TWN Info Service on Finance and Development (Jun08/02)
12 June 2008
Third World Network


Following deepening turmoil and rising concerns about systemic risk in the first two weeks of March, financial markets have witnessed a “cautious return” of investor risk tolerance, but interbank money markets continued to show extreme stress, the Bank for International Settlements (BIS) said Monday in its latest review of international banking and financial market developments.

These assessments were provided by the BIS in its latest “Quarterly Review, June 2008”, outlining recent developments in the financial markets.

Below is a report on the BIS’ findings. It was published in SUNS # 6492, Tuesday, 10 June 2008. This article is reproduced here with the permission of the SUNS.  Reproduction or recirculation requires permission of SUNS (

With best wishes
Martin Khor

Cautious Return of Risk Tolerance, But Extreme Stress in Money Markets

By Kanaga Raja, Geneva, 9 June 2008

Following deepening turmoil and rising concerns about systemic risk in the first two weeks of March, financial markets have witnessed a “cautious return” of investor risk tolerance, but interbank money markets continued to show extreme stress, the Bank for International Settlements (BIS) said Monday in its latest review of international banking and financial market developments.

These assessments were provided by the BIS in its latest “Quarterly Review, June 2008”, outlining recent developments in the financial markets.

In its review and related research, the BIS has also suggested (box on pp 6-7) that estimations of sub-prime mortgage-based securities, based on the commonly used ABX indices, may be over-stating the losses (resulting in writedowns in major banks) by about 60%; the BIS itself estimates the losses to be about $73 billion.

[While the BIS quarterly review speaks of a “cautious return” of risk tolerance on the part of investors, and bond markets are giving diverse signals, an article in the Wall Street Journal reports that even seasoned professionals on Wall Street are nervous since sustainable rallies rest on a combination of factors all in favour of stocks - earnings outlook, interest rates and economic prospects - and that’s hardly the case now.

[Meanwhile, the Financial Times reported that four uncertainties plague the economic outlook - prospects of more currency volatility, particularly of the dollar; further housing market deterioration; the credit crisis prompting banks to slash lending to companies and consumers; and the “de-leveraging” since central bankers still have no effective way of measuring how far the leveraging has fallen and how much further it might go. The FT cited on this last that the BIS General Manager, Malcolm Knight, had expressed concerns as early as a year ago about the unknown extent of leveraging in banking and other “shadow-bank” financial institutions like hedge funds, and the damage that would be caused when all this debt has to be cut.

[The latest BIS quarterly review attributes the cautious return of investor risk tolerance to the actions of the US Federal Reserve and other central banks in cutting rates and providing ample liquidity, including through special windows for investment banks, and the Fed-orchestrated buyout of Bear Stearns by Goldman Sachs. But other media reports show that the Fed flooding the market with excess liquidity may have ignited inflationary processes globally, and the dollar’s depreciation, combined with leveraged operations of hedge funds, is pushing up prices of oil and commodities. And two Fed governors have come out publicly with their concerns over the “moral hazards” created by the Bear Stearns rescue. - SUNS]

The BIS said that in contrast to developments in other markets, interbank money markets continued to show clear signs of extreme stress from March to May. Spreads between Libor rates and corresponding overnight index swap (OIS) rates, due to counter-party credit risk as well as liquidity concerns, were generally at least as high at the end of May as three months earlier, across most horizons and in all three major markets.

“This appeared to imply expectations that interbank strains are likely to remain severe  fell into the future,” said BIS.

According to the Basel-based central bank for the world’s central banks, the process of disorderly de-leveraging which had started in 2007 intensified from end-February, with asset markets becoming increasingly illiquid and valuations plunging to levels implying severe stress. However, said BIS, markets subsequently rebounded in the wake of repeated central bank action and the Federal Reserve-facilitated takeover of a large US investment bank.

Mid-March was a turning point for many asset classes, said BIS, noting that amid signs of short covering, credit spreads rallied back to their mid-January values before fluctuating around these levels throughout May. Market liquidity improved, allowing for better price differentiation across instruments.

The stabilisation of financial markets and the emergence of a somewhat less pessimistic economic outlook also contributed to a turnaround in equity markets. In this environment, government bond yields bottomed out and subsequently rose considerably. A reduction in the demand for safe government securities contributed to this, as did growing perceptions among investors that the impact from the financial turmoil on real economic activity might turn out to be less severe than had been anticipated, said the Basel-based bank.

