Cost of credit improves as the slump extends

There was a certain optimism in financial markets as we started 2009, a hope that the new year would be better than a dreadful 2008. However, February was destined to bring us back to reality as companies reported their final results for 2008.

Among the highlights were horrific bank losses and bleak outlook statements.

Over the first eight weeks of 2009 the S&P500 is down by almost 19 per cent. The S&P, and the Dow Jones (down 20 per cent) hit twelve year lows last week as fears of bank nationalisations peaked in the US.

The S&P/ASX 200 is down by a more modest 10 per cent but is now hovering around a five year low.

Yet, as observed last week, when looking at the performance of financial markets over the week before, credit markets have been less affected.

Europe's Main CDS index finished the month barely changed from the start of the year although it has moved around over the intervening period. The CDX 11 investment grade index in the US finished out about 11 per cent and the Aussie iTraxx is about seven per cent wider.

Market trends are more favourable among corporate bonds, with primary issuance volumes and pricing all stronger, as we have noted progressively over the last two months. There is more on this below.

Moreover, conditions in money markets have steadily improved.

The TED spread has fallen to around 99 basis points from 130 bps at the end of the year. This is the result of Libor yields falling by about 20 bps while yields on three month US Treasury bills have increased by 15 bps; while in our market the spread between the three month overnight index swap and bank bills has also narrowed to around 55 bps from 75 bps at year end.

Can we breathe a sigh of relief at the end of February with reporting season out the way? Maybe.

President Obama frightened markets at the end of last week when he unveiled a US$1.75 trillion budget deficit for 2009: the largest ever in absolute terms and the largest since 1945, at 12.3 per cent of US GDP. Both equity and bond markets sold off.

And then there was the news that the US economy shrank at an annualised rate of 6.2 per cent in the last quarter of 2008.

On the other hand though, the outlook for some of the world's largest banks is becoming clearer.

The consequence of any of the 19 largest banks in the US failing the impending "stress test" is not as bad as was feared. If a bank needs more capital, it will have six months to raise that capital from the private sector. If it can't, the government will inject preferred capital with conversion to common stock without voting rights, after seven years.

The US does not want to nationalise its banks, but then it agreed a third rescue package for Citigroup that will see it convert up to US$25 billion of its US$45 billion of preference shares into ordinary shares, giving the government ownership of up to 36 per cent of the group. To some this is nationalisation; it is inevitable, and there will be more to come.

And for British banks that avail themselves of that government's asset protection scheme, the cost will be less than what had been anticipated, if the deal done by Royal Bank of Scotland is a reliable indicator. Lloyds Banking Group announced that it would seek similar insurance cover from the government.

But there are still time bombs ticking in the real economy too. General Motors announced a 2008 loss of US$30.9 billion on Thursday. This is its second largest loss, following its US$38.7 billion loss incurred in 2007. In fact, GM has lost US$82 billion over the last four years and its auditors are expected to express doubts about its ability to continue as a going concern.

Is it possible to rescue a company that is losing this much money year after year?

Well, as we noted last week, the planned rescue isn't going to be much different from entering Chapter 11, at least as far as credit markets are concerned. GM advised that it is still negotiating with bondholders on an end of March exchange of two-thirds of their US$28 billion of bonds for equity.