"SUB PRIME connected to your RMBS connected to your ABX connected to LCDX connected to Credit in general"

Having negotiated the change in short rate expectations over the last six weeks, the credit markets are now re-focussed on the fall-out from the US sub-prime meltdown. The connection between the US housing market and the risky bond markets in Europe is tortuous but understandable.

The US housing market has been spurred on by crazy lenders willing to lend to anyone with a pulse. These lenders then sell on the mortgages to others who repackage them up into groups of asset backed bonds (residential mortgage backed securities). These RMBS asset backed securities were again re-packaged into CDOs (collateralised debt obligations) and then re-sliced into high and low risk tranches.

These complicated CDO structures tend to be relatively stable (due mainly to a lack of transparency) but also because they are usually heavily diversified. The tranches are sold to banks and other conservative long-term investors who don't need to mark to market daily. Expected returns reflect the level of risk being taken, but the distribution of actual returns can be very different. The two main events that can undermine this stable relationship are large downgrades of the underlying bonds or large defaults of the borrowers.

We haven't had any meaningful defaults for such a long time that there is increasingly a large amount of complacency. The longer the period of low defaults and low volatility goes on, the more money that is thrown at structures that leverage the spread. The second concern, downgrades, has more recently come to the fore. The most recent example of a downgrade impacting structured credit prior to last week was the Ford GM downgrades of July 2005 which caused a significant wobble in the credit bull market.

This time it is not company downgrades or defaults, but personal mortgage delinquencies that are causing the excitement. Moodys have spotted that some of the mortgages in some RMBS may not get repaid and so downgraded certain securities reliant upon them. This had the effect of forcing some CDO structures to be re-valued. Most of these structures are designed to be fixed for the term life of the issue. Mark to market of the underlying bonds does not really happen so anything that forces the investors to lift the lid and have a look inside can be a rude awakening.

The recent problems at a Bear Stearns supported hedge fund that invest in CDOs highlighted this transparency issue. The hedge fund buys tranches of CDOs that are constructed from sub-prime RMBS type bonds. It has taken several months for the problems of these sub-prime assets to work up through the system and affect the hedge fund's performance. Without the support of Bear Stearns, the fire sale liquidation of the assets would provide a price for many holdings in other CDOs thereby throwing into doubt the value of other similar securities.

Central banks have been relatively complacent about the systemic risk of this house of cards. They argue that the risk is heavily diversified amongst a large group of investors. They may have a point. The creation of instruments that enable investors to hedge credit risk - such as credit default swaps have reduced the possible fallout from actual defaults. The risk from downgrades and devaluation is harder to hedge against, although the creation of indices that can be used to short the credit markets has helped.

In a previous note we described the ABX indices that are used to hedge repackaged mortgage credit risk. The declines in the ABX Index earlier in the year were a good warning sign that the sub-prime mortgage market problems were impacting upon investors. The price of the lowest rated ABX Index has taken another lurch south as the news about the Bear Stearns hedge fund problems have started to break.

Similar signs of stress are just appearing in corporate land: a relatively new instrument, LCDX (a basket of leverage loan default swaps), has had a difficult start since it was launched in May. The spread has widened from 103bps to 114bps in the space of 17 days as investors use it to hedge their loan risks.

In general there has been deterioration in the quality of the pool of loans of late due to increasing demand for loans with reduced covenants (cov-lite). To hedge the risk that these new loans are going to struggle in an environment of declining corporate profits, investors have been using the LCDX to hedge their underlying loan book. ABX and LCDX instruments are like the canaries in the mine. They provide early signals of stress but ultimately limit the damage.

As we have said before - investing in risky credit these days is dependent on the liquidity story rolling on. We are in the final phase where deteriorating fundamentals, low spreads and rising borrowing cost will eventually burst the credit bubble. The connections between the various parts of the credit bubble are difficult to follow, but worth understanding nonetheless.