Watch the corporate bond market

September 15, 2008

There’s a lot taking place today, and at times it is hard to remain updated on all that is occurring. It is better to remain distant and assess the developments once the heat of the situation has passed, but the extraordinary change in sentiment on corporate default risk is so quick and momentous that it merits more than a brief examination.


Lehman’s demise by itself isn’t of great importance. The firm was a significant actor in many fields, but the fall of a single firm in any field is unlikely to trigger and sustain the fears of systemic risk and financial meltdown that the markets are now experiencing. The real cause of this rapid and worrying change of sentiment in the credit markets is the sudden realisation that the government and the financial system at large are out of options. It is the failure of the fallacious notion that the pockets of the government are bottomless, that all kinds of problems can be resolved if the US government decides to print more treasuries and sell them to Asians and others. This was the idea propagated by the likes of Bill Gross, and apparently endorsed at Wall Street; but as I have repeatedly emphasised here, the financial situation of both the public and private sectors is in very questionable health, and there is no ready supply of funds available for patching all the gaps that are appearing in the financial system.


Bear Sterns was transferred to JPMorgan by the Fed. Merrill Lynch and Countrywide have been acquired by Bank of America. The identity of the next firebrigade is unclear; since, in the words of Mr. Gross, the head of Pimco, they are “all underwater. We, as well as our SWF and central bank counterparts, are reluctant to make additional commitments.”


This shouldn’t surprise. The company that Singapore’s Temasek bought doesn’t exist anymore. CIC’s investments in Citigroup, Blackstone, and Morgan Stanley are all under water as of today. But most importantly, with the disappearance of three of the most important US investment banks, the long term prospects of US firms are in doubt, and this makes raising capital and covering losses a matter of great difficulty.


The problems at AIG are not unique: their problem is the same problem at the root of this entire crisis, and it is leverage. The entire country, from citizens, to corporations, to the government are leveraged, and the maintenance and functioning of such a high level of leverage presupposes an environment of financial sensibility and calm. When goodwill disappears, however, what yesterday was perceived as the door to Paradise becomes the gate of Hell, and the subsequent risk aversion has the potential to ruin everything on its path, from huts, to citadels.


It’s quite natural to expect the Fed to cut rates tomorrow, and I claimed that this would be the outcome on my post of September 11th. I wrote that the timing would be determined by markets, and a 500 point fall in the Dow, with three month libor at 3.10, are enough to force them in this direction. But even if they choose not to, it will only be a matter of procrastination; it’s simply inconceivable that the Federal Reserve, or any central bank in its place can raise rates in this environment. Mr. Bernanke is likely to push rates down to zero eventually, but, as he’s an academic, and lacks the necessary strength of will and maybe confidence to steer the entire board to his direction through leadership, we will wait for worse data to confirm his position to see rates reach zero.


At the moment,  the most crucial issue is the behaviour of the corporate bond market. It remains to be seen if today’s freezing will lead to a reliving of the disaster in the securitisation markets. The implications of this outcome are beyond statement; if corporates find capital markets frozen at a time when consumers are cutting back on spending and banks are reducing credit, what will prevent a financial catastrophe?



2 Responses to “Watch the corporate bond market”

  1. We seem to be somewhat on the same page, but you’re more eloquent even than I.

    You touched on CDS. If the corp market stumbles, the CDS market will freeze. Or switch to Armageddon mode? I’m not sure, just feeling out ideas.

    See my blog for a more anecdotal discussion.

    You also mention “financial crisis.” How would you define that?

  2. moneymill said

    I don’t know about armageddon. It’s hard to predict what’s going to happen, as tail event risk is high nowadays. Something unexpected could happen.

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