The Financial Times reported this morning that trouble in the US mortgage markets roiled investors in the derivatives markets the world over yesterday:
Investors in European and US credit markets accelerated their flight from risk yesterday as the turmoil from the US mortgage markets continued to spill over into other asset classes. The change in sentiment, which triggered violent swings in credit derivatives markets, suggested that the fallout from the recent problems in the subprime mortgage sector could be spreading to other corners of the financial world .. JPMorgan said the swings in derivatives prices were so extreme that they implied “scenarios in which the core of the global liquidity system suffers a serious assault”. But it stressed “the meltdown in the credit indices seem completely at odds” with trends in the real economy, implying it should be reversed.
Which explains why all eyes are probably on Deutsche Bank today — the co-head of the investment bank, Anshu Jain, is scheduled to speak. And when Jain speaks, market makers will likely listen: Jain called the subprime slump more than one year ago, when nobody really thought he would be right.
… Mr Jain is keen to avoid sounding alarmist about market woes. However, he accepts that there is now a rising danger of so-called “event risk”, not simply in the subprime sector, but also in leveraged finance – the business of lending to risky clients, such as buy-out groups. “The question is whether what has happened in subprime could now be repeated in leveraged lending, given that leverage ratios continue to ratchet up,” he told the Financial Times ahead of his Barcelona speech. “[It is] likely not – at least for as long as the world economy keeps growing in line with our analysts’ projections. [But] if growth slows down, there could be consequences” … Mr Jain, for his part, does not expect to see widespread panic. “Certainly, there may be more pain to come in CDOs based on subprime collateral – but most of the participants in this market are real money investors who don’t employ irresponsible leverage ratios. They aren’t likely to suffer devastating losses.”
This should come as good news to nervous portfolio managers, given Jain’s track record, but my concern here is an overreliance on the “market participants know what they’re doing” logic.