Credit contagion

Editor's letter

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Subprime mortgage woes in the US have sparked a contagion effect that has caught out institutions from banks in Germany to hedge funds in Australia. The sharp widening of spreads in the credit markets has left many positions looking distinctly unhealthy. And forced sellers - even of fundamentally sound credits - are feeling real pain. Indeed, many hedge funds are fighting for their very survival.

Despite expectations that credit spreads would inevitably widen - something Asia Risk has written about on many occasions - it's still unclear exactly who is exposed in the region. And this has led to many market participants de-leveraging. That may be prudent on a firm-wide level, but it also exacerbates the situation.

There are two divergent views emerging about the depth of the credit problems in Asia. One contends that Asian investors have bought billions of dollars of collateralised debt obligations (CDOs), some linked directly to subprime, while others are based on poorly constructed pools of underlyings with a lot of leverage. What's more, several financial institutions are also guarantors to asset-backed commercial paper conduits that are struggling to meet funding commitments.

The doomsayers are waiting for the first Asian financial institution to admit it has issues on a similar scale to those of IKW or Sachsen LB in Germany, both of which needed bailing out after they seemingly disregarded basic rules about liquidity risk. Taiwanese institutions are cited - presumably due to the hangover in the country after its bond fund crisis - as are Australian banks.

So far, only DBS has real egg on its face. Singapore's largest bank appeared to forget about S$1 billion ($656 million) of its CDO exposures it held via a special investment vehicle. Hedge funds hadn't, however, which might be why DBS subordinated debt credit default swap spreads have widened from 8 basis points at the end of last year to 64bp in late August.

The other view is that the current market represents a technical rather than fundamental dislocation. Optimists argue that subprime is contained, and that while CDOs of asset-backed securities are being quoted on an interest-only basis, corporate CDO default rates are not that high. Indeed, some say the widening of spreads at the high end of the capital structure relative to junior tranches means investors could move up the capital structure in a cheap manner. More generally, simpler managed structures with shorter maturities look like good value.

But it will take brave chief investment officers to try to convince their boards that collateralised credit is their investment of choice.

Christopher Jeffery.

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