Government bailout to cap corp debt weakness-analyst
NEW YORK, Sept 22 (Reuters) - Government plans to bail out the financial system have averted a systemic financial collapse and are likely to put a floor under weakness in investment grade credit spreads, Morgan Stanley said on Monday.
High-yield credit, however, may underperform as investors return to evaluating corporate debt based on the leverage and fundamental outlook of the issuer, Morgan Stanley analysts said.
The U.S. government unveiled a $700 billion bank bailout plan over the weekend after an unprecedented sell-off in financial stocks raised concerns of a systemic financial failure.
The move came after a bankruptcy filing by Lehman Brothers Holdings (LEHMQ.PK) LEH.N on Sept. 15 that shocked markets.
"What separated this recent policy response from past so-called fixes is, up until now we've had only a highly reactionary, ad hoc response, which has never clearly addressed the problem," Greg Peters, chief U.S. credit strategist at Morgan Stanley said on a conference call.
"This plan is broad, a sweeping response. It addresses the core issues and I do think it caps systemic and tail risk, which in turn should have an enduring positive market reaction," he said.
The benchmark investment grade credit derivative index tightened to 151 basis points on Monday after gapping out as far as 220 basis points immediately after Lehman filed for bankruptcy.
"The reduction in systemic risk allows for a renormalization of data, and this allows for more natural or rational risk measurement and that is in process," Peters said.
Spreads of higher-rated corporate debt are likely to normalize following the government action, and U.S. debt is now a better bet than European debt, he said.
As the economy slows and investors return to evaluating companies based on their fundamental outlook, however, high-yield bonds are likely to underperform investment grade, Peters said.
LEHMAN EFFECT
After organizing a bailout of Bear Stearns in March, the Fed and the Treasury Department allowed Lehman to fail, marking the first instance in which the government allowed a large counterparty to go under.
However, jitters caused by the event brought the financial system to the verge of collapse, Peters said.
"There was the complete and utter lack of appreciation of what (impact) the Lehman bankruptcy had on the system, and it was really a two-fold problem," he said.
Lehman had around $165 billion in debt and its default left its unsecured bondholders facing a loss of around $120 billion overnight, Peters said.
In addition, Lehman was a counterparty to a number of trades, including a credit derivative book estimated at around $700 billion, and its default "just created massive instability in the market because investors really weren't sure what their risks were," he said.
Credit default swaps on financial companies soared after the failure, with "dealers hedging out other dealers' risk, banks hedging out dealers' risk as well as clients hedging out dealers' risk," Peters said.
"It was a one-way flow as there was no protection selling, and so you just saw a massive move wider in credit spreads on the various CDSs and that really drove a lot of the other action," he added.
Losses from Lehman's debt also caused a loss in a money market fund, making the bank's failure a problem in the cash markets as much as in derivatives, Peters said. This is likely what provoked the government response, he said.
"It was unsustainable in its current form or the entire system would collapse, and I do think many would agree that it was on the verge of collapse," he said. (Reporting by Karen Brettell; Editing by Dan Grebler)
