How big a deal was the decision by Treasury Secretary Henry Paulson to let Lehman Brothers fail?
Turns out, it was huge. And the aftermath could send corporations scrambling for an ever-shrinking pool of credit, exacerbating the recession.
Investors are just now taking a 90 percent haircut on $1.2 trillion in rotten securities known as collateralized debt obligations (CDOs). Lehman’s collapse is a big part of the reason why, and the general failure of Iceland’s banking system.
The new losses could swamp the holders of those securities, including banks, insurance companies, and money managers, reports Bloomberg News, on top of the $660 billion banks had already written off.
It will be a serious test of the ability of the world’s central banks to backstop the coming losses. They’ve already committed to pump in $3 trillion.
Some of the so-called “synthetic” CDOs, those tied to credit-default swaps on corporate bonds, trade at less than 10 cents on the dollar, Sivan Mahadevan, a derivatives strategist at Morgan Stanley, told Bloomberg.
“Synthetic” because these instruments pool derivatives based on bonds and loans and guarantee them. If the borrower defaults, the contract holder pays the lender and takes the collateral.
The big risk is the sliding value of that collateral. Hard to price, it's going for pennies on the dollar at best.
The previous wave of bad CDO-based assets was tied to collapsing home values; these new CDOs were built on the back of corporate credit, now in question thanks to impending global recession.
Although interbank lending rates – a key measure of credit flows – are relaxing as governments step in, things don’t look great for companies trying to issue new debt.
Corporate bonds are being issued at the weakest pace in a decade, John Atkins, a fixed-income analyst at IDEAGlobal.com, told The Associated Press.
A cycle sets in: Companies can't get money from the markets, so they hit credit facilities at their banks. That cuts credit supply and forces lending rates higher.
As the economy weakens, "the companies that are going to need funding the most desperately are the ones further down the credit quality ladder," Atkins said.
Standard & Poor’s now says it expects defaults on speculative bonds to rise significantly in the next 12 months to a six-year high of 7.6 percent.
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