Credit Markets May Weaken as Lehman Collapse Spurs Risk Flight

By Shannon D. Harrington

Sept. 15 (Bloomberg) -- Credit markets are poised to weaken on concern the collapse of Lehman Brothers Holdings Inc. will trigger losses across derivatives markets.

A benchmark gauge of corporate credit risk in North America traded at a record during an emergency session yesterday as investment banks sought to minimize losses from Lehman's bankruptcy. U.S. Treasuries rose the most since January as investors sought the relative safety of government debt.

Lehman today said it intends to file for bankruptcy after Barclays Plc and Bank of America Corp. abandoned talks to buy the crippled company. The fourth-largest securities firm until the past week, Lehman has thousands of trades in the $454 trillion market for over-the-counter derivatives. Its announcement came as Bank of America said it agreed to buy Merrill Lynch & Co. amid concern over the health of U.S. financial companies.

``The immediate problem is the derivative default swaps market, in which a plethora of institutional accounts and dealer accounts are at risk,'' Bill Gross, manager of the world's largest bond fund at Pacific Investment Management Co., said in an interview with Bloomberg Radio yesterday. ``It induces a tremendous amount of volatility and uncertainty in terms of Monday morning trading.''

The Markit CDX North America Investment Grade Index, linked to the bonds of 125 companies in the U.S. and Canada, was trading at 200 basis points, according to Phoenix Partners Group in New York. It closed at 152.5 basis points Sept. 12, according to CMA Datavision in London. The index, which rises as investor confidence falls, reached 197.5 basis points in March.

Leveraged Loans

A gauge of risk in the U.S. leveraged-loan market that falls as credit risk increases was being quoted 1.25 percentage points lower, contingent on a Lehman bankruptcy, according to Goldman Sachs Group Inc. The Markit LCDX index was being quoted at a mid-price of 95.75. The index is tied to high-yield, high- risk loans.

Corporate bond yields may increase by as much as 40 basis points more than Treasuries, said Gross, who is also co-chief investment officer at Newport Beach, California-based Pimco. Investment-grade bonds traded at 344 basis points more than U.S. Treasuries on Sept. 12, according to Merrill Lynch's U.S. Corporate Master index, after climbing 22 basis points. A basis point is 0.01 percentage point.

Lack of Regulation

New York-based Lehman has been among the top 10 counterparties in the $62 trillion market for credit-default swaps, according to a report last year from Fitch Ratings.

Credit-default swaps alone have grown 100-fold in the past seven years, and the emergency trading session held yesterday highlights the market's lack of regulation and absence of a central clearinghouse designed to help absorb losses from a bank collapse.

Barclays Capital analysts in February estimated that if a financial institution that had $2 trillion in credit-default swap trades outstanding were to fail, it might trigger between $36 billion and $47 billion in losses for those that traded with the firm. That doesn't include ``large, potentially concentrated'' market value losses others would face, the analysts, led by Arup Ghosh in London, wrote on Feb. 20.

Derivatives markets may lose several hundred million dollars on trades if a major dealer were to default, and would have trouble replacing those trades, causing risk premiums to widen, Moody's Investors Service said in May.

Derivatives such as credit-default swaps are traded in bilateral agreements between banks, hedge funds, insurance companies and other institutional investors, and the collapse of a market-maker has the potential to wipe out profits made on those contracts that aren't backed by collateral.

A Lehman bankruptcy ``obviously puts a lot more risk in the market, so it's definitely going to be wider,'' said Brian Yelvington, a strategist at CreditSights Inc. in New York.

Fed Widens Acceptance

In an effort to mitigate market risks, the Federal Reserve yesterday widened the collateral it accepts for loans to Wall Street bond dealers.

The Fed will accept equities in the Primary Dealer Credit Facility, its program for lending cash directly to securities firms, in addition to investment-grade debt. Collateral for the Term Securities Lending Facility, which auctions loans of Treasuries, will now include all investment-grade debt securities. The size of the TSLF will also increase to $200 billion from $175 billion, the Fed said.

Merrill Lynch, JPMorgan Chase & Co., Bank of America and seven other firms said in a joint statement yesterday that they will provide a total of $70 billion to a borrowing facility aimed at providing liquidity to financial institutions.

`Ample Warning'

The cost of protecting Australian and Asian corporate bonds from default jumped. The Markit iTraxx Australia index rose 26 basis points to 180 as of 11:04 a.m. in Sydney, Citigroup Inc. prices show. The Markit iTraxx Asia index of 50 investment-grade borrowers outside Japan, including the Thai government and Hong Kong's Hutchison Whampoa Ltd., advanced 20 basis points to trade at 185, according to JPMorgan data.

The yield on two-year notes dropped 33 basis points, or 0.33 percentage point, to 1.88 percent as of 12:55 p.m. in Singapore, according to bond broker BGCantor Market Data. The price of the 2.375 percent security due in August 2010 rose 20/32, or $6.25 per $1,000 face amount, to 100 30/32.

Investors may have had enough warning to limit their losses, said Tony Crescenzi, chief bond strategist at Miller Tabak & Co. in New York.

``Market participants have had ample warning on Lehman and have likely already taken the precautions they felt were necessary to guard against risks Lehman's potential failure might pose,'' Crescenzi said in a note to clients yesterday.

Emergency Session

Derivatives are financial instruments linked to stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or weather.

Banks and brokers yesterday opened trading desks to enter into derivatives transactions that would offset trades with Lehman in case the firm filed for bankruptcy before midnight. The International Swaps and Derivatives Association said the ``netting trading session'' began at 2 p.m. and continued until at least 6 p.m. New York time. The trades would have been canceled had Lehman not filed for bankruptcy.

``Some people say that `yes, when you net up all the Lehman trades it will be less than the gross amount', but we have no idea because we've never attempted anything like this before,'' said Jim Bianco, president of Bianco Research LLC in Chicago. Dealers also face losses from the government takeover of Fannie Mae and Freddie Mac on Sept. 7, which caused a technical default on the contracts.

``We've fallen so far off the edge of the earth right now that we can't even begin to describe what we are seeing,'' Bianco said. ``Nobody begins to know what will happen because we've never come to anything remotely close to this before.''

Behind Schedule

Banks are behind schedule on plans for a clearinghouse that would absorb the failure of a market-maker such as Lehman. The Clearing Corp., the Chicago clearinghouse, isn't set to be completed until at least the end of this year, or early 2009, because it was told by regulators it needed a banking license, according to a person familiar with the process who asked not to be named because the discussions are private. The clearinghouse previously said it would guarantee trades in the third quarter.

The Federal Reserve Bank of New York has pushed Clearing Corp. to obtain the banking license as the regulator oversees a transition to a central processing system for CDS trades. The license would place the company's CDS clearing operation under the Fed's watch, according to the person.

``What we've seen this year is regardless of the fundamentals, regardless of efforts made by the Fed and the Treasury to restore confidence, you can't order that up,'' said Martin Fridson, chief executive officer of Fridson Investment Advisors, said in New York.

To contact the reporter on this story: Shannon Harrington in New York at Sharrington6@bloomberg.net