(Updates late market action, adds table)
By Richard Leong
NEW YORK, March 6 (Reuters) - U.S. interest rate swap spreads blew out to their widest ever on Thursday as investors unwound hedges no longer needed following a massive liquidation of mortgage bond investments.
The turmoil in U.S. credit markets this week has spread to what had been viewed as the least-risky part of the mortgage market as investors unloaded bonds backed by Fannie Mae FNM.N and Freddie Mac FRE.N to raise cash to meet margin calls.
Compounding the situation was news that a mortgage lender and an investment fund were in trouble after banks that lent them cash to finance their investments demanded their money back.
Moreover, news of a Moody’s downgrade of bond insurer CIFG Guaranty and Citigroup Inc’s (C.N) plan to shrink its mortgage business added to investor jitters.
“It’s a flight to quality into Treasuries, which makes swap spreads wider,” said James Caron, co-head of global rates research with Morgan Stanley in New York.
In a swap transaction, there is an exchange of fixed-rate and floating-rate payments between two parties. The party that receives fixed-rate cash flows is vulnerable to a spike in long-term rates, which happened this week.
Interest rate swaps are used to hedge or bet on interest rate moves. The spread on the swap rate and comparable Treasury yields reflects the cost to exchange fixed-rate for floating interest-rate payments.
The two-year swap spread widened to 112.50 basis points in late trading, compared with 105.75 basis points late Wednesday. It eclipsed the record of 106.50 basis points in December.
Swap spreads ranging from two years to nine years broke 100 basis points collectively for the first time ever, analysts said.
Short-dated and intermediate spreads have expanded as much as 25 basis points so far this week with the sharp steepening of the Treasury yield curve, which reflects the difference between short-term and long-term interest rates.
Swap spreads are considered gauges of risk aversion among investors. They have expanded in recent days on credit worries stemming from ongoing problems in the financial sector due to their subprime exposure.
Risk aversion, together with the unwinding of hedges by mortgage investors, intensified on Thursday following news that an affiliate of private equity firm Carlyle Group [CYL.UL] failed to meet some margin calls and has received a notice of default.
Speculation that Thornburg Mortgage Inc. TMA.N, a lender that specializes in expensive homes, might file for bankruptcy caused the credit market to unravel further.
This week’s exodus from mortgage investments did not come from the battered subprime segment, but rather from the higher-quality agency and “Alt-A” sector.
Some funds that had invested in these less-risky mortgage securities did so by borrowing heavily. A sharp price decline on mortgage securities has triggered demands from the lenders for the loans to be repaid.
“In times of stress this can exacerbate losses, create forced liquidations and increase hedging needs, which can drive swap spreads wider,” Morgan Stanley’s Caron said.
These forced sales have kicked off a vicious cycle that has led to more losses on mortgage securities and further selling to meet margin requirements on leveraged portfolios, analysts said.
Investors have been closing out their mortgage-related hedges in the swaps market by paying in fixed-rate cash flows. This boosts swap yields and their spreads over Treasuries.
Among longer-dated swaps, the five-year spread was last quoted at 115.75 basis points, beating the record 113.25 basis points set earlier.
The spread on 10-year swaps was last quoted 92.75 basis points, the widest since April 2001. (Reporting by Richard Leong; Editing by Dan Grebler)