Lehman Brothers filed for bankruptcy five years ago. It was titanic – the largest bankruptcy filing in the history of the US. It was personal, directly affecting friends and indirectly affecting hundreds of other employers (including our own). It was terrible, ushering in a period of volatility where the very fabric of the financial system felt like it was coming apart.

And then, from that darkest hour, things got better. The US government provided an enormous backstop to the financial sector and a new administration injected badly needed stimulus into the economy. The world’s central banks acted aggressively, creatively and with historic co-operation. The relative caution of many non-financial CEOs, who had managed to preserve balance sheet quality despite pre-crisis euphoria, meant a surprisingly short default cycle, given the levels of stress.

Indeed, by May 2009, spreads on liquid credit indices (iTraxx Main, CDX IG) had recovered all of their post-Lehman widening. By the end of 2009, CDS indices were significantly tighter than their pre-Lehman levels. It was a credit market miracle. And then, almost mysteriously, the spread improvement stopped.

Is this lack of progress an indication that credit markets have seen little actual reform? Is it something else? We look at the changes over the last five years in four areas of credit most affected by Lehman’s fall – bank funding, corporate funding, CDS market trading and clearing, and credit pricing.

A shift in how banks fund themselves
A credit crisis requires time and hubris, meaning it rarely strikes the same sector twice. In 1986, falling oil prices brought down an ambitious US energy sector. In the early 1990s it was a confidence bubble bursting in Japan. In 2001-02 it was a TMT sector that used its ‘defensive’ moniker to aggressively increase leverage. And between 2004-07, the rise in gearing was concentrated in global banks, which had navigated the previous recession well and were enjoying some of the highest ratings in their history.

The resulting crisis was the worst seen since the Great Depression, and stressed nearly every part of the banking model. Markets that had been happy to lend to banks more cheaply than corporates suddenly (and dramatically) changed their mind. Investors who had previously paid little heed to loan/deposit ratios now questioned why they were so high. A world that had previously tolerated investment banks to run with leverage of 30-40x was now demanding half of that. The banking sector has spent the last five years addressing these issues, some with more success than others.
We start with funding. Fig.3 shows loan/deposit ratios in three regions (the US, UK, and Western Europe) since their peak. The US has made the most progress, with a loan/deposit ratio that is now ~70% (lower than where Japanese banks were in 2005). The UK has made impressive strides, pushing loan/deposit ratios from 127% to 95%. The rest of Europe has improved, but with a lag, roughly mirroring the pace of Japanese banks in the mid-1990s.

This improvement has been the result of fewer loans (deleveraging) and increased deposit-gathering (aided by cautious consumers). This has narrowed the ‘gap’ in funding that banks need to raise elsewhere, resulting in remarkably lower bond issuance. Fig.4 shows LTM net issuance (bonds issued minus bonds maturing) for financials since 1995. The rise in 2004-07 reflected banks trying to grow their balance sheets much faster than underlying deposits. The drop since shows its reversal. Banks have gone from one of the largest net issuers of corporate bonds to one of the largest redeemers – a powerful (positive) technical.

Lehman’s bankruptcy also forced banks to change the way they approach capital. Here, progress is more varied. Measured on core Tier 1, both European and US banks have seen capital levels move dramatically higher, improving from 6-7% in 2008 to 11-12% in 2013. When we consider that this has occurred despite heavy crisis-driven losses, it is impressive indeed.

However, other measures of capital show less uniform progress. If we ignore ‘risk weightings’ and focus simply on the amount of common equity being held against each asset, a major US improvement contrasts with a more modest European one. US banks, under pressure from more aggressive regulators, are substantially better capitalised than before Lehman’s fall, under either measure.

These improvements are more than cosmetic, and have had an effect on market-based proxies of bank financial health. In Fig.5, we show the difference in funding costs between financial and non-financials, in both the US and Europe. Prior to Lehman’s collapse, banks funded at cheaper levels, making it profitable to borrow and re-lend these funds to corporates. The crisis dramatically shifted the maths, but five years later the differential has normalised significantly.

Besides the normalisation of what investors charge banks relative to other companies, there has been a notable improvement in measures related to liquidity and funding stress. The Euribor/Eonia spread, Libor-OIS spreads and the EUR/USD basis swap all currently sit near their lowest levels of the post-Lehman period. All speak to significantly less stress, and better balance, in banks’ funding profiles.

A shift in how corporates approach funding
While banks have seen the largest changes to their funding models post-Lehman, non-financial companies have also responded to the stress in their lenders and the vulnerabilities this revealed in their previous funding strategies.

