LONDON, March 13 (Reuters) - Investors piled into relatively risky assets before late February's global market ructions but mortgage market movements may have given advance warning of the turbulence, the BIS said on Tuesday.
In its quarterly review, the Bank for International Settlements cited buoyant economic data, strong corporate earnings and a perception that U.S. interest rates might be on hold for some time as driving a scramble for risk and yield as 2007 got underway.
Global equities surged to new highs, top-rated government bond yields climbed, gauges of future market volatility ebbed and both corporate and emerging market sovereign premiums over benchmark government debt fell to super-tight levels, it said.
But concern about a slowing U.S. housing market and strains on the sub-prime mortgage sector was already evident in credit markets in January and February — well before the steep equity sell-off and credit disturbance on Feb. 27.
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"Spreads in some collateralised debt obligation (CDO) markets, mainly those centred on the housing sector in the United States, widened significantly over the past two months, possibly foreshadowing a broader turn in the credit cycle in the months to come," said the report from the BIS, a forum for central banks around the world.
CDOs pool together debt instruments such as bonds, loans or credit default swaps and then slice them into various tranches, allowing investors to take the risk and achieve the return they desire on a diversified group of assets.
SUB-PRIME WARNINGS
The BIS said spreads on non-investment grade tranches of home equity CDOs had widened considerably in December, reflecting growing bad debts and news of the bankruptcy of several sub-prime lenders in the United States.
It also highlighted an additional widening in these spreads of more than 200 basis points in just two days after HSBC Holdings announced on Feb. 8 an increase in provisions to cover bad debts in its subprime portfolio and after New Century Financial revised down its 2007 loan production forecast.
New Century, the largest independent U.S. subprime mortgage lender, has since moved to the brink of bankruptcy as its lenders plan to halt financing to the company. The U.S. Securities and Exchange Commission and the state of California are both investigating the lender.
Concern about sub-prime mortgages show up most clearly in the so-called ABX subprime indexes in the U.S.. ABX indexes, labelled 07-1 and 06-2, gauge the cost of protecting bonds backed by the riskiest 2006 subprime loans against default.
By Feb. 27 the 07-1 index had fallen over 30 points since launch in January to 63.50. It has since regained a little of its poise and was trading between 68 and 72 on Monday.
"Problems in the sub-prime sector of the U.S. mortgage market have become more visible, although it is not yet clear how these might spill over into the broader credit market," the BIS said.
FED ON HOLD
Its quarterly report went on to highlight a "strong appetite for risk among investors" and accumulation of risky positions prior to February 27's sudden retreat from equity, corporate credit and emerging market assets and despite the alarm bells in the subprime mortgage.
While this buoyancy seemed unusual at a time when global interest rates were rising and both the Bank of England and Bank of Japan hiked official rates, the BIS noted that a more hawkish view of the U.S. rate outlook actually helped reduce expected volatility.
"Uncertainty about the outlook for short-term interest rates fell to new lows in January and February," it said, citing a slide in three-month implied volatility in one-year interest rate swaps and across the debt maturity spectrum in general.
"Possibly, this was a result of growing perceptions among investors that the Federal Reserve would be likely to keep interest rates on hold for some time," the report added.
This decline in volatility may have encouraged investors to continue to reach for risk despite rumblings in the U.S. mortgage market and other seemingly contrary developments.
The BIS also highlighted how credit investors seemed "unconcerned about the ongoing global M&A boom and its possible implications for credit quality".
"Debt financing of these deals...has risen sharply in recent months, possibly signaling a rise in corporate leverage levels."
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