Deutsche Bank issued a report showing spreads on single-A rated corporate bonds now imply an out-of-this-world default rate of 15%. Credit spreads have widened dramatically since June 2007 and offer incredible value. The report came out just as the US Federal Reserve connived with JPMorgan to take over Bear Stearns at a humiliating price, and value in credit has risen since. So why arenÆt fund managers rushing to buy?

One reason is that some managers at dedicated bond houses say the tight spreads of early 2007 û when some banksÆ implied default cost only 2 basis points û was a delusion. Think of the Nikkei hitting 39,000 points in 1989. You can still find the occasional Japanese equities manager who looks at todayÆs levels (around 14,500) and sees huge upside based on historical levels. ItÆs a mirage. Credit spreads are not going to return to June 2007 levels any more than the Nikkei is going to return to the heights of the 1980s.

The illusion was created because of huge demand for credit default swaps to create leveraged structures that gave investors yields they could not otherwise achieve in an era of low volatility, high correlations among asset classes and strong economic growth.

This in turn was made possible because of securitisation, allowing risk to be chopped up and spread around, away from the lender û and done so in an atmosphere of easy money, light covenants and little due diligence. The combination of weakening economic fundamentals in the United States and Europe, combined with the unwinding of massive (and still unknown) amounts of leverage, has brought securitisation and the financial system to its knees.

ôIf this crisis were just about liquidity in banks, then the FedÆs actions [opening its discount window to investment banks, slashing interest rates to stimulate growth] would have been enough,ö says one bond fund manager in London. ôBut we donÆt believe itÆs just that. The problems of liquidity show weÆre just at the first stage of significant re-pricing and de-leveraging.ö

Interviews with several managers at specialist bond-fund houses in London show the buy-side has become pessimistic that the credit crisis can be solved without massive government intervention.
ôMarch is when everything stopped working,ö says one portfolio manager. Although the crisis has been unwinding since June 2007, market participants had continued to believe things would return to normal, that the crisis was simply about US subprime mortgages in dubious structures.

But the first quarter of the year saw the likes of Carlyle GroupÆs bond fund and Peloton Partners fail, not because of subprime but despite portfolios of high-quality assets; they were hurt instead by margin calls.

ôYou canÆt even trade triple-A paper,ö says a manager. ôItÆs not about the companyÆs fundamental value, but the lack of liquidity. ThereÆs no fresh cash coming from the market. Who are the buyers? ItÆs like waiting for Godot.ö

The Fed has tried to restore liquidity, first by slashing interest rates, and then by orchestrating the rescue of Bear Stearns, in which it opened its discount window to a securities company (via the auspices of a bank, JPMorgan), and pledged $30 billion to cover any bad Bear assets if JPMorgan would take it over.

On the one hand, this act relieved bond investors. It showed the Fed was drawing a line in the sand, that it would do anything in its power to avoid the collapse of a major counterparty. But the Bear episode is also frightening: it appeared to be solvent and creditworthy just days before the rescue. This, after a continuing string of problems at other investment banks (SocGenÆs fraud and subprime losses, or Credit SuisseÆs first announcing good results and then revealing another $1 billion loss a week later). Confidence has not been restored, and therefore there is no buy-side. The Fed is injecting lots of money but these are one-offs; thereÆs no continuous secondary market. Fund managers still lack any sense of the value of paper, whether itÆs double-B or triple-A.

The only way to re-establish the true price of risk (by anchoring a recognised value for the most safe triple-A paper) and create a continuous pool of demand is creating a buyer of last resort.

In the 1990s savings and loans crisis, the Resolution Trust Corporation played this role. It spent $400 billion to buy these failed banksÆ assets, or 9% of GDP. If the US government were to act today in a similar capacity, spending 9% of GDP to salvage the banks would cost taxpayers $1.2 trillion.

It could be a good deal for those taxpayers: the government could borrow at rock-bottom rates to buy outstanding credit. It doesnÆt have to mark these to market. It can sit on these bonds for a few years, stabilise and restore the market, and realise a terrific return. Lesser options would be to explicitly back mortgage agencies such as Freddie Mac and Fannie Mae.

The other option is to allow sovereign-wealth funds serve this role û which might be better for taxpayers and avoids the need for an overt bailout, but could prove politically difficult, particularly in a US election year.

Either way, bond investors are convinced Bear Stearns is not the last bank to disappear. The Fed might rescue other banks but it canÆt allow them to resume business as usual. This is likely to involve either taking specialised firms (like a Bear Stearns) and merge them into bigger, more diversified groups; or in the example of Citi, perhaps forcing it to sell crown jewels like its Salomon Smith Barney investment bank.

In the meantime bond fund managers see lots of value in these credits but arenÆt willing to start chasing bargains until they are confident theyÆre not going to get burned. And in the past two weeks that has come to mean waiting for massive government intervention.