The Tanking Spreads

The global financial squeeze is spreading to investments linked to the corporate-debt market, slamming the value of contracts that provide insurance against defaults and marking one of the first times that the debt of major companies has been affected by the turmoil.

Bonds issued by major corporations have been a rare bright spot in the battered credit markets -- few investors believe these companies will go bust even if there is a serious recession.

In recent days, investors in credit-default swaps, which act as insurance policies against defaults, have grown increasingly gloomy because of worries about the global economy and the possibility of problems in the market.

The losses are tracked by several indexes, which track the cost of buying insurance on bonds issued by 125 big companies. Two of the indexes are at records and have doubled since the start of the year, meaning investors who sold this insurance suffered losses. The worry is that the indexes' moves could prove to be self-fulfilling prophecies, causing heavy losses for investors and making it even harder for people and companies to borrow money. Adding to the anxiety: Analysts can only guess at the volume of investments tied to the indexes, who is holding them and what it would take to trigger a full-scale sell-off.

"You don't know when it is going to happen; you don't know how much it is going to be," said Michael Hampden-Turner, a credit strategist at Citigroup Inc. in London. That "makes everybody really nervous."

Credit-default swap contracts have been written on the equivalent of some $43 trillion in all types of bonds, according to the Bank for International Settlements. Analysts estimate that about $6 trillion of those contracts tied to corporate bonds have been pooled into investments called synthetic collateralized-debt obligations, or CDOs, and constant-proportion debt obligations, or CPDOs, which channel the insurance payments on multiple contracts to investors.

The trouble is brewing in the market for these esoteric investments. Markit iTraxx Europe tracks the cost of insuring a basket of 125 investment-grade debt issues by European companies, including banks such as Barclays PLC, beverage company Diageo PLC, and retailer Tesco PLC. The Markit CDX North America Investment-Grade Index references the cost of insuring against default by 125 U.S. and Canadian investment-grade companies, including telecommunications company AT&T Inc., retailer Wal-Mart Stores Inc. and fast-food operator McDonald's Corp.

As of yesterday, the annual cost of five years of insurance against default on $10 million in bonds on the CDX index had risen to $152,000 from $80,970 at the start of the year. The cost of €10 million ($14.7 million) of insurance on the iTraxx had rose to €123,750 from €51,320 at the beginning of the year.

A rise in the cost of insurance means a loss for investors who sold insurance, because the only way to get out of these investments is to buy another insurance policy to replace the policy they sold in the first place. For example, if the cost of five-year insurance on the CDX rose to $100,000 a year, an investor who had sold the insurance for $50,000 a year would have to pay an added $50,000 for five years to get out of the contract -- a loss with a present value of about $200,000.

Some investors say the indexes' sharp moves represent an unfounded anxiety that will ultimately cool. They note that corporate-bond prices haven't fallen nearly as far as the indexes have moved, suggesting that the cost of insurance doesn't reflect the actual likelihood that companies will default. In the mortgage market though, credit-default swaps preceded the problems in the market.

Even in the absence of greater defaults, the moves in the indexes can cause a great deal of havoc, triggering a downward spiral in which the forced unraveling of complex investment products drives ever-larger losses for investors and rises in the cost of insurance, which in turn could ultimately drive up borrowing costs for companies all over the world.

"It is a kind of vicious circle," said Demetrio Salorio, deputy head of debt capital markets for Société Générale in London.

Among the most vulnerable are the CPDOs, which have only been on the market two years. They offered a supposedly safe stream of income to investors by selling default protection on all of the companies in either the iTraxx or the CDX, or in some cases on a basket of financial firms that included bond insurance companies. But they had a flaw: They used borrowed money, or leverage, to increase the returns they could provide to investors -- a strategy that also magnifies losses. They also contain triggers that force them to call off their bets if losses reach a certain level, a feature that can force them to rush into the market to buy insurance just when the market is falling.

"Whether you bought without leverage or with leverage, you've been hurt," said Steve Lobb, head of credit and alternatives marketing at ABN Amro Holding NV, which sold CPDOs. "If you bought...with leverage, you've been hurt more." Still, he said, CPDOs "are not the problem in the market. They are a tiny piece of what exists out there."

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Commercial-real-estate investors and Wall Street firms are finding their attention turned to a little-known credit-market index that is sending ominous signals about the outlook for their business.

The index is called the CMBX. It tracks the values of bonds backed by commercial mortgages on office buildings, hotels, malls and the like. It is signaling that the odds of distress in this business are soaring, even though actual commercial-real-estate defaults, unlike housing, still remain low.

The CMBX is one of many credit-market indexes created in the past few years that have quickly become controversial bellwethers on Wall Street. While the Dow Jones Industrial Average and the Standard & Poor's 500-stock index track the performance of stocks, the CMBX and other credit indexes track the cost of buying insurance against default on different kinds of bonds.

The CMBX is run by London-based Markit Group Ltd. Another of its credit indexes, the ABX, which tracks the riskiness of subprime mortgages, showed soaring odds of mortgage defaults last year as the housing crisis was about to intensify.

Critics of these indexes say they might be exaggerating the amount of distress in both markets. Short sellers have been flocking to these indexes to make bets against real estate, possibly driving their performance.

Actual delinquencies on commercial-mortgage bonds hit a record low of 0.27% in January, according to Fitch Ratings. Among 40,000 loans in these bonds, only 293 were delinquent last month. The most bearish market prognosticators predict defaults on commercial mortgages will reach 2% over the next year or so, in line with the historical range. By comparison, the performance of the CMBX implies the default rate could be four times that level, according to analysts. "The level we're seeing in the CMBX right now just doesn't make sense," says Lisa Pendergast, managing director for RBS Greenwich Capital in Greenwich, Conn.

The CMBX began trading in March 2006. It tracks the performance of commercial-real-estate bonds with different credit ratings, ranging from triple-A to double-B. Portions of the index have more than tripled this year, indicating soaring perceptions of risk.

The index itself has become one of the most popular ways to make bets on the outlook for real estate, and also to hedge against a downturn. Investors can make bets through derivatives instruments called credit-default swaps. Owners of these swaps get paid when defaults rise -- the same way that an owner of an insurance policy gets paid when a storm damages his house.

The annual cost of insuring against default on a $10 million bundle of triple-A rated commercial-real-estate-backed bonds had risen from $65,000 in early January to more than $212,000 last week, but a rally of the CMBX this week had reduced the cost to about $180,000 yesterday, according to Citigroup Inc. analyst Darrell Wheeler.

While trading in these derivatives has soared, it has dried up in actual commercial-real-estate bonds, making it harder to determine what the bonds are worth.

Some banks are using the CMBX to determine the size of write-downs on the values of their holdings, even though the underlying properties are still generating cash.

Don Truslow, chief risk officer for Wachovia Corp., one of the nation's largest commercial lenders, said in a Jan. 22 earnings call that the CMBX "has been a large part of the reason for the write-downs and the market marks that we have taken" -- $600 million in the fourth quarter -- even though the bank hadn't seen any material deterioration in the properties or loans themselves. The poor performance of the CMBX, in turn, might be making it even harder for commercial borrowers to get access to credit in an already tight lending environment.