29 July 2007

Banks burnt by credit meltdown

Credit derivatives markets saw a strong bout of further heavy selling on Thursday in both Europe and the US, with the widely watched indices of riskier credits bearing the brunt of the pain.

Behind the headline numbers, banks and other financials have been among the worst affected as investors worry about their exposure to a range of problem areas from mortgage markets to the leveraged loans that fund private equity buy-out deals.

The iTraxx Crossover index, the key barometer of appetite for credit risk in Europe, saw the cost of protecting €10m ($13.7m) of mostly junk rated corporate debt jump above €400,000 per year on the five-year contract for the first time in almost two years.

The index at 400 basis points is more than twice the level at the start of June. Its US cousin also traded at record levels, hitting 326bp.

The perceived credit risk of owning the debt of US banks, which has soared in recent weeks, jumped to new highs yesterday as investors reacted to revelations that Wall Street had been left saddled with billions of dollars of unsold corporate debt.

Analysis by the Financial Times shows that investment banks in the US and Europe could have already been forced to retain more than $40bn worth of high-yield debt that they intended to sell in recent weeks.

Investor appetite for high-risk, high-yield debt has significantly diminished – illustrated this week by the failure to place about $20bn worth of loans for just two companies, Chrysler and Alliance Boots.

US banks especially had already seen both their stock prices and credit default swaps – which provide a kind of insurance against non-payment of debt – under heavy pressure owing to their exposure to US subprime mortgage crisis and to the hedge funds that were invested in related products.

“A lot of people are spooked that the [credit] lines extended to hedge funds have created massive counterparty risk,” said Christian Stracke, a senior analyst at CreditSights. “We can’t really have a great sense for what counterparty exposure is – and these players are beginning to drop off like flies under the weight of subprime.”

However, he added that the market was nervous more because of uncertainty than because banks were obviously in dire straits.

JPMorgan and Goldman Sachs postponed on Wednesday the sale of $12bn of debt financing for Cerberus’s purchase of Chrysler. The US carmaker has agreed to hold $2bn, leaving the banks with a hefty $10bn on their books.

The two banks’ CDS hit their highest levels since 2003 yesterday. JPMorgan’s CDS was at 75bp, an increase of 25bp on the day, according to data from broker Phoenix Partners Group.

The bank is Wall Street’s biggest underwriter of leveraged loans, according to Bloomberg data, and its cost of protection in CDS markets has tripled in the past five weeks.

Meanwhile, Goldman’s CDS jumped as much as 18bp to 85bp.

However, one of the worst hit is Bear Stearns, the largest US underwriter of mortgage-backed bonds, which saw its CDS rise to 105bp from 83.50bp on Wednesday. This is five times the level seen at the beginning of this year, and the highest of any bank on the Street.

Most of these banks have also seen their stock prices stumble. Bear is down 23 per cent this year after falling another 3.7 per cent to $124.49 on Thursday. JPMorgan is down 8.5 per cent and Lehman 16 per cent.

The S&P investment bank index tumbled 3.7 per cent on Thursday and is down 9.1 per cent in 2007.

Another barometer of bank stress and a leading indicator for credit market weakness is the interest rate swaps market, which is now at the widest levels over US Treasury yields since February 2002.

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