Hedge funds, banks and other financial institutions come under pressure to cut their losses before conditions deteriorate further.

Tim Bond, head of global asset allocation at Barclays Capital, said: “It’s inflicting heavy losses on the banking system, eroding their capital and reducing their ability to lend. The spread widening is so severe, you’re seeing a rise in borrowing rates across the board for everybody except top-quality governments. It’s affecting both the price and availability of credit.”Turmoil in the credit derivatives markets is having an increasingly brutal impact on the wider financial system as a vicious cycle of forced selling drives risk premiums on company debt to new highs
The trend accelerated on both sides of the Atlantic last week as investors rushed to unwind highly leveraged positions in complex structured products. The cost of protecting US investment grade debt against default soared to a high of 188 basis points, from 80bp in January.Institutions that lapped up credit risk products in recent years – many financing their purchases through borrowing – are scrambling to reduce their exposure following heavy losses, traders say.
But many investors fear conditions could worsen as hedge funds, banks and other financial institutions come under pressure to cut their losses before conditions deteriorate further.Liquidating structured credit instruments requires buying large amounts of protection using credit default swaps. This, in turn, drives the cost of protection higher, potentially triggering a chain reaction.
“There is potential for some wild and possibly inexplicable price movements as the unwinds get bigger,” said Mehernosh Engineer, credit strategist at BNP.
The markets are so illiquid that a few trades can lead to sharp movements, producing violent price swings and knock-on effects.Some structured credit vehicles have in-built triggers that force them to be liquidated.Bank of America estimates that if the cost of US investment grade credit insurance rises above 200bp, the unwinding of structures could trigger a jump towards 220bp.Jim Sarni, portfolio manager at Payden & Rygel, an investment management firm, said: “The market is very concerned about counterparty risk and how stable positions are as they are marked to market as prices keep falling.”