Under siege, credit markets add to U.S. growth woes

By Al Yoon

NEW YORK (Reuters) - An unrelenting flight from risky securities sent yields on bonds that finance corporate operations and residential and commercial real estate to record highs on Thursday, exacerbating the credit squeeze tipping the U.S. economy into recession.

Selling by investors forced to reduce assets financed on borrowed money has accelerated the moves this month, analysts said. The process of "deleveraging" has also been blamed for skyrocketing yields even on top-quality securities, including the debt of housing finance companies Fannie Mae (FNM.P) and Freddie Mac (FRE.P), which has implied government backing.

But the rise in yields has accelerated in the last month as economic data on retail sales to the housing market points to a prolonged recession. The Federal Reserve, in minutes from its October 28-29 policy meeting released on Wednesday, said it slashed its own economic growth forecasts, noting that steep interest rate cuts to date may not be enough.

Yield spread premiums on a commercial mortgage-backed securities index roared higher to records for a third straight day, leading deterioration in fixed-income securities on concerns that economic weakness will boost defaults on loans that depend on office building and shopping mall rents.

Cash flowed into U.S. Treasury securities, where 10-year benchmark yields dropped to their lowest level in a half century. Stock indexes crumbled.

"It's a combination of deleveraging and fear," driving the bond markets, said Michael Cheah, a portfolio manager at AIG SunAmerica Asset Management in Jersey City, New Jersey.

A third day of selling on the CMBX-5 AAA derivative index of top-quality commercial mortgage-backed securities pushed spreads as much as 170 basis points higher to a record of 885 basis points over interest-rate swap benchmarks, before closing at 847.5, according to a dealers and Markit. The spread was around 200 basis points in October.

Illustrating corporate debt stress, U.S. credit default swaps widened to record levels on Thursday that suggest investors expect the worst period of investment-grade corporate bond defaults since at least 1980, according to analysts.

The main investment-grade credit default swap index widened to a record 282.5 basis points in late trade, according to data from Markit Intraday.

The cash corporate bond market was "falling apart" with spreads gapping wider, one trader said.

The drama in Washington over the fate of U.S. automakers drove much of the attack on corporate bond markets. After days of wrangling, Democratic lawmakers appeared close to securing a deal that would allow automakers to tap a $25 billion in funds earmarked for auto technology advances, providing some respite in selling, traders said.

Investors ramped up bearish bets against mortgages and other assets after the Treasury last week revised a plan to use a $700 billion bailout to buy securities in a bid to unfreeze capital markets, investors said. The Bush administration pushed off requests on another $350 billion chunk of the fund to President-elect Barack Obama, leaving the market in flux.

"The fear is that now we have a policy vacuum," Cheah said. "We look at what is really troublesome in this downturn, and we need to know what the game plan is."

"Technical" selling has pushed spreads on CMBS wider than even eroding fundamentals would dictate, said Susan Merrick, head of CMBS group at Fitch Rating in New York.

But CMBS yields now above 16 percent could exacerbate the downturn as investors demand compensation in the form of better capitalization rates, Barclays Capital said in a note. Property values would have to drop 59 percent to equalize cap rates with the higher yield, based on adjustments through price versus higher rents, said Barclays, noting that was not a forecast.