This CDS report was written by Markit’s Gavan Nolan
A glance at the table below suggests a fairly unexciting week in the credit markets, with spreads relatively flat overall. Nothing could be further from the truth, however, as everything from credit events to rumours of major bank failures caused serious volatility, shown in the chart here.
Spreads tightened significantly on Monday in response to GSEs Fannie Mae and Freddie Mac being taken into “conservatorship”, a form of public ownership. Despite the free market predilections of the investor community, the intervention was welcomed by the markets. The GSEs play such an important role in both the US housing and financial markets that failure was not an option, a fact correctly recognised by investors. Whether, the state should be financing mortgages to the general public in the medium- to long-term, with the accompanying risks to tax payers and the inevitable distortions created by intervention, is more debateable.
At this point, many commentators were forecasting a protracted period of spread tightening, prompted by the lower mortgage rates provided by Fannie and Freddie. However, the rally proved even more evanescent that the one following the Bear Stearns takeover in March. The optimists overlooked the still parlous state of balance sheets throughout the financial sector, a fact brought home by Lehman Brothers this week. The brokerage suffered a torrid time with spreads ballooning to over 800bp yesterday following a negative reaction to its restructuring plan. Lehman, alongside its disappointing third-quarter earnings statement, announced a series of measures aimed at strengthening its credit profile. The centrepiece was the so-called good bank/bad bank structure, where Lehman would spin-off its loss-making commercial mortgage assets into a separate entity, leaving the remainder of the bank with a “clean” balance sheet. A well-trailed plan to sell a majority stake in its profitable investment management division (IMD)was also announced.
But, after an initially positive reaction, investors took a dim view of the strategy, causing spreads to widen considerably. Doubts over Lehman’s ability to raise capital – despite its insistence that it doesn’t need to – inflamed the negative sentiment surrounding the firm. Uncertainty about Lehman’s ability to find a buyer for the IMD stake also contributed. Speculation that the only way out for the firm is an outright sale gathered momentum later in the day, and at the time of writing seems the most likely outcome. The big question is whether the US government will underwrite an acquisition a la Bear Stearns, or if its appetite for intervention has waned under the weight of its recent activities. Spread direction in the global credit markets could depend on the answer.
The conservatorship of Fannie Mae and Freddie Mac constitutes a credit event under ISDA documentation. This seems strange as no bonds have actually defaulted. Indeed, most of the debt is now trading above par because of the government guarantee.
But the ISDA language is clear: if an entity “becomes subject to the appointment of an administrator” – in this case the government – then the bankruptcy credit event is triggered.
The default is the first in an on-the-run Markit CDX IG index, and it is also the largest in the history of the CDS market. Fannie and Freddie have thousands of bonds outstanding, and defining the deliverable obligations and recovery rate will prove more challenging than in the past. That said the settlement protocols and auctions conducted in the past have proved up to the test, and there is every reason to believe they will be just as successful this time.
(For updates on this process, visit Markit’s index news page)