The BIS said that following two weeks of increasingly unstable conditions in early March, credit markets were buoyed by a cautious return of risk tolerance, with spreads recovering from the very wide levels reached during the first quarter of 2008.

Sentiment turned in mid-March, following repeated interventions by the Federal Reserve to improve market functioning and to help avert the collapse of a major US investment bank (Bear Stearns). As these actions alleviated earlier concerns about risks to the financial system, previously dysfunctional markets resumed trading and prices rallied across a variety of risky assets.

Between end-February and end-May, the US five-year CDX high-yield index spread tightened by about 144 basis points to 573, while corresponding investment grade spreads fell by 63 basis points to 102. European and Japanese spreads broadly mirrored the performance of the major US indices, declining by between 25 and 153 basis points overall. Between 10 and 17 March, all five major indices had been pushed out to or near the widest levels seen since their inception. They then rallied back and seemed to stabilise around their mid-January values, remaining significantly above the levels prevailing before the start of the market turmoil in mid-2007.

Turmoil in credit markets deepened in early March, setting the stage for the pronounced shift in market sentiment later during the period. Pressures on bank balance sheets had been accumulating throughout the crisis, but further intensified early in the month, said BIS, noting that as banks continued to cut their exposures across business lines, tightening repo haircuts caused a number of hedge funds and other leveraged investors to unwind existing positions. As a result, concerns about a cascade of margin calls and forced asset sales accelerated the ongoing investor withdrawal from various financial markets.

In the process, spreads on even the most highly rated assets reached unusually wide levels, with market liquidity disappearing across most fixed income markets. This included assets, such as certain US student loan securitisations, whose underlying exposures are almost entirely protected by federal guarantees, as well as mortgage-backed securities underwritten by US government-sponsored enterprises. Heightened uncertainty was also evident from implied volatilities, which, expressed in absolute spread terms, returned to levels comparable to those during the onset of the crisis in the summer of 2007.

Fears about collapsing financial markets reached a peak in the week beginning 10 March, triggering repeated policy actions by the US authorities. Actual and anticipated de-leveraging pressures had continued to weigh on markets early in the week, with financial sector spreads widening and investment grade credit default swap (CDS) indices under-performing lower quality benchmarks. Spreads were temporarily arrested when, on 11 March, the Federal Reserve announced an expansion of its securities lending activities targeting the large US dealer banks. European CDS indices tightened by more than 10 basis points on the news, while the two key US indices closed 17 and 41 basis points down, respectively.

However, said BIS, market sentiment resumed its deterioration later in the week, triggering a severe liquidity squeeze on Bear Stearns. This, in turn, prompted the Federal Reserve, on the morning of Friday 14 March, to take the extraordinary step of invoking section 13(13) of the Federal Reserve Act, allowing it to make secured advance payments to the troubled investment bank, followed by its takeover by JPMorgan the following Monday.

These developments appeared to herald a turning point in the market, ushering in a phase of broad-based spread narrowing. The sense of relief associated with the rescue of Bear Stearns was compounded by a 75 basis point policy rate cut by the Federal Reserve on 18 March, bringing the federal funds target down to 2.25%. Earnings announcements by major investment banks on 18 and 19 March that were better than anticipated provided further support, with investors increasingly adopting the view that various central bank initiatives aimed at re-liquifying previously dysfunctional markets were gradually gaining traction.

Consistent with perceptions of a considerable reduction in systemic risk, spreads, and particularly those for financial sector and other investment grade firms, tightened from the peaks reached in early March. Movements were partially driven by the unwinding of speculative short positions, as suggested by changes in pricing differentials across products with similar exposures, according to the ease with which such positions can be opened or closed, said BIS.

Tightening spreads coincided with a notable recovery in indicators of investor risk tolerance over the period. While remaining elevated, the price of credit risk, as extracted from credit spread-implied and empirical default probabilities of lower-quality borrowers, declined markedly from the very high levels observed earlier in 2008.

Lower risk premia were also consistent with observed movements in the term structure of credit spreads, as indicated by current relative to implied forward spreads, which suggested that investors had adjusted the compensation required for near-term risks. Similarly, implied volatilities from CDS index options eased into the second quarter, indicating a somewhat reduced uncertainty about shorter-run credit spread movements.

