Hedge funds spark fixed income stress

Date: Friday, March 7, 2008
Author: Michael Mackenzie, FT.com

Fears over the health of the financial system intensified yesterday as forced selling and margin calls at hedge funds sparked acute stress in many areas of the fixed income markets.

Equity investors also reacted to the strains, with the bear market in US bank stocks entering new territory. The S&P 500 financial index fell to its lowest level since May 2003 after sliding more than 30 per cent from last year's peak.

In the fixed income sphere, stress is most acute in the mortgage, corporate, municipal bond and interest rate swap areas. Credit default swap spreads for banks, including Citigroup, JP Morgan, Bank of America and Wachovia reached record wide levels. Meanwhile, broad measures of investment grade default risk hit record wides in the US, Europe and Japan.

Tom di Galoma, head of Treasury trading at Jefferies & Co, said: "There is an extreme lack of liquidity and markets are being moved by liquidation fears and margin calls. Funds are being tapped on the shoulder and it seems there is no margin for slippage when it comes to a margin call from the banks."

In a sign that risk managers at banks are calling the shots, Lehman Brothers announced it had suspended two equity traders after discovering "issues" with some of their trades.

This followed a statement from Carlyle Group on Wednesday that its mortgage bond fund had missed margin calls and had received a notice of default.

Forced selling is hitting the US mortgage market particularly hard, as investors are unable to discern when home prices will stop falling and foreclosure rates will ease.

In turn, swap spreads, which are a measure of the difference between Treasury and money market collateral and seen as a barometer of bank counterparty risk, scaled new territory.

The two-year spread reached a record peak of 111 basis points, eclipsing a brief rise above 100bp in December when year-end funding pressures were paramount.

Analysts are increasingly calling for a Federal bailout of the mortgage market in order to stem the rout that has rippled across markets and now threatens the broader economy.

A steeper Treasury yield curve, which over time boosts net interest margin for banks, is not helping ease concerns.

William O'Donnell, strategist at UBS, said: "It seems it is time for the Congress to put a floor under markets that are not directly responding to the actions of the Fed.

"The US taxpayer's wallet, and not just rate cuts, is what's needed to restore order during the most chaotic times in the credit markets seen since the Great Depression."