Credit Markets Reign Supreme Once Again

A: Ugh, it sure is ugly out there in the credit markets, which is putting pressure on the equity markets. While the fear level seems to be contained, even as stocks fall 15% in 4 weeks, I get the feeling that investors feel the fed will always be there to bail us out; or bail the failing company out. When I look at the credit markets, I see CDX spreads widening, ABX's down big time, credit default swap spreads on MER/LEH/MS trading at highest since March, and the new fear around the GSE's (Fannie & Freddie) need for capital due to a coming accounting change. It all adds to uncertainty around the financials, the write-downs, the need for money, the economy, oh and oil is still around $140/barrel even after a brief selloff.

The fed has all but runout of bullets, after using 325 basis points of umph juice to stimulate the financial sector and the economy. They can't cut rates anymore because of the effect it will have on pushing commodities higher and the dollar lower. Instead, they just announced an extension of the PDCF lending program into 2009; the Primary Dealer Credit Facility included investment banks as an emergency measure to ease the credit crisis. The extension of this program is an admission by our fed that the credit markets are not fixed, and will need this support as we enter next year!

According to Bloomberg:

Bernanke, who prompted expectations for a rate increase when he said last month the Fed would "strongly resist" a rise in inflation expectations, said today officials may extend the securities dealers' access to loans into 2009 as long as emergency conditions "continue to prevail."

The Fed started the PDCF in March, invoking its powers under "unusual and exigent circumstances'' to forestall a collapse in confidence after the near-bankruptcy of Bear Stearns Cos.

Moving on to what is going on in the credit markets, take a look at CDX spreads and how they widened in the past few weeks! The below chart is via Markit and shows the CDX.NA.IG Series 10 Spread:

As corporate spreads widen, investors see increasing risk between corporate debt and the safety of treasuries; hence the widening! The rate investors demand for corporate debt rise, as the yield for treasuries fall, widening the gap between the two! It's a sign that distress is back in creditville. As Bloomberg states:

Credit-default swaps on Lehman Brothers Holdings Inc., Merrill Lynch & Co. and Morgan Stanley debt are trading close to their highest since March. The contracts let investors bet on the risk that a company will default on its bonds.

Another gauge of financial stress watched by the Fed has also remained elevated. The difference between the overnight indexed swap rate, a measure of what traders expect for the Fed's benchmark rate, and three-month interbank loans in dollars was 0.78 percentage point yesterday, about the same as the start of May.

The notional value of the CDS market is a bit scary, at around $65 Trillion or so. For more on Credit Default Swaps, visit Accrued Interest who frequently discusses the topic:

Credit-default swaps (CDS) pose the greatest systemic risk to the worldwide financial system. Housing and oil may be what's pushing the U.S. into a recession currently, but the economy has a way of dealing with these kinds of shocks. Were the CDS market to suddenly collapse, it would truly threaten the very existence of the financial system.

A CDS is very much like a put on a particular credit. If a company defaults on its debt obligations, owners of CDS protection can, in effect, sell one of the defaulting company's bonds to the seller of protection at full face value. This is similar to an equity put, which gives the owner of the put the right to sell the stock to the seller of the put. Both a long CDS position and a long put position express a bearish view on the underlying security. Both can be used to hedge long exposure to the underlying.

This is not the only indicator of distress in the credit markets, here are the others:

a) TED Spread still around 1
b) ABX's continue to freefall
c) Corporate Spreads widening
d) 3-MTH LIBOR is about 79 basis points above Fed Funds Rate; 1-MTH LIBOR about 46 bps higher

If you are trading equities, it would be wise to keep an eye on the credit markets for buy/sell signals of your positions. I know most of you do not trade, but for any traders that read this site, the credit markets continue to lead the equity markets! I do not see this trend changing anytime soon. At this point, with treasury yields falling and commodities possibly correcting, perhaps there will be some money available to be put to work in equities around these levels; giving us a bounce. After a 15% straight selloff, a painful one for many, I wouldn't be surprised to see a bounce assuming an event doesn't occur; say for example, LEH being taken under at $15/share because of insolvency.

As for us real estate junkies, all of this means that the fall in 10-YR bond yields (some 36 basis points) recently probably will NOT result in a comparable fall in lending rates, as risk continues to be re-priced in the mortgage markets. As long as the credit markets are fragile like this, lending rates will behave independant of the bond market; as it did from AUG 2007 to March 2008 when the fed cut rates so aggressively yet lending rates stayed put. Read my post back in NOV 2007, "Bond Yields & Mortgage Rates No Longer Related" if you want more details on this side effect of the credit crisis.

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