Despite further deterioration in housing fundamentals, the change in sentiment was also evident in US sub-prime mortgage markets. Spreads on ABX indices referencing AAA bonds backed by home equity loans came off their earlier peaks, bringing down estimates of losses based on ABX prices. Supported by optimism about banks’ re-capitalisation efforts, spreads continued to rally throughout April before retracing some of these gains in May. While announcements of large writedowns by major financial institutions continued throughout the period, recovering markets supported an increasing pace of capital replenishment, said BIS.

Following news of a rights issue on 31 March, CDS spreads referencing debt issued by Lehman Brothers tightened. UBS announced large first quarter losses and a fully underwritten capital increase on 1 April, and other institutions followed over the rest of the month. Globally, banks managed to raise more than $100 billion of new capital in April alone, stemming the deterioration in capital ratios. Financial CDS spreads, the monoline segment excluded, outperformed corresponding equity prices in the process, reflecting diminishing concerns about imminent financial sector risk as well as the dilutory effects of equity financing.

Markets retraced some of these gains in early May, partially driven by strong supply flows from corporate issuers that included, at $9 billion, the largest US dollar deal by a non-US borrower in seven years. Volumes were dominated by financial and other investment grade issuers, with high-yield markets still essentially closed. Yet market sentiment remained broadly positive, with spreads fluctuating around their mid-January levels throughout the rest of the month.

By the end of the period in late May, said BIS, the process of disorderly de-leveraging had come to a halt, giving way to more orderly credit market conditions. Market liquidity had improved and risk appetite increased, luring investors back into the market and allowing greater price differentiation. Bank capitalisation had recovered, while remaining weaker than before the crisis. At the same time, still-elevated implied volatilities suggested ongoing investor uncertainty over the future trajectory of credit markets.

“With the credit cycle continuing to deteriorate and related losses on exposures outside the residential mortgage sector looming, it was thus unclear whether liquidity supply and risk tolerance had recovered to an extent that would help maintain this improved environment on a sustained basis,” said BIS.

Mirroring developments in credit and equity markets, yields on long-term government bonds in major industrialised economies continued to fall until mid-March, at which time yields bottomed out to establish an upward trend for the remainder of the period under review, said the Basel-based bank.

From its low point on 17 March, the 10-year US Treasury bond yield rose by 75 basis points to reach 4.05% at the end of May. During this period, 10-year yields in the euro area and Japan climbed by around 70 and 50 basis points, respectively, to 4.40% and 1.75%. In US and euro area bond markets, the increase in yields was particularly pronounced for short maturities, with two-year yields rising by 130 basis points in the United States and by almost 120 basis points in the euro area. Two-year yields went up in Japan too, but by a more modest 35 basis points. According to BIS, in addition to reduced safe haven demand for government securities, the rise in short-term yields reflected a reassessment among investors of the need for monetary easing, following the stabilisation of financial markets.

Global equity markets broadly tracked events in credit and bond markets during the period under review. After falling from the start of the year, stock prices bottomed out around mid-March and began a gradual recovery. The S&P 500 Index, which by 17 March had lost 13% compared to end-2007 levels, gained almost 10% between 17 March and end-May. Equity markets in Europe and Japan, which had seen losses in excess of 20% between the turn of the year and 17 March, subsequently also displayed a strong recovery, with the EURO STOXX gaining 11% and the Nikkei 225 rising more than 21% until end-May.

Reflecting the improved situation in financial markets during this period, financial stocks outperformed other sectors. By end-May, the investment banking and brokerage sub-index of the S&P 500 had risen by 16% compared to mid-March levels, while similar sub-indices in Germany and Japan were up by almost 20% and 34%, respectively. These gains occurred despite announcements by several banks of record losses during the first quarter amid continued credit-related write-offs.

Investors obviously took solace from the fact that losses - although big - were no worse than expected, and that a number of banks had been successful in their re-capitalisation efforts, said BIS.

As in other market segments, the strong performance of global equity markets after mid-March was further fuelled by perceptions among investors that uncertainty about future developments had declined somewhat, coupled with an increase in risk tolerance. This contributed to rising equity prices by lowering risk premia through a reduction in the amount of perceived risk as well as a decline in the price of risk. Consistent with such perceptions of lower risk, implied volatilities fell across the board, after having peaked in mid-March. Meanwhile, indicators of risk tolerance in equity markets recovered after a sharp dip in March.

Emerging market assets performed broadly in line with assets in the major industrialised economies, although returns in emerging bond markets tended to trail the recovery observed in other asset classes. In a continuation of the general market weakness that had started in 2007, spreads widened and equities fell up to mid-March, before rebounding in the wake of the change in market sentiment following the Bear Stearns rescue in the United States.

