From Peter Tchir of TF Market Advisors
CDS - Hoarding and Downgrades and Collateral
I mentioned earlier this month that I expected banks to keep their hedges on for the rest of this month so that they could show the minimum amount of exposure possible on their quarter end statements. With the crisis increasing and spreading, this hasn't changed. So there will continue to be no profit taking from banks on their hedges until at least October. If anything, as the crisis is expanding to more financial institutions both in Europe and here, we will likely see banks adding to their hedges.
Yesterday's downgrade of BAC was potentially problematic for credit markets. I am less concerned about the holding company downgrade. Downgrading the bank to A2 from Aa3 could become problematic. That is the entity most derivative counterparties will face. A2 is still fine, but I suspect many counterparties will be having meetings over the next few days to discuss how comfortable they are facing BAC as a derivative counterparty. It might be wrong, and unnecessary, but it is something that will be occurring. BAC should be doing everything in their power to address this potential risk immediately.
The risk of ratings downgrades to a bank is twofold. On a basic level, it may reduce the flows they see as counterparties prefer to trade with higher rated entities for their derivative trades. That is manageable. The bigger, and far more problematic issue, will be if firms cut their lines to that bank. This would cause banks to unwind or assign existing trades, or to buy protection on the downgraded banks to "hedge their hedge". Protection buying would drive their spread higher (if this was all exchange traded, it wouldn't be an issue). Unwinds could force the bank to raise some cash. Most hedge funds will have one way collateral agreements with banks, so that on any positive mark to market, they are posting collateral to the bank, which the bank can typically use "rehypothecate". Hedge funds will unwind or assign profitable trades, which will force the bank to return collateral to the hedge fund. It is a subtle, but painful, way for a bank to experience a run. It happened with Bear and with Lehman.
The downgrades yesterday were not too bad, but, this is worth watching. If it occurs, it will take some time as bank hedging desks in particular tend to be slow to move or change a counterparty risk limits. Hedge funds have more exciting things to do today than worry too much about how much collateral they have posted at any individual bank, but eventually they will discuss it. Banks should prepare for this. Maybe they can convince counterparties to maintain the status quo, but they shouldn't be fooled into believing the problem isn't there, just because it didn't occur instantly.
With emerging markets also joining the sell-off it is hard to find an asset class that looks particularly cheap, but LCDX in particular is looking interesting. HY16 and LCDX16 have both underperformed the market and even the HYG/JNK etf's. HY16 is down over 10% from its peak. Basically inline with the move in stocks. I don't think we have seen another round of capitulation in the cash bond market and are still riding a wave of outflows, but HY16 seems to offer value. HYG needs to sell off 2 to 3% more to be as interesting. LCDX has been beaten down due to concern about LIBOR remaining low for an extended period. Since many of the loans have LIBOR floors, that isn't as horrible as it seems, and if we are about to take another big leg down in risk assets, the senior secured nature is worth something, and trading at a steep discount to "par", there is actually upside. I just don't see any need to rush into credit. Hedges will remain in place until at least October, the impact of bank downgrades hasn't fully made its way through the system, and there is supply, but I would rather own these assets here than stocks for risk/reward.