This CDS report was written by Markit’s Gavan Nolan
In the UK, Gordon Brown has been accused by his critics of “initiativitis” – a tendency to announce swathes of new initiatives with little inherent substance. Unfair perhaps, but the financial markets in particular have been yearning for concrete action from their leaders.
The US government and its agencies have also been busy trying to make themselves felt. Last week, the Federal Reserve surprised investors by announcing an aggressive new policy of quantitative easing – buying back government and agency debt from banks through expanding the central bank balance sheet. After a positive response initially from the markets, the subsequent rally was muted by concerns that the money supply expansion could trigger inflation further down the line.
But the US Treasury followed up on Monday to ensure the rally was sustained. Tim Geithner, the US Treasury Secretary, unveiled a plan to tackle the issue of distressed assets, or “legacy assets” as they are now euphemistically known. The Public Private Investment Programme (PPIP) will use funds from TARP and augment it several times over with loans from the Fed and FDIC. Private investors will only have to put up a fraction of the capital to buy the assets, thereby protecting them from potential losses. Most of the risk, of course, is taken by the tax payer. This approach was taken to encourage private investors to participate and establish an effective price discovery mechanism.
However, on both of these issues the jury is still out. The uncertainty on whether a price can be reached that will satisfy both parties has risen after the initial euphoria. The “lemon” problem – informational asymmetries – is still present. Banks know their own balance sheets better than investors and could try and offload the poorest-quality assets first. This could deter investors from buying securities.
Nonetheless, the Markit CDX IG index continued to rally, though it has given back some gains today. But the rally was modest compared to equities, even more so if one looks at single names. The basis between the index and its theoretical level stands at 40bp. Even if technical factors surrounding the roll have played their part, the focus on idiosyncratic risk has kept a lid on the single name rally.
Banks, which should benefit from PIPP, have been among the worst performers this week. Another Geithner intervention – this time a testimony to Congress on regulation – crated negative sentiment around the sector. Moody’s downgrades on Wells Fargo and Bank of America only served as a reminder that banks need more capital, public or private. PPIP has its fair share of supporters, though another dire jobs report on Friday and poor corporate earnings could shatter the fragile optimism.
