A hint of panic


Speak to a credit trader these days - no easy task in the current environment - and you might pick up on a certain edginess, perhaps even a barely concealed hint of panic in their voice. Little wonder. It's been a hugely volatile and, in some cases, painful couple of months for dealers and hedge funds.

We've seen mass downgrades of US residential mortgage-backed securities (RMBS) and collateralised debt obligations of asset-backed securities (CDOs of ABSs), a drying up of liquidity, and uncertainty over the valuation of CDO tranches. There's also been a knock-on effect in other markets. Short-term money-market rates have soared as asset-backed commercial paper (ABCP) investors - concerned about potential exposures to the subprime and CDO markets by banks, ABCP conduits and structured investment vehicles (SIVs) - have pulled out of the market, leaving these entities unable to roll over short-term funding. Equity and currency markets have also experienced a sharp spike in volatility, as hedge funds, hit with margin calls on their credit exposures, have unwound positions in other, more liquid markets.

It's easy to get carried away and predict apocalyptic scenarios. Experience shows, however, that the markets will recover, memories are short, and soon the media will be lauding those institutions that took advantage of the lack of confidence to buy structured credit at fire-sale prices.

Nonetheless, things could get worse. So far, there has been relatively little selling of CDOs by investors. It's easy to see why. Liquidity is virtually non-existent, and with huge uncertainty over the accuracy of valuations, combined with massive negative sentiment, prices have been driven to rock-bottom. Investors point out, rightly, that the fair value of these securities is often much higher than the prices quoted in the market - after all, there have been relatively few defaults and, even given worst-case expected loss predictions, investors in AAA-rated tranches are likely to be safe.

However, we could be about to experience a wave of forced selling. As more AAA-rated tranches get downgraded, a whole class of institutional investors could be forced by their internal mandates to sell. At the same time, a number of SIVs and SIV-lites, unable to raise short-term funding in the ABCP market, are close to hitting their net asset value and liquidity tests - once they have, they may be forced to unwind and sell their CDO and RMBS assets. Indeed, some SIV-lites, such as Mainsail II, managed by Solent Capital, have already begun to wind down.

Given the complete lack of liquidity, investors will have to sell their assets at a discount and realise huge losses. That's not only bad news for SIVs. The volume of assets being sold will push prices down further, and with these new deals being executed, many dealers will have to re-mark their books to market rather than rely on models - in turn, causing increased mark-to-market losses. Given the current uncertainty and 'what-ifs', it's little wonder dealers have that edge of panic to their voices.

Nick Sawyer, Editor.

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