The first change, more noticeable in the US than Europe, has been the extension of liabilities through the issuance of longer-dated bonds. 2008/09 saw extremes in the volatility and availability of credit through the new issue markets, and in the years since, the issuance of longer-dated bonds has offered issuers the ability to lock in low rates and retain the option of staying away from capital markets for extended periods of time.

Although Europe has been slower to embrace the extension trend, it has seen more changes in how companies fund in the first place. Loan financing, which accounted for around 50% of funding for European high-yield companies in 2011, now accounts for around 35%. Bond usage is up by a similar degree, and while this still trails the US, the gap is significantly smaller than what we feel is commonly believed.

Another (perhaps unsurprising) legacy of Lehman is the desire to pair higher cash holdings with longer-dated, more bond-focused liabilities. Cash/debt levels rose in the aftermath of the crisis, and have kept rising in Europe as new challenges have materialised. We take this as a sign of a desire for flexibility, as much as caution. Any CEO who experienced the crisis was either thankful for the flexibility that a large cash buffer offered, or painfully aware of the lack thereof.

A standardised and transparent CDS market
The asset class within credit that has probably come under the most scrutiny due to the crisis and also seen the greatest amount of reform in the last five years is the credit derivatives market. Amid the unprecedented market volatility of the crisis, the several vulnerabilities of the CDS market were exposed. Contract mismatches (different coupons, contract languages) for the same credit reduced netting ability and caused a build-up of large notionals. Counterparty risk fears due to a number of defaults from institutions once thought unassailable and lack of collateral posting agreements in some cases affected CDS. While the CDS market had undergone a few rounds of standardisation before, the crisis, and the challenges it highlighted, were key drivers in shaping the CDS market into a more efficient form today.

First, the contract underwent several key changes, with what was known as the ‘Big Bang’ protocol in the US, followed by a similar ‘Small Bang’ protocol in Europe. The focus of the changes was to further standardise CDS, improve netting and improve liquidity and transparency, with the ultimate objective being exchange trading/clearing. Changes included:

• Coupon standardisation: The CDS market moved from a par swap contract to one with fixed coupons of 100bp and 500bp. The main purpose of this change was to make the unwinding and netting of risk simple, and make contracts fungible in the clearing house.
• Contract standardisation: Prior to the SNAC changes in the US, restructuring was a credit event trigger for single-name CDS, though not the indices. In 2009, the US credit events were changed to include only bankruptcy and restructuring, consistent with the index contract.
• Other contract changes (hardwired credit event settlement and dispute resolution): The already well established ISDA process for credit event settlement via the auction process went from optional (though had very high participation) to mandatory. Additionally, the dispute resolution process became the standard for dealing with any potential disputes in credit event declaration, deliverability or succession events. Finally, the new contract narrowed the window in which a credit or succession event could be declared.

Finally, there have been a number of reforms to the market stemming from the implementation of Dodd-Frank and other regulatory endeavours, including real-time reporting and mandatory clearing for index-based products. These are more recent changes, and much of the implementation has been only in the last several months. Related to this, the market has undergone several exercises designed to reduce the overall number of contracts and gross notional amounts outstanding, with some success.

CDS de-risking and shift to index products
The crisis also focused market attention on reducing notional risk. The combined effect of the netting and maturing of legacy CDS positions has resulted in a major de-risking of net notionals in the CDS market across regions (see Fig.7). One of the big drivers of single-name CDS volumes was also the CSO flows, which is absent today. Thus, the emphasis has shifted to indices and index-based products, and away from single-name CDS and bespoke structures. Perhaps the most visible manifestation of this is illustrated by the growth in the credit index options market, which has gone from a handful of trades, mostly in Europe, to one of the most liquid products in the credit markets today, second only to the CDS indices.

The advent of the credit options market has brought with it some important changes to the overall culture of credit as well, in our view, as credit went from being a product primarily valued by default risk, to one where volatility was acknowledged to be an important part of the risk premium. Anecdotally, we would argue that this market has brought back the culture of hedging in credit, not entirely dissimilar to the genesis of the CDS market in the late 1990s (although from a default risk perspective). This time around we saw greater interest from non-traditional credit investors, particularly in the late 2011 volatility period. The influx of macro-focused investors into credit also helped this shift towards index-type products.

