of its presence in the CDS market would lead to a cascading effect of huge defaults. Though the Federal Reserve has stated that Lehman does not have much presence in the CDS market, Fitch has listed Lehman among the top 10 largest CDS counterparties in terms of number of trades and debt value of contracts. As CDSs are sold and resold creating an entanglement between institutions, Lehman’s default is likely to have far-reaching effects on the entire financial system. Therefore, the domino effect arising from Lehman’s fall raises questions regarding CDS settlements. Update: I have done some digging into this since the Butterfly Effect was originally published. See “Do you who’s going to screw who next week?” and “I can tell you who’s holding the bag” for some hard numbers and facts relating to this.
According to Fitch, Lehman acted as the CDS swap counterparty in 27 Fitch-rated public synthetic CDOs and 35 private CDOs. Of the 27 public CDOs, 12 are in Europe and 15 in Asia. Among the 35 Private CDOs, 17 are based in Europe, 15 in Asia, and 3 in the US. The impact of CDS transactions and CDO note ratings, in which Lehman acted a swap counterparty, would rely on a number of factors. Some of these factors include the swap being transferred to another counterparty; the status of the CDO transaction – whether or not it faces an automatic unwind in view of Lehman’s bankruptcy; and the extent to which CDO note holders would be subject to the market value risk of eligible securities in the event of early termination of the transaction. This is similar to earlier cases in which Aon Corporation (Aon) booked a huge loss on its protection sold to Bear Stearns. The failure of Lehman highlights the counterparty risk of global financial institutions. The International Swaps and Derivatives Association (ISDA) needs to come up with a mechanism for settlement in the CDS market. Accordingly, the credit default instrument should be exchange traded rather than OTC. A regulated exchange with proper mechanisms in place would be better equipped to take care of the counterparty risk and operational inefficiencies in the CDS market.
The deteriorating financial market coupled with worsening macroeconomic conditions are expected to result in a significant rise in defaults in the near future. Highly volatile market conditions along with considerably higher spreads are increasing investors’ concerns regarding financial services companies and non-financial enterprises such as automotive and manufacturing companies. The trouble in financial markets has begun to impact the manufacturing sector and is likely to have a significant effect on the global economy. The considerable rise in default rate in the US economy points to the worsening scenario. The US high-yield corporate default rate rose to 3.1% at the end of June 2008 from 0.5% at the end of 2007. For the moment, we believe that economies around the globe are in for difficult times as the financial turmoil worsens and impacts growth in the real economy.
Originally published at BoomBustBlog.com and reproduced here with the author’s permission.