The RGE Monitor regularly covers a variety of issues in credit markets and credit derivatives. Here is below the bi-weekly RGE Monitor note that was sent today to our subscribers where we discuss the latest developments and stresses in credit markets. If you like to receive such a bi-weekly note please send a message with your name, affiliation and contact info to info@rgemonitor.com 

Signs of Stress in the Credit Markets 

Good Morning! 

Today we look at how rising defaults by U.S. subprime mortgage borrowers are casting their shadow across credit markets.
 

The most immediate impact of rising subprime default rates, of course, occurs in the market for residential mortgage backed securities (RMBS).  RMBS represent claims on principal and interest payments from various mortgages in a homogenous pool.  Rising defaults shrink the pool of assets backing a RMBS, reducing the valuation of all its tranches either through direct first-loss exposures or through deteriorating collateral/credit enhancement for the higher rated RMBS tranches. Were the rating agencies slow to recognize this link or did a lack of data prevent an informed judgment? See Prospective Downgrades of Subprime (sp)RMBS by S&P Rattles Markets: Surprise, Surprise.
 

The same basic reasoning applies to Collateralized Debt Obligations (CDOs), many of which include a number of subprime RMBS in their collateral pool. This risk concentration enhances returns in good times but also losses when the underlying cash flow begins to dry up simultaneously in different spots within the collateral pool. Read more in What Makes Subprime CDOs So Dangerous?
 

There is now evidence that concerns about rising defaults among the commercial real estate mortgages are now affecting the value of commercial mortgage backed securities (CMBSs) and the spreads for protection against default on such securities (the CMBX indices). See Commercial Mortgage Backed Securities (CMBS) and Indexes: Signs of Strain?
 

The first clear signs of contagion to the broader credit market emerged last week in the Bear Stearns hedge fund aftermath. The perceived risk of holding corporate bonds in Europe and the U.S. (as measured by the iTraxx and CDX indices) rose sharply amid fears of forced fire sales by leveraged players with subprime exposure facing margin calls. See: ABX Derivatives Indices Sell Off Across the Board: Contagion To AAA Indexes and the Corporate Bond Markets Underway.
 

Corporate bond market jitters, in turn, also put pressure on the U.S. dollar as private demand for corporate debt combined with central bank demand for agency bonds financed the bulk of the US current account deficit in the first half of the year. See U.S. Subprime (sp) Issues: Local and Contained or Spanning the Globe?
 

Last, but perhaps most worrying, are the potential parallels between the mortgage market and the leveraged loan markets. These include borrowers’ high leverage ratios, declining credit standards (“cov-lite” loans instead of subprime), insufficient monitoring by lenders due to the “originate and distribute” model (loans repackaged into CLOs instead of CDOs), banks’ retained exposure (bridge loans as opposed to CDO equity tranche).
 

It hardly needs to be mentioned that CLO demand for corporate debt helped fuel the private equity sponsored LBO wave over the past few years, and thus contributed to the recent bull market in equities.  A couple of banks are now reportedly holding some LBO-related corporate debt that they cannot sell.  See: Banks' Involvement in LBO Financing: A Bridge Too Far? and Are We Witnessing the Top of the Leveraged Buyout (LBO) Cycle?
 

For more on this increasingly complex alphabet soup of credit derivatives see the extensive RGE coverage of Derivatives and Structured Finance and Corporate Bonds and Leveraged Loans