"Donald, where are your true losers?"

One of the interesting facets of the current credit market sell-off is the underperformance of financial institutions compared to industrial companies. The chart below shows that banks (red line) had typically paid less than industrials (blue line) to borrow in the sterling bond market, but that the trend has recently reversed:

While that is hardly surprising in the context of the US, which has an obvious problem in the form of rocketing sub-prime mortgage delinquencies and falling house prices. When shown against still decent corporate profitability and low defaults, it is less obvious why this should be the case in Europe, or specifically UK (see chart above) where sub-prime constitutes much less of the mortgage market, delinquencies remain low, and in most countries property prices are still going up, albeit at a slower rate. Equally, it is unusual to see almost as much weakness in 'safer' tiers of bank debt (Senior and Lower Tier II) as in riskier tiers (Upper Tier II and Tier 1).

Protestations from heads of European banks that exposures to US sub-prime are 'easily manageable', 'negligible', or even 'zero' are falling on deaf ears, partly perhaps because some of the early protestations proved hopelessly optimistic (e.g. IKB, LB Sachsen have both already undergone state-engineered bail-outs), also because the complexity of the financial system has increased with greater derivatives usage, and (as we have written in recent pieces) banks are hording cash in case they have unforeseen liquidity needs, and because they are nervous about lending it to their competitors who might have exposure either directly, in structured or in derivative form. Ultimately, no-one knows exactly how far the repercussions will be felt across the banks' other lines of business. This situation is not sustainable, because in the long run, well rated banks will not lend to lower rated corporates at a yield below their own funding cost.

The five-year regression analysis on the sterling market amply illustrates that it is highly unusual for bank debt to trade at such a higher spread relative to corporate debt: the red dot is the current relationship while the blue dots show how that relationship has been deteriorating over the past year or so, compared to the longer term relationship (2002-2006, shown by the yellow and green dots).

The former US Secretary of State for Defence, Donald Rumsfeld, could have been speaking for many banks Chief Credit Officers, nervous of lending into the inter-bank market for fear of a black hole, when he said: "Reports that say that something hasn't happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns - the ones we don't know we don't know."

First the "known knowns": Everyone knows that one of the ways banks make money is by borrowing short term and lending longer term. No-one who opens a newspaper can be unaware that sub-prime mortgage borrowers are defaulting in their hordes, due to lax underwriting standards, and the pain of higher interest rates once teaser rates fall off, and BBB tranches of sub-prime RMBS are the new weapons of mass destruction. Also there is a glut of bridge-type leveraged loans used to fund LBOs that needs financing, and a buyers strike.

Next the "known unknowns": we know a lot of the delinquent mortgages no longer reside with mortgage banks that originated them, but have been repackaged and sold on to other investors - but we don't know who and how much, only that it is somewhere in the financial system. We also know that a lot of this repackaged debt forms the collateral for ABCP issuance, but the individual ABCP programmes are generally opaque.

Finally the "unknown unknowns": how much will bank balance sheets balloon as repackaging/re-financing routes (ABCP, CDO, RMBS, high yield bonds) are closed off and what exactly are the linkages between the volatility in the financial markets and the general economy? What might be the further unexpected consequences of current events? And what about the 'deus ex-machina' that is central bank intervention?

Outlook: Rumsfeld also had some words of wisdom here, once famously saying: "I would not say that the future is necessarily less predictable than the past. I think the past was not predictable when it started". Bottom line, we can expect more volatility, but the relationship between banks and corporate spreads will need to normalise (in favour of strong, diversified banks).