Credit spreads snap week-long rally

European credit spreads widened on Monday, halting a week-long sharp rally, after Bank of America Corp revealed a bigger-than-expected drop in quarterly profits. By 1535 GMT, the Markit investment-grade iTraxx Europe index was at 86.5 basis points, according to Markit data, 5 basis points wider versus late on Friday.
The iTraxx Crossover index, made up of 50 mostly "junk"-rated credits, was 13 basis points wider at 477 basis points. Both indexes hit contract lows earlier in the session and had shrugged off weak earnings reports from Citigroup Inc, J.P. Morgan Chase & Co and Wachovia Corp last week.
But the mood turned slightly more negative on Monday after Bank of America said quarterly profit fell 77 percent, dragged down by some $5 billion of writedowns and credit-related costs.
Results fell short of analyst forecasts as more consumers and businesses fell behind on debt payments. "The banking results are showing writedowns across the different asset classes. It's not just mortgages anymore, they are showing writedowns in small business loans and on consumer debt like auto loans," said Willem Sels, a credit strategist at Dresdner Kleinwort.
Sels said that if tight lending standards persist, corporate defaults will start to rise relatively sharply. Sels, like many other credit strategists, believes credit spreads have rallied too sharply.
Also in the spotlight was a plan by the Bank of England to support the UK mortgage market by offering to swap government bonds worth 50 billion pounds ($99 billion) for bank mortgage securities. "The key test will be whether banks, if they do manage to clean up their balance sheets, will actually start to lend more," said Sels.
Elsewhere, the cost of insuring the debt against default of European papermakers Norske Skog and UPM-Kymmene was volatile after Standard & Poor's downgraded the credit ratings of both companies by one notch.
Five-year CDS widened by about 30 to 40 basis points after the ratings action, but fell back. Five-year CDS on Norske Skog were at 860 basis points while UPM CDS were at 320 basis points by late afternoon, according to Markit, about 5 to 10 basis points wider on the day.
S&P cut Norske Skog's rating to BB-, and said it may do so again, downgraded UPM to BBB- and changed its outlook on Sappi to negative from stable, citing weaker demand prospects and sustained cost inflation.