Thursday, January 15, 2009

How Lending Impacted Trading

At the root of the credit trading losses was the way banks quit lending to one another amid concerns about failures following the Lehman bankruptcy filing on Sept. 15 and the near-collapse of U.S. insurer American International Group Inc. That upended a popular trade, in which banks bought corporate bonds, then hedged the investments by using derivatives called credit-default swaps to buy insurance against defaults on the bonds. Because the default insurance costs less than the corresponding income from the bonds, the trade allowed banks to reap a seemingly safe profit. When the lending markets froze, though, traders could no longer borrow the money they typically used to buy the corporate bonds. That helped trigger a sharp drop in bond prices, which a rise in the value of the default insurance failed to cover. The mismatch led to losses for Deutsche traders, including Mr. Weinstein.

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