According to Jim Leonard, CFA, Morningstar's senior bank credit analyst, "In the financial sector, what we've learned over the past few years is that where there is smoke, there is not a fire, there's a raging inferno!"
JP Morgan's surprise announcement Thursday shocked the credit markets with the extent of its losses tied to a hedging/trading position in the CDX indexes. Bloomberg and The Wall Street Journal first reported a dislocation in the index credit default swap market several weeks ago. J.P. Morgan was identified as the player causing the divergence between market trading prices and theoretically appropriate levels. However, the markets had no concept of the size of the risk that J.P. Morgan had undertaken.
Considering that credit spreads have widened only 12 basis points since the story first broke in early April, we are amazed at the notional size of the risk position that J.P. Morgan must have undertaken to lose $2 billion. While this is certainly a negative mark on Jamie Dimon's reputation, we do not believe this hit to the bank's capital levels is substantive enough to affect our issuer credit rating. We are not entirely convinced that the size of the loss is contained to the reported amount, as it appears that J.P. Morgan has not completely exited from the trade that caused this loss. The counterparties on the other side of the trade will have very little inclination to unwind their positions until they inflict maximum pain. In addition to the loss itself, this episode will provide additional ammunition to those politicians looking to expand regulation and gain greater control over the banking system.
Credit Markets Hate Uncertainty
Above all else, the credit markets hate uncertainty, and the view is getting increasingly foggy. While first-quarter earnings reports have generally been in line with expectations, a few companies (especially those exposed to the European consumer sector) have begun to warn that they see further economic softening ahead.
Several European nations reported negative GDP growth for the first quarter, with the United Kingdom and Spain slipping into recessions. S&P downgraded Spain's rating by two notches to BBB+ with a continuing negative outlook. The rating change by itself did not have an impact, as the market was already trading Spanish debt with yields that were indicative of a much lower rating, but the rating downgrade will probably result in additional downgrades within Spain's banking system. The corporate credit market also continues to wait for the outcome of Moody's re-evaluation of its ratings for European and U.S. banks, which could force numerous financial institutions to either reduce lending or raise capital to post additional collateral to their counterparties.
Subsequent to the recent round of elections, political risk has been substantially heightened as France's newly elected president, Francois Hollande, has been very critical of the European Union's response to the sovereign debt crisis, questioned the role of the European Central Bank, and voiced his desire to renegotiate France's financial support for the sovereign rescue funds. Beleaguered Greece has been unable to form a cohesive government as a number of radical political parties have gained support.
After vacillating above and below the 6% barrier for much of April, the yield on Spanish 10-year bonds rose as high as 6.12% on May 9 before dropping back to 6.01%. The market has deemed 6% as the yield beyond which Spain would no longer be able to continue to sustainably finance itself in the public markets and thus may require a bailout and financing from the ECB. While the yield has halted its climb at 6% for now, the country's 5-year credit default swaps have continued to rise to new highs, reaching +521 on May 9.
Last month, we wrote that while we were worried the sovereign debt crisis appears to be at the precipice of re-emerging, our fears were allayed by the fact that Spain's credit curve had not yet begun to flatten. But over the past few weeks, the spread between the 2-year and 10-year bonds has begun to compress. The spread decreased 28 basis points in April and another 28 basis points since the beginning of May to +226. While this curve is steep enough to indicate that the market is not pricing in near-term jump-to-default risk, if the credit curve continues to flatten, we think Spain's access to the public markets could be limited, forcing the country to seek bailout financing the ECB and International Monetary Fund.
When the EU members agreed to the fiscal compact that would limit the "structural deficit" of any individual country, we opined that it was one thing to agree to, but another thing entirely to implement and enforce it. We also thought that defining a structural deficit rather than using actual deficits would allow countries to try to game the fiscal compact. We are now seeing several countries beginning to look for loopholes in how they interpret a structural deficit in order to reduce their need to make further budget cuts. For example, Italy's prime minister is seeking to exempt large infrastructure projects from the deficit rules as a way to support the Italian economy. With its 24% unemployment rate, Spain is asserting that at full employment, its GDP would be substantially higher and as such it can run a much larger budget deficit in the near term as economic growth from declines in unemployment would significantly reduce its structural deficit.
Click to see our summary of recent movements among credit risk indicators.
