The cost of protecting corporate bonds from default soared to a record as investors purchased credit-default swaps to hedge against mounting losses in the $2 trillion market for collateralized debt obligations.
``The market is full of rumors of unwinding of CDOs, and the price action suggests that people believe the rumors,'' said Peter Duenas-Brckovitch, head of European credit trading at Lehman Brothers Holdings Inc. in London. ``It sort of has that Armageddon feel, and the market is feeding on itself.''
Constant proportion debt obligations, which package indexes of credit-default swaps, may have to unwind about $44 billion of assets, UniCredit SpA analyst Tim Brunne in Munich said today. Some so-called synthetic CDOs that sold credit-default swaps on an estimated $1 trillion in debt also are at risk as investors grow concerned about plunging market values, Morgan Stanley analysts led by Sivan Mahadevan wrote in a Feb. 15 note.
``The mark-to-markets on these have got to be pretty nasty,'' said Byron Douglass, an analyst at Credit Derivatives Research LLC in Walnut Creek, California. ``I would imagine that as spreads go wider, more and more CDOs are probably being unwound.''
Much of the surge in credit-default swaps also may be linked to the dealers that structured such investments, who are increasing hedges against potential losses, said Ashish Shah, head of credit strategy at Lehman Brothers in New York.
Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent if a borrower fails to adhere to its debt agreements. A rise indicates deterioration in the perception of credit quality; a decline, the opposite.
CDX Index
Credit-default swaps on the Markit CDX North America Investment-Grade Index of 125 companies with investment-grade ratings rose as much as 13 basis points to a record 167 before closing at 156 in New York, according to Deutsche Bank AG.
The CDX index has more than doubled this year as bank losses and writedowns on debt investments soared above $145 billion worldwide. The losses have prompted banks to tighten lending standards as economists predict the U.S. economy may be teetering into a recession. In Europe, the equivalent iTraxx index tied to 125 companies rose 15 basis points to 133 today, according to JPMorgan Chase & Co., the biggest one-day move since the index started in 2004. The index, which traded as high as 135, was at 51 basis points on Jan. 2.
CPDO Ratings
The ratings of 28 CPDOs arranged by banks including ABN Amro Holding NV and Lehman Brothers were cut by Standard & Poor's today because they may not be able to cover future interest payments.
``We expect further downgrades from rating agencies, which could lead investors to accelerate closing CPDO positions,'' JPMorgan analysts led byJonny Goulden said in a note to investors today.
CDOs package assets such as mortgage bonds and buyout loans and use the income from that debt to pay investors in the new securities. CDOs made up of credit-default swaps are known as synthetic and drop in value as the cost of credit-default swaps rises. CPDOs are based on the CDX and iTraxx indexes. Some were created with credit-default swaps linked to banks, securities firms, insurers and other financial institutions.
Bear Stearns, Lehman
Contracts on Bear Stearns Cos., the New York-based securities firm that posted its first-ever loss last quarter on mortgage-asset writedowns, climbed 10 basis points to a record 290 basis points, according to broker Phoenix Partners Group in New York.
Contracts on Lehman Brothers, the fourth-largest U.S. securities firm by market value, rose as much as 10 basis points to a record 210 before falling back to 203 in later trading, Phoenix prices show.
A basis point on a credit-default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.
Credit-default swaps on Credit Suisse Group jumped 12 basis points to 125. The bank yesterday suspended its London-based global chief of synthetic CDOs, Kareem Serageldin, after writing down $2.85 billion on debt investments, the Times reported today.
Contracts on U.K. mortgage lender Alliance & Leicester Plc jumped 40 basis points to 245 after the bank slashed its profit target for this year and next, citing rising borrowing costs and declining valuations on asset-backed securities because of the U.S. subprime mortgage slump.
Standard Chartered
The Markit iTraxx Crossover Index of 50 companies with mostly high-risk, high-yield credit ratings jumped 22 basis points to 607, after earlier trading at a record 614, according to JPMorgan prices. Contracts on the benchmark Markit iTraxx Asia Ex-Japan index rose by 24 basis points to 295, according to ICAP Plc.
In the U.S., the CDX index rebounded somewhat in later trading as stocks rose, partly on better-than-estimated profit at Hewlett-Packard Co., the largest personal-computer maker.
``You get to a point where finally shorts are willing to cover, and you snap back in,'' Lehman's Shah said in an interview. ``And the snap back is just as vicious as the move wider.''
Contracts on Standard Chartered Plc rose 3 basis points to 112 after the London-based bank abandoned a plan to refinance its $7.15 billion Whistlejacket Capital Ltd. structured investment vehicle, the largest SIV run by a bank to collapse.
KKR Financial Holdings LLC, the $18 billion publicly traded credit fund run by Kohlberg Kravis Roberts & Co., delayed repaying some of its asset-backed commercial paper and started restructuring talks with its creditors, according to a regulatory filing yesterday.
``What seems to be clear in both Europe and the U.S. is that the continued unwind of leverage and structured products has continued to lead to underperformance in investment grade,'' Nick Burns, a London-based credit strategist at Deutsche Bank, wrote in a note today.
To contact the reporters on this story: Abigail Moses in LondonAmoses5@bloomberg.net; Shannon D. Harrington in New York atsharrington6@bloomberg.net;
