In particular, due to the growing presence of new participants in credit markets with greater risk tolerances, it seems that firms with lower creditworthiness (credit ratings) may have found it easier to refinance and restructure their debt. This refinancing activity has included the greater use of weaker loan covenants than in the past. Thus, to a certain extent, firms may only be deferring their financial difficulties into the future. When the credit cycle finally turns, the consequences could be more abrupt and severe than past experience might suggest. In this context, the recent episode of re-appraisal of credit risk pricing in the US sub-prime mortgage market may provide some guidance on how the credit market could behave in a broader downturn. Since mid-2005, the combined effect of resets of initial borrowing terms to higher interest rates and reduced abilities of borrowers to avoid such resets through house sales or to carry out cash-out refinancing, has been associated with rising delinquency rates on securitised sub-prime mortgage loans. The impact of sub-prime mortgage delinquencies on the lower-quality-end of the credit risk transfer (CRT) market has been substantial. Early this year, the concern of market participants about deteriorating sub-prime credit quality led to a significant and, so far, persistent increase in the cost of credit protection associated with sub-prime non-agency residential mortgage-backed securities (RMBS), as shown in the chart on the right of slide 5. Box 2 of the Review contains a more detailed assessment of the potential risks of the sub-prime episode.
It concludes that there is some concern that the deteriorating performance of sub-prime RMBS could affect the broader market for structured credit instruments, due to the fact that the concentration of sub-prime mortgage loans as collateral for collateralised debt obligations (CDOs) is very high. It cannot be ruled out that further poor performance of this type of collateral could trigger rating downgrades of CDO tranches themselves and lead to a reassessment of risk in other segments of structured credit markets. Financial market liquidity An overarching theme, pertaining to several sources of risk and vulnerability in the financial markets, is the abundant liquidity characterising global markets. Indeed, there appears to be a consensus among market participants that market liquidity has reached unprecedented levels. Financial market liquidity is a measure of the ability of market participants to undertake securities transactions without triggering large changes in their prices. The concept of financial market liquidity is distinct from the concept of monetary liquidity, but there can be links between the two. Although the measurement of market liquidity is rather complex, symptoms of the abundance of liquidity include high leverage, low yields, low market volatility, narrow credit spreads, and high market turnover. Overall, abundant liquidity seems to be intertwined with the “search for yield” which has been discussed in past issues of the FSR and it appears to be dependent on confidence remaining in the smooth functioning of the market.