Credit markets caught out with CDS and bonds

On the Monday after Bear Stearns was forced into the arms of JP Morgan Chase (in March 2008), the Aussie iTraxx CDS index hit its widest level of 208 bps and in the three weeks prior to this the index had widened by more than 25bps, on two days.
 
Yesterday, the index widened by 41bps to 195 bps. The largest, one-day movement yet seen; but not the widest level.

The size of yesterday's movement signals the extent to which the market was caught by surprise as events did not unfold as expected. The move back to almost 200 bps indicates the extent of the market's revived fears about credit quality and particularly that of financial institutions, which make up 28 per cent of the index.

Fortunately, this fear was not so apparent in banking system liquidity as it was in March. The spread between the 90-day bank bill rate and the overnight cash rate has narrowed since it became clear the Reserve Bank of Australia was about start cutting interest rates. Yesterday it was at 29 bps, out four bps from Friday, and a long way from the 100 bps reached in early March.

And while the Reserve Bank pumped some A$2.1 billion into the banking system yesterday, this is only around twice the daily average seen since May and is some 50 per cent to 100 per cent less than the volume of liquidity provided on some days since the start of the year.    

As for holders of physical bonds and those issued by Lehman Bros and Merrill Lynch in particular, the news ranges from bad to pretty good. Lehman has A$600 million of August 2011 bonds on issue in Australia. Analysts are speculating that senior bondholders may recoup only 60 to 80 cents in the dollar, if Lehman is liquidated.

On the other hand, Merrill Lynch has some A$3.9 billion of bonds outstanding with maturities ranging from November this year to February 2012. Not only is Merrill Lynch unlikely to default on these bonds but its credit rating could be upgraded. S&P and Moody's have Bank of America Corp. rated three notches higher, although those ratings may come down a little now.

Bank of America also has A$3.9 billion of bonds on issue in the domestic market with maturities ranging from December this year to February 2012. Some A$3.0 billion of the bonds have been issued by the higher rated bank rather than the holding company.

As for other US financial institutions that are now looking vulnerable, AIG, Morgan Stanley and Goldman Sachs have also issued bonds in Australia, along with Citibank and a number of others. For the former, outstandings total A$990 million (via AIG SunAmerica), A$3.9 billion and A$2.7 billion, respectively.   

Overnight Bloomberg reported that credit default swap spreads for Morgan Stanley widened by 189 bps to 453 bps and those for Goldman Sachs widened by 119 bps to 318 bps. Both are now at record wide levels.

The up-front cost to obtain credit default protection on AIG is 29 per cent, with the insurance company's bonds trading around 55 cents in the dollar. However for Washington Mutual, the largest savings and loan company in the US, the up-front cost for CDS protection is now at 47 per cent and 500 bps a year thereafter.