Rattled by subprime

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It's a little early to utter the words 'market meltdown', but traders have certainly been rattled by the sharp spread-widening in the credit markets in February. What started as anxiety about rising delinquencies in the US subprime mortgage sector has swept through the credit markets in Europe and the US, causing some of the biggest moves since the correlation crisis of May/June 2005.

There has been a steady deterioration in the US subprime sector for months. Delinquencies have been on the rise, while around 20 subprime mortgage lenders have either been sold or closed their doors in the past six months. The ABX.HE. 07-1 BBB- index, which comprises credit default swaps referencing 20 US subprime home equity securities rated BBB-, has widened dramatically over the past month, reaching a spread of around 1,700 basis points as of the end of February.

This has had a knock-on effect elsewhere in the markets. Dealers report that the last two days of February were among the busiest since the correlation crisis in 2005. Spreads widened across the board, and particularly in the Dow Jones CDX and iTraxx Crossover indexes, while notional volumes traded on indexes soared. With market sentiment turning distinctly bearish, some participants have expressed fears that the long-awaited correction in the credit markets might have begun in earnest.

But are these fears overplayed? There was a record issuance of subprime loans in the US last year, and concerns about lax underwriting standards, particularly on adjustable-rate mortgages that offer low initial teaser rates, do appear to be justified. However, the $492 billion of subprime loans originated in 2006 is still small potatoes when taken in the context of the overall mortgage market. Indeed, for most of the month, the sell-off was focused in the lowest-rated subprime home equity securities - the ABX.HE. 07-1 AAA index has remained relatively robust.

As Risk was heading to the printers, the credit market seemed to be settling down. Some participants say the spread widening was a blip caused by investor jitters and profit taking of long positions. Nonetheless, most traders remain convinced that a fundamental repricing of credit is on the cards. The question is: when?

- Nick Sawyer, Editor.

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