Between end-February and end-May, the MSCI emerging market index gained about 4% in local currency terms, and was up more than 14% from the lows established in mid-March. Latin American markets, which had seen a more muted decline than other regions early in the period, posted the strongest gains, advancing by about 12%.

Economic growth in the region continued to be buoyed by strong prices for key commodities, such as base metals and oil, which remained on an elevated trajectory even in the face of expectations of slower global growth. While some observers cited high trading volumes in commodity derivatives and speculative demand as a source of part of that strength, others pointed to low supply elasticities and expectations of sustained rates of industrialisation throughout the emerging markets.

With the region being a major net commodities importer and natural disaster contributing to weaker equity prices in China, Asian markets were broadly flat over the period. Emerging Europe, in turn, remained exposed to the risk of a reversal in private capital flows, owing to large current account deficits and associated financing needs in a number of countries. Nevertheless, strong gains in Russia and the better-than-expected growth performance of major European economies in the first quarter seemed to aid equity markets in May, said BIS.

In contrast to developments in other markets, interbank money markets continued to show clear signs of extreme stress from March to May. Spreads between Libor rates and corresponding overnight index swap (OIS) rates, due to counter-party credit risk as well as liquidity concerns, were generally at least as high at the end of May as three months earlier, across most horizons and in all three major markets. This appeared to imply expectations that interbank strains were likely to remain severe well into the future, said BIS.

After a relatively smooth turn of the year, the interbank market tensions had appeared to ease somewhat until early March 2008, and Libor-OIS spreads had shown some signs of stabilising. However, said BIS, as the financial turmoil suddenly deepened in the second week of March, following an acceleration in margin calls and rapid unwinding of trades, interbank market pressures quickly increased. With market rumours proliferating about imminent liquidity problems in one or more large investment banks, banks become increasingly wary of lending to others. At the same time, their own demand for funds jumped as they sought to avoid being perceived as having a shortage of liquidity.

The near collapse and subsequent takeover of Bear Stearns on 14-18 March highlighted the risks that banks face in such situations. On the one hand, the Federal Reserve-facilitated takeover of Bear Stearns by JPMorgan was generally perceived by investors as signalling that large banks would not be allowed to fail, and this helped restore order in other markets. On the other hand, the speed with which Bear Stearns’ access to market liquidity had collapsed underscored the vulnerability of other banks in this regard, which kept Libor-OIS spreads high even as CDS spreads on banks and brokerages dropped significantly.

Throughout the period, said BIS, central banks maintained and even stepped up their efforts to ease tensions in interbank markets. Measures included increasing the size of liquidity facilities, extending lending maturities, and broadening the pool of eligible collateral. Even so, this flurry of activity from central banks seemed to have limited immediate impact on interbank rates.

One significant source of short-term funding for banks in the past has been money market mutual funds. Such funds have seen substantial inflows since the outbreak of the financial turmoil, reflecting a noticeable reduction in investors’ appetite for risk. However, this loss of risk appetite also resulted in money market funds shifting their investments increasingly into treasury bills and other safe short-term securities, hence depriving banks of a key funding source. According to BIS, this suggests that determining how persistent the interbank tensions will be may depend significantly, among other things, on how long the risk appetite of money market fund managers, and investors more broadly, will continue to be depressed.

Adding to the tense situation in interbank markets, the reliability of the Libor fixing mechanism, in particular for US dollar loans, was increasingly questioned by market participants. Suspicions were voiced to the effect that some banks in the Libor panel had been reporting rates lower than their actual borrowing costs. It was alleged that they did so in order to hide their true demand for dollar funds, and hence to appear less vulnerable than they actually were. The BIS noted that as the media focussed on the issue and the British Bankers’ Association began investigating in mid-April, US dollar Libor rates suddenly adjusted upwards by 15-40 basis points.

Apart from interbank money markets, some other market segments also seemed to paint a picture of continuing fragility. Swap spreads, for example, while off their peaks, remained higher than before the outbreak of financial turmoil, possibly reflecting ongoing tensions in interbank markets. Similarly, swaption volatilities had by end-May dropped only modestly from their highs, suggesting continued uncertainty about future movements in short-term as well as long-term interest rates.

The BIS review also highlighted recent activities in the international and financial markets.

