Credit market participants took a shellshocked pause on Monday, with the spectre of more structured product unwinds hanging heavily over the market.
Trade was thin in Europe, but spreads did not recede far from the record wides reached on Friday, when again the talk was that structured products – synthetic CDOs or CPDOs – were being liquidated.
“If these things do get unwound en masse, the effect on the market will be horrible,” said credit strategist Barnaby Martin at Merrill Lynch. “Between 1 and 2 trillion dollars of synthetic CDOs have been issued over the last four years. Any unwinding will likely be crammed into a much shorter time period.”
A fire-sale is every market participant’s worst nightmare, but even the more orderly process of deleveraging will put pressure on spreads.
On Friday afternoon, Moody’s downgraded 16 CPDOs – all linked to corporate names. They are hovering near levels at which their arranging banks will be forced to delever, by buying up swathes of CDS protection.
The iTraxx Crossover index of mostly junk-rated corporate debt edged 3.5 basis points tighter to 562bp. This means in costs €562,000 annually to protect €10 million worth of Crossover debt against default over five years. The iTraxx Europe index of investment-grade credits was 1.5bp tighter at 107.8bp.
Credit markets were also depressed by reports that FGIC, the fragile monoline, might be divided into a good municipal part and a bad structured finance part.
“If this scenario were to be applied for MBIA and Ambac (this should be decided by the end of February), it would significantly expose the banks to further write-downs on structured finance securities wrapped by the bond insurers,” said analysts at BNP Paribas in a note.