Friday, October 20, 2006

More prescience Down Under

In a follow-on from yesterday's post on the credit-default swap market, comes more evidence - or suspicious indication - of market uber-efficiency. And right in downtown Australia. Today's world of finance knows no boundaries.

Coles Myer Credit Derivatives Fell Before Bid Failed
Traders of credit-default swaps were betting Kohlberg Kravis Roberts & Co.'s leveraged buyout offer for Coles Myer Ltd. would collapse before the Australian retailer rejected the bid.

The price of credit-default swaps based on Coles Myer's A$400 million ($303 million) of bonds fell 7 percent yesterday. The Australian Stock Exchange today said Coles Myer had turned down an A$18.2 billion offer by KKR that would have increased its debt. Shares of the Melbourne-based company plunged 9 percent after the announcement, the biggest drop in four years. Credit- default swaps fell another 33 percent.

``The technical explanation might be that the credit-default swap market is more efficient than the bond or cash equity markets, but the simpler explanation is that the participants in the CDS market have very good information,'' said Volker Marnet- Islinger, who helps manage about $5.6 billion as head of corporate bonds at Cominvest Asset Management in Frankfurt.

Concern that traders in the market for credit-default swaps have access to information before it gets announced has grown in recent months after big swings in prices ahead of buyout offers for casino operator Harrah's Entertainment Inc. and healthcare provider HCA Inc. Money managers including Pacific Investment Management Co. and Fidelity International have said regulators need to better monitor fluctuations. The U.K.'s Financial Services Authority said it's building a computer system to alert it to ``unusual or suspicious transactions.''

Jennifer O'Donnell, head of compliance at the Australian Securities & Investments Commission in Melbourne, wasn't immediately available to comment, said spokeswoman Angela Friend. Scott Whiffin, a spokesman for Coles Myer, couldn't immediately be reached for comment. Zoe Watt, a spokeswoman in London for KKR, declined to comment.

Leveraged buyouts typically cause bonds to tumble and credit-default swap prices to surge because the firms making the acquisition finance the purchase by adding debt.

The credit-default swaps based on Coles Myer debt posted larger declines than other Australian credit derivatives. Credit- default swaps based on bonds sold by Australian companies fell 0.48 percent yesterday and 4 percent today, according to an index compiled by the International Index Company, a London-based venture set up in 2001 to track bonds and credit derivatives.

``If there were leaks coming through yesterday'' and people traded as a result ``it wouldn't be surprising,'' said Stephan Bassas, a London-based fund manager at Blackrock International, which oversees $447 billion of fixed-income assets. He declined to comment on current holdings.

Credit-default swaps, contracts based on debt, are the fastest growing part of the market for derivatives, financial instruments used to hedge risks or for speculation. Derivatives are linked to stocks, bonds, loans, currencies or commodities, or to specific events like changes in the weather or interest rates.

Investors who buy the contracts, sold by financial firms such as New York-based JPMorgan Chase & Co. and HSBC Holdings Plc in London, are paid the face value of the notes should the company default. A decline in credit-default swaps indicates improvement in creditworthiness; an increase suggests deterioration.

Marnet-Islinger said one reason credit-default swap prices may move before an announcement is that the banks and other financial firms that are involved in the transactions may be using the contracts to reduce their risks.

``They're often banks or similar institutions; they might be close to the company or the bidder and can react immediately through the CDS market,'' said Marnet-Islinger.

A London Business School study last year of 79 North American companies from 2001 to 2004 found ``significant'' evidence that contracts were moving ahead of news that could affect credit quality.

Pimco, manager of the world's biggest bond fund and a unit of Munich-based insurer Allianz AG, started warning about the potential for abuse four years ago.

Chris Dialynas, a managing director at the Newport Beach, California-based firm, wrote a report in 2002 calling for the Federal Reserve and regulators to check whether banks were using private information to reduce their loan risk through credit- default swaps, which he said threatened to undermine confidence and curb trading in fixed-income markets.

Banks are the biggest buyers and sellers of credit-default swaps, according to a British Bankers' Association report last month.

"I don't think it needs regulation, just more in-house policing," said T.J. Lim, founding partner of London-based NewSmith Financial Solutions, which advises companies on debt management and financing.


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