The Beginning of the End (Part 2)

No, we don’t mean the end of the world, but the end of this credit cycle.

An aside: forgive us if you found some of our posts last week sketchier than usual. We’re at a location with very erratic broadband, which makes it hard to get anything Internet-related done efficiently.

We’ve run a few comments on the topic of liquidity and unusually tight risk spreads, meaning investors are accepting relatively low returns when they are making risky investments (or in more colloquial terms, investors are so desperate to get higher returns that they are willing to buy just about anything). One of our recent posts asked the question “Where has the perception of risk gone?” We are starting to see the answer.

Defaults on sub-prime mortgages, mortgages given to particularly weak borrowers, have risen sharply. In the Wall Street Journal article below, we are also seeing signs of distress among weak corporate borrowers and a sharp increase in the interest rate premium charged to certain types of risky corporate creditors.

It isn’t as if the economy is about to fall off a cliff. But it has also been a long time since this economy has experienced tight credit, specifically, since the early 1990s. The Fed has created liquidity at any sign of a downturn, and even in the reasonably robust economy of 2003-2006, money supply growth has been around 10%. But instead of inflation, we are getting asset bubbles. Price/earnings multiples are averaging close to 20 times earnings, which is greatly overvalued given 10 year bond rates of about 5% and no obvious engine of growth for the economy (consumers are overextended and it’s not clear what could take up the slack).

If we start seeing more distress among weak credits in other areas of the economy, credit spreads should widen (i.e., the weak will have to pay more than now). And in a tightening credit environment, the story isn’t just about rates but willingness to lend. For example, nominal interest rates in the early 1990s weren’t all that bad, but banks weren’t willing to lend to many types of borrowers, particularly small businesses. Again, this isn’t the early 1990s, since banks have much stronger balance sheets, but a more stringent attitude towards lending will at a minimum put a damper on growth. And as we’ve noted before, if there was a crisis a la 1998 and a flight to quality (meaning prices of risky assets fell sharply), you could see a lot of damage to hedge funds and to investment banks that were heavily exposed to them.

From the Journal’s story, “?”

Even as banks suffer a bad housing-boom hangover — brought on by risky loans to some customers who are suddenly unable to pay them back — the lending bender continues in a similarly precarious market: corporate high-yield debt.

Emboldened by default rates that keep moving improbably lower and a credit cycle that seemingly refuses to turn south, investors keep lending their money to highly speculative companies that appear to exist solely at the mercy of the next refinancing.

“The assumption is that the broader underlying fundamentals remain strong,” said John Olert, an analyst with Fitch Ratings. “But typically, assumptions are made about the broad market that may or may not hold water in a worse market.”

Banks are finding out exactly how wrong some of their assumptions can be. In recent weeks, subprime lenders have been hit hard by mortgage defaults at levels that seemed like a distant possibility just a year ago….

Yet an eerily similar scenario is still playing out in the high-yield debt market, particularly in the riskiest sectors of that market, and many investors seem disinclined to believe that a day of reckoning is inevitable.

“I don’t think it’s happening yet [in high yield] because liquidity is robust enough to delay any type of effect,” Mr. Olert said.

Indeed, many cite the influx of money into credit derivatives, which has helped investors to spread out their risk and provided ballast for the high-yield market as a whole. Some have even suggested that derivatives such as collateralized debt obligations have permanently altered the historical rhythms of the credit cycle.

But Mr. Olert said the signs of increasing risk are apparent by the amount of companies shifting toward the riskiest end of the ratings spectrum. Bonds assigned a CCC rating by the three major rating agencies currently constitute 15.9% of all junk bonds, according to the Merrill Lynch High-Yield Master II Index. Since 1996, the percentage of CCCs has ranged between 5.9% and 17.5%.

Investor confidence has been bolstered not only by low default rates, but by historically high recovery rates of 65% for bonds and nearly 90% for leveraged loans when these companies do default, according to Edward Altman, a finance professor at New York University’s Stern School of Business.

“It’s not only the low default rate, it’s also the high recovery rate. We’ve never seen that before. This is an indication to me that the situation will not persist,” he said.

With many predicting an economic slowdown and a rising default rate in 2007, some analysts say investors in the riskiest junk bonds will be exposed to potentially severe losses when the companies that issue these bonds run into trouble. But many market participants were sounding similar alarms a year ago, and instead investors rode a booming junk-bond market to double-digit returns in 2006.

The comeuppance has clearly begun for some dabbling in derivatives linked to subprime home loans. On Friday, the riskiest BBB-minus slice of the benchmark ABX derivative index widened by 1.5 percentage points to 8.75 percentage points over the London interbank offered rate, or Libor. Less than a month ago, that figure stood at 4.62 percentage points.

The ABX index, which was created about a year ago to help investors hedge their exposure to the housing market, includes five subindexes ranging from the highest AAA slice to the lowest, and riskiest, BBB-minus slice. Investors such as hedge funds and banks wagering on the performance of subprime loans have focused their trades on the riskiest tranche of the index in recent months.

Meanwhile, risk premiums for highly speculative bonds have fallen to historic lows. The index of CCC-rated bonds posted a record-low spread level of 4.59 percentage points in late January, according to Merrill Lynch, well below the historical average of 11.20 percentage points over 10-year Treasury notes.

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