No end in sight, or the worst is yet to come

The Bank for International Settlements, the central bankers' central bank, released its September 2008 Quarterly Review last week. One local newspaper (the AFR) misquoted the BIS from one of the articles in the review, suggesting that the BIS had said there is no end in sight to the credit crunch. This is not quite what the BIS said.

The overview section charts the progress of the credit crunch through this year, as it has waxed and waned. In the June 2008 quarter of this year it seemed to be waning but that depends on how you read the evidence. The BIS notes that international bond sales almost tripled in the second quarter from the first, amounting to a net US$1071 billion. This is almost as much as was recorded in the second quarter of 2007, just before the credit crunch began in earnest.

In looking at the composition of this second quarter increase in international bond issuance, the BIS notes that issuance by financial institutions quadrupled to US$827 billion, while corporate issuance was a little more than twice the volume seen in the first quarter, at US$131 billion. The significant increase in financial institution issuance is consistent with what we saw with Australia's financial institutions - there was a rush to lock away funding before it became even more expensive or markets dried up.

Much to the credit of Australia's financial institutions, they got in early, with the greater volume of their international funding undertaken in the first quarter of this calendar year. Indeed, the BIS notes the decline in international bond issuance from Australia in the second quarter. However, this did not stop domestic issuance by our financial institutions, which was up more than 50 per cent over the first quarter to almost A$13.5 billion.

There are other Australian parallels with some BIS observations: Samurai bond issuance almost doubled in the second quarter to US$7.0 billion and issuance of mortgage backed bonds more than tripled to US$188 billion. Australian issuance into the Samurai market was little changed between the two quarters at more than A$3.0 billion in each, but one quarter's issuance alone is more than has been issued in any other year.

The Samurai market hit its straps because it has been cheaper to issue there than in the Euromarket or the US markets. The Japanese appear to have a greater risk tolerance than other investors; or against their very low interest rates, the wider credit spreads on offer were just too good to refuse.

As for mortgage backed bond issuance, the second quarter saw the market re-open in Australia with almost A$1.9 billion issued. However, this looks sick against the almost A$24 billion of mortgage backed bonds issued in the second quarter of 2007.

The BIS also noted the change in sentiment that gripped global financial markets from late May onwards and that has continued through to the present time.

Credit markets came under renewed pressure as spreads widened to reflect the implications of on-going cyclical adjustment for loss expectations and deteriorating financial institution balance sheets. This was happening despite (or perhaps exacerbated by) falling oil and commodity prices and action in the US to support its housing market and ailing banks and other financial institutions.

The widening of credit default swap spreads that has been seen shows the market is pricing in lower economic growth and rising inflation, which will lead to lower corporate earnings, a consequent deterioration in credit quality and increased defaults. The BIS takes heart in CDS spreads having not widened to the levels seen in mid March, commenting that concerns over systemic risk have not been revived - but this may be a fine point when asset prices globally are continuing to fall.

Following Merrill Lynch's US$4.4 billion write-off on the sale of CDOs in August and the larger than expected writedowns incurred by Fannie Mae, Freddie Mac and AIG, the BIS says global losses since the start of the credit crunch have now reached US$503 billion. The BIS notes that the market is expecting further writedowns and losses over coming months, which will add to the capital constraints experienced by financial institutions and increase their funding needs. This will inevitably lead to tighter funding conditions, which will drive lower corporate earnings and decreasing credit quality.

This is the BIS interpreting market sentiment at the present time. However, market sentiment is critical and one of the more influential people in global credit markets underlined these views last week.

Bill Gross, who leads the world's largest bond investor, Pimco, said global financial markets are in the process of deleveraging - driving down asset prices.

Asset liquidation when assets are levered inevitably leads to margin calls and debt liquidation when the margin calls cannot be met and the assets are forcibly sold. This drives down asset prices further and leads to more debt liquidation, and so the process goes on, in a downward spiral.

Gross says the only way to stop this downward spiral is to introduce new capital to put a floor under asset prices. Specifically, he is calling on the US government to come to the rescue.

Gross' comments could be viewed as alarmist or simply a case of talking his own book. Regardless of the arguments that could be mounted for and against this proposal, if Bill Gross does drive market sentiment then the worst is yet to come - a financial tsunami, as he puts it.