Sunday, 29 July 2007

Who is getting hurt in equity/credit?

There are, if not falling cubes, then certainly some falling knives out there. Indeed the current market gyrations seem to suggest a dislocation between the equity and credit markets as well as a weakening of sentiment. As the often amusing Naked Capitalism puts it:

[...] fixed income types speak of truly grim conditions, of the markets for riskier credits having shut down completely, and concerns that the market seize-up could extend its reach to better quality credits. By contrast, many of the equity market participants sounded relatively sanguine, believing that the credit markets are working through a repricing of risk, but that earning yields are sufficiently high so as to be able to withstand an increase in yields.
Meanwhile according to the FT:
Fear now rules the credit markets, where the effective cost of ensuring against a default, in both Europe and the US, has increased by more than half in barely a month. A steady drip of bad news has prompted fears that the subprime debacle could trigger a credit crunch, raising the cost of financing worldwide as investors are forced to sell healthy investments to make good their losses.

Most recently, the equity markets have shown only modest falls, but credit rationing is in full swing, and spreads have moved out markedly, to the extent that they are visible, from the ridiculously tight levels of the first half of the year.

Now this would all be merely interesting, were it not for capital structure arbitrage. CSA posits a relationship between the equity and credit markets, and CSA funds use models based on this relationship to put on equity vs. credit positions. The first generation of these models were based on Merton's work or elaborations of it. What I would really like to know is how models like these, calibrated to the conditions earlier in the year, are performing at the moment. To end with the FT again:
...we may well be in the middle of a regime shift
In fact it could even be that the new regime was the last four years or so, and what we are seeing now is a return to more 'normal' conditions, albeit one that is proceeding in jumps.

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