In Asia, the changes that occurred in credit derivative markets globally, particularly related to the pricing of counterparty credit risks, stalled the growth of what looked like a promising CDS market. Consequently, even as Asian cash markets grew at a compounded annual growth rate of 20% over the last five years, CDS market growth stayed flat. This is illustrated by the significant shrinkage of iTraxx AxJ gross notional outstanding as percentage of cash market size from 70% to 26% (see Fig.8) and in the contraction of median notional outstanding on single-name CDS by about 5% since 2008.

Another reflection of this trend would be the list of issuers in iTraxx Asia IG index which is no longer reflective of the Asian credit market, considering the panoply of issuers that have tapped USD bonds markets but are not a part of the CDS index. As the market moved from CDS to cash on the supply side, we saw a shift on the demand side towards asset managers and other real money investors. Investment funds now account for about two-thirds of allocation in the primary market, and the significant chunk of this demand comes from cash bond-focused real money investors.

Tranches and capital structure pricing
The CSO and index tranche market was at the centre of the post-Lehman storm as structural and financial leverage unwound during the crisis. While we don’t go into the details of these in this report, we had a significant reduction in activity and a shift in the investor base and the nature of risk-taking in these products. The securitised form of tranches (bespokes) was a large and influential market pre-Lehman, and drove the liquidity of the single-name CDS. Tranche risk-taking was dominated by banks/insurers, focused higher up the capital structure, and ‘ratings efficiency’ was a very important consideration. In a benign, low default environment where central banks were deemed to have the tools to avoid any tail scenario, any spread on the super senior risk was considered worth selling (i.e., long risk). As such, the leveraged super senior (LSS) drove spreads in this part of the capital structure to single-digit levels pre-crisis. These flows naturally unwound as volatility of spreads and defaults in US credits caused losses.

Five years on, the nature of risk-taking is very different and, not surprisingly, this is reflected in valuations across the capital structure today versus levels we saw pre-crisis. Given the pain associated with the unwinding of legacy LSS positions (among other factors), the senior part of the capital structure has not traded at comparable levels pre-crisis. From a risk-taking perspective, the super senior risk appetite is nowhere near as strong today and, within tranches, there is a defined bias towards junior forms of risk. Ratings do not matter anymore as the investor base has shifted away from banks.

Looking at spreads offers some insight into the significant pricing differentials (see Table 1). Even as the broader index trades roughly flat to levels seen in September 2007 and 2008, equity tranches in the ‘clean’ IG19 portfolio trade over 20 points tighter. Even the IG9 10Y portfolio with more than 15 high-yield names has equity tranches trading tighter than pre-crisis levels. As such, junior risk has (more recently) benefited from strong flows, given wide spreads (relative to default risk), lower portfolio tail risk, the demand for double-digit-type yields and a general scarceness of distressed assets. In contrast, junior mezzanine tranches trade almost 100bp wider than levels seen in September 2007. Bottom line – idiosyncratic and levered risk (junior tranches) has found new sponsors but systemic/cyclical risk premiums are still very high.

The high-yield/investment-grade compression
The Lehman event also precipitated a change in the mindset of credit investors in pricing credit spreads. Pre-Lehman, high-quality investment-grade (IG) credit was perceived to be default-remote and therefore commanded very little spread. Little attention was paid to the other major driver of credit spreads: volatility risks. However, the credit crisis flipped the relative importance of volatility versus default risk in investors’ minds. With corporates becoming more conservative and hoarding cash, staving off defaults, we have had high-yield (HY) credit do quite well in the last several years. IG credit, on the other hand, has continued to pay a high spread to compensate for the systemic risk spike that was still fresh in the memory. Particularly in Europe, this IG credit under-performance is significant and continues to persist, although other metrics have healed. This HY/IG spread compression might have been justified when systemic risks were high but is out of place in a world where volatility in FX and equity markets is already through the Lehman levels, in fact almost 30-50% lower than those levels. If systemic risk is indeed reduced as options markets across asset classes suggest, high-quality credit has to be a major beneficiary of this healing as it is more sensitive to the broader market volatility.

What trades tighter/wider to pre-Lehman levels
At the single-name level, there is considerable dispersion of names which have the same (whole letter) rating today relative to the pre-Lehman era and yet trade materially wider or tighter than spreads in that regime. In Europe, the list of names trading wider than Lehman levels is dominated by the financials and utilities, whereas the list of names tighter is dominated by consumer cyclicals.

In the US, we see a pretty even mix of sectors when looking at names that trade wider today. However, names that trade tighter today are dominated by consumer cyclicals.

This article is based on a research note that was published on 13 September 2013 by Morgan Stanley Research.