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Can you quote me? This can be seen in Figure 1, where both the spreads on credit default swaps CDSs and corporate bonds increased significantly from Q3 What happened to structured assets and derivative markets? Many of the securitised mortgages placed into the market were structured as collateralised debt obligations CDOs.
Capital markets explained
Due to the need to hold increased capital for these CDOs, a number of companies, notably the North American monolines, became forced sellers and found there were very few buyers. Therefore, holders of mortgage CDOs were forced into significant asset write-downs. Contagion also led to CDOs based on more standard credit instruments and other structured assets being written down significantly, even though default levels remained at historically low levels.
The lack of demand can be seen in Figure 2, which shows total CDO issuance by quarter.
While a number of credit markets effectively closed down due to lack of buyers, interest rate derivatives and credit derivative markets remained liquid throughout the credit crunch. The outstanding amount of interest rate and credit default swaps has in fact risen over the period. As discussed above, credit spreads widened on both CDSs and corporate bonds. However, Figure 1 shows that CDS spreads were more volatile than those for corporate bonds.
Title Page - Credit Securitisations and Derivatives: Challenges for the Global Markets [Book]
This was mainly because the derivative market stayed liquid and had lower bid-offer spreads so institutions wishing to adjust their exposure to credit were most likely to use the derivative market. The relative stability of the corporate bond market was often due to the lack of trading leading to the true market price not being actively tested.
The CDS market remained liquid as investors still wanted to take positions on the credit market, and using CDSs was the way this could be achieved for minimal asset transfer. New challenges The credit crunch has revealed a number of challenges to insurers in respect of their financial reporting and general risk management. We have deliberately stopped short of suggesting answers as, in many cases, there is no obvious correct one and the questions have vexed many leading academic minds over the past year. Does this reflect greater default expectation or greater liquidity premium?
What allowance for default should be made? To what extent is it reasonable to assume a further spread-widening from the current position? Can it be justifiable to have an ICA stress less severe than has been experienced in the past 12 months? Credit ratings are generally based on long-term default risk but the credit crunch has shown that historic default rates may be a poor guide and, in addition to actual default experience, different assets can have markedly different mark-to-market movements.
QIS4 attempts to tackle this by imposing greater capital on structured credit to reflect the higher expected volatility in market values. If a market price is not available, then a prudent value should be assigned. When is it reasonable to regard trading as too thin to validate a market price? Any collateral agreements should be reviewed to understand the inherent levels of counterparty risk.
On the positive side, there are still many willing sellers of CDOs and other structured products in the market.