It said that activity in the international banking market continued to expand in the fourth quarter of 2007, despite the ongoing tensions in the interbank market. A significant portion of this increase was accounted for by new credit to emerging markets.

Credit to borrowers in emerging economies surged in the fourth quarter of 2007, with record expansions in BIS reporting banks’ claims on borrowers in Asia-Pacific and Africa and the Middle East. In addition, there were large movements in reporting banks’ liabilities to key emerging markets; while some central banks reduced their holdings of reserves in commercial banks, Middle East oil exporters deposited record amounts in banks abroad, as did the banking sector in China.

Credit to borrowers in emerging economies surged in the fourth quarter of 2007, with record expansions in BIS reporting banks’ claims on borrowers in Asia-Pacific and Africa and the Middle East. Total claims booked by BIS reporting banks grew by $1.2 trillion (21% growth year over year), the fifth consecutive quarterly expansion of $1 trillion or more. Claims on emerging economies accounted for a relatively large $232 billion (or 20% of the total expansion), driving total claims on these borrowers to $2.6 trillion, or 7% of total claims (from 6% in the previous quarter and 5% in early 2005).

Borrowing in the international debt markets remained broadly stagnant in the first quarter of 2008 amid the continued turmoil in financial markets, said BIS. Net issuance of bonds and notes decreased to $360 billion, below even the level recorded in the third quarter of 2007, when the recent turmoil first hit global financial markets. That said, added BIS, signs of recovery were evident in such segments as investment grade bonds and money market instruments. In particular, net issuance of money market instruments surged from $24 billion to $153 billion in the first quarter of 2008, the largest net issuance on record.

The fall in net issuance in bonds and notes came chiefly from the euro-denominated segment, which had rebounded in the fourth quarter of 2007. Net issuance of euro-denominated bonds and notes declined to $105 billion in the first quarter of 2008, almost half the level of the previous quarter. Stagnation was also evident across an array of other currency denominations. Net issuance of dollar-denominated bonds and notes decreased from $204 billion to $180 billion in the first quarter of 2008, while that of yen-denominated bonds and notes dropped from $14 billion to $6 billion.

By sector, both financial institutions and corporate issuers in the developed countries slowed net issuance, from $346 billion to $239 billion and from $85 billion to $54 billion respectively. In particular, net issuance of bonds and notes by private financial institutions in developed countries fell markedly, from $332 billion to $208 billion. In contrast, international institutions increased net issuance from $5 billion to $22 billion. Mortgage-backed bonds continued on a significant downtrend in the first quarter of 2008, said BIS. Gross issuance of mortgage-backed bonds fell from the previous quarter’s $71 billion to $33 billion, the lowest level since the third quarter of 2003.

The first quarter of 2008 saw a large rebound in activity on the international derivatives exchanges. The total turnover based on notional amounts increased from the previous quarter’s $539 trillion to $692 trillion in the latest quarter, the highest turnover on record. Most of the increase was observed in derivatives on short-term interest rates. In contrast, turnover in derivatives on stock indices showed a slight decline, possibly reflecting overall weakness in stock markets in the first quarter.

Trading in commodity futures and options continued to be robust in the first quarter of 2008. Global turnover in commodity derivatives measured in numbers of contracts (notional amounts are not available) grew from 420 million to 489 million, representing a year-on-year growth rate of 52%. Major contributors were agricultural and energy products. In the past several years, the volume of trading activity in derivatives on agricultural and energy products has tended to move with the level of their prices substantially more than has been the case with other commodity derivatives.

Trading recovered in the foreign exchange segment of the derivatives exchanges as well. Turnover went up from $6.0 trillion to $6.7 trillion in the first quarter of

2008, representing a year-on-year growth rate of 32%. On the other hand, activity in equity derivatives fell slightly in the first quarter of 2008 to $73 trillion from $75 trillion in the previous quarter, although the year-on-year growth rate was still high at 22%.

Despite the continued turmoil in global financial markets, the over-the-counter (OTC) derivatives market showed relatively steady growth in the second half of 2007. Growth was particularly strong in the credit segment, due possibly to heightened demand for hedging credit exposure. Notional amounts of all categories of OTC contracts increased by 15% to $596 trillion at the end of December, following a 24% increase in the first half of the year.

Other segments, including markets for foreign exchange, interest rates and commodity derivatives, were also robust, each recording double digit growth, while the equity segment posted a negative growth rate, said BIS.