Catching a credit cold

Australia, like other global financial centres, is being ravaged by high levels of volatility across asset classes, sparked by the subprime mortgage meltdown in the US. And the country's credit markets have received intense scrutiny following the losses incurred by hedge fund Basis Capital's exposure to US mortgage assets.

The development has led investors to deleverage, by unwinding risky positions, which has caused a ripple effect throughout the country's financial markets. But it appears that many investment grade corporate issuers have, so far, emerged relatively unscathed, as there has been a negligible impact on the real economy. That means default rates remain low.

Clearly, the flurry of cheaply funded, leverage buyout and private equity deals witnessed earlier in the year has petered out. The high-profile, A$22 billion Westfarmers buyout of retail group Coles, along with the attempt by a Macquarie-led consortium to purchase flagship airline Qantas, seem a distant memory - at least for those parties that didn't offer contingent derivatives linked to the failed Qantas deal.

That is bad news for international hedge funds, proprietary trading desks and other market momentum participants that were attracted by the earlier increase in volatility resulting from the leveraged buyout bids. In the case of Qantas, five-year credit default swap (CDS) spreads moved from 30 basis points out to a wide above 250bp before the deal eventually fell through. And within the large credit moves were sharp rises and falls in spreads that presented many money-making opportunities.

Some dealers reckon their CDS trading volumes grew by more than 100% in the first half of the year. This was in contrast with previous years when spreads in Australia were generally much tighter and more stable.

This pick-up in volumes earlier in the year meant dealers had to provide offshore clients with access to Australian-based traders and research analysts across a 24-hour trading day. While dealers have probably made enough profits to weather the short-term slowdown in the markets, it is still unclear what will happen in the medium term.

That is causing investors - most of which are suffering mark-to-market losses - some concern. At present, they are adopting a wait-and-see approach, which is causing the structured credit markets to freeze. And that's unlikely to change until Australia's leading financial institutions have fully disclosed their exposures to conduit finance programmes and collateralised debt obligations, as well as subprime credit.

- Christopher Jeffery, Editor, Asia Risk.