Finance Weblog: Fears on the debt market - Instituto de Empresa Business School

The credit squeeze is rattling the markets. The leveraged buy out fever is facing the absence of high yield/ high risk investors and the end result is that the underwriters (banks) of those deals are loading their balance sheet with unwanted corporate debt. A group of banks failed this week in their attempt to obtain sufficient finance for two of the major private equity deals, those of Chrysler and Alliance Boots. This failure implies a burden in the creditworthiness of banks that see their balance sheet full of unsold corporate debt. The easiest way to evaluate the creditworthiness of the banks is the behavior of the credit default swaps written on the debts of these institutions. These CDS provide an insurance against the default or non-payment of the bank’s debt. These CDS on banks such as Goldman or JP Morgan raised fast this end of the week. Banks forced to hold these debts have a risk credit exposure in the form of mark downs of the debt. The fear is obviously that all the corporate deal in the pipeline planned for the next weeks end up in the hands of the banks if they are not able to find any buyers.

But the banking sector faces other exposures. The sub prime crisis has exposed banks to the counterparty risk of some of the hedge funds affected by this crisis. Absolute Capital Group Ltd. (a hedge fund that invests in collateralized debt obligations which suspended withdrawals from two of its funds this week), has been the latest casualty of this rout. Though the recent fail currently does not seem a great danger, they might be in a recent future in the number of fails increases.

On the other hand the equity market has been pretty resilient. There has not been a big correction in the stock market given the movement followed by the government bond market and compared with the values attained by the credit spreads (CDS, swap spreads,…). An investment bank reports that the response of the equity market to the credit market has a lag of six months. The credit nervousness (some people already name it a crunch) has induced a flight to quality where government debt has been bided up pushing yields on ten year paper to 4, 81 and 4, 33 in US and Europe respectively. This is far away front the 5, 25 level reached by the US less than three weeks ago pushed by an unexpected fears of higher expected inflation. Volatility is a back in markets that seemed dormant. But remember that with volatility comes a higher risk premium. The corporate/treasury yield is already reflecting part of this, but the premium might go higher.

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