Uncertainty boosts government debt

With banks wary of lending to each other in the wake of market turmoil, corporate bond issuance has fallen to almost zero while government bonds benefit from market uncertainty.

Over the past three months, the unravelling of the market for subprime mortgages and the fallout that threatens to permeate its way through the global financial system have dominated the bonds market. Asset-backed securities have grown rapidly in recent years. Demand for such structured products has been high, although many investors buying them may not have fully understood the risks involved.

Since 2001, global interest rates have stayed low. Back then, the world’s central banks reduced policy rates. While there was no co-ordinated effort, each had the same overriding aim – to avert a confidence crisis in the wake of the attack on the World Trade Center. The danger was that the American consumer would retrench in the face of the threat of terrorism, causing global trade to suffer.

In subsequent years, inflation has stayed resolutely low, mainly owing to China’s burgeoning economy. Companies across the globe have been shifting production to this cheaper country: China has been effectively “exporting deflation”. Some sectors, such as clothing, cars and consumer electronics, have actually seen prices fall.

Low inflation has allowed central banks to keep interest rates unprecedentedly low. As a result, liquidity has exploded in recent years. Asset prices have rocketed – for example, the British housing market has doubled in just five years. With a scarcity of traditional assets, new financial markets have been created to soak up the excess liquidity.

Structured credit was born: new forms of bonds were created, backed by items not previously considered as assets – for example, credit card receivables and mobile phone revenues. Anything that has a predictable future income stream can be securitised and sold as a bond including, of course, mortgages. Banks started to bundle up mortgages into tranches and sell them – releasing capital to create more mortgages. Yet demand outstripped supply, and the prices of structured products were driven up to levels that failed to reflect the risk in them – a dislocation between risk and reward.

The root of the problems has been the market for subprime mortgages in America. These are taken up by poor credit risks in return for paying higher levels of interest. American financial institutions have packaged these into structured products, selling tranches of bonds. Buying such a bond entitles the holder to the monthly mortgage repayments, and the security is the value of the house. In good times, this works well; however, the American housing market is down as much as 30% in the past two years (depending on area), so the asset is now worth just 70% of what they owe.

Not only is the quality of the subprime assets backing these bonds lower than it was, but also the structures of the collateralised debt obligations are opaque. There is no register of structured bonds – as there is with government bonds. No one is sure to what extent they – or anyone else – is exposed to subprime.

The banks have taken fright. The structure of the world’s banking system relies on the banks balancing their books each night; they rely on a system of lending to each other – in Britain, at Libor (the London Interbank Offered Rate). However, banks became reluctant to lend to each other, as each eyed their rivals warily, unsure of the extent of their exposure to subprime – so the Bank of England had to step in as lender of last resort, offering liquidity at base rate plus 1%.

The same scenario was replicated elsewhere. The European Central Bank offered to lend licence-holding banks the necessary liquidity at the repo rate. Take-up was €93 billion (£63 billion) – not surprising, given it was effectively “free” money. The Federal Reserve, meanwhile, offered something of a middle ground – liquidity at the Fed funds rate plus 100 basis points – a fairly penal level, which might explain the absence of take-up at first. It then cut the cost of its facility to Fed Funds plus 50 basis points. Behind the scenes, the Fed has encouraged higher-quality licence holders to come to the window to deflect the stigma of being the first to borrow, and thus reveal themselves as in trouble.

What are the implications? Liquidity is reducing. Risk appetite is also reducing, and yields on risk assets are rising to more normal levels, so corporate borrowers will have to pay more to raise funds. While this may be good for the banking sector and the long-term stability of the economy, it remains to be seen whether the central banks can manage the reduction of liquidity without a significant effect on the real economy.

The Fed has estimated the total losses from the subprime mortgage situation could be higher than $50 billion (£25 billion). Yet, so far, the announced losses of banking institutions come nowhere close to this figure. No one knows how large the black hole is – and who will bear the brunt.

The outlook for corporate bonds has changed. Performance was poor in August, and uncertainty continues to hang over the market like a cloud. Yield spreads have widened substantially. No investment bank is willing to take any paper on its books, and there is little appetite for credit from investors.

Liquidity has all but dried up; a few weeks ago, the average bid/offer spread on British corporate bonds was around five basis points; now it is nearer 20 basis points. Issuance has fallen practically to zero in Britain and Europe. While there has been some in America, this has been specific to one or two players. Investment banks are expected to deliver poor results. Credit spreads should not go any wider; but if new issuance does pick up, we are likely to see some spread widening.

Government bonds have been fairly strong, benefiting from the flight to quality that such conditions of uncertainty provoke. If the central banks manage down the liquidity well – slowly and gradually – yields can stay broadly where they are at present. However, if the process is not managed well – if we see many subprime tranches in default, with the result that some hedge funds and investment banks default – central banks will have to respond by cutting rates.