Tuesday, June 19, 2007

Credit Market Doomsday #2

This from yesterday’s Wall Street Journal, a different take on the credit markets. It appears that some people are getting nervous about the credit markets.

. . . . In this fast-growing arena of loans to business -- these days, mostly, private equity deals -- lending proceeds as if the subprime debacle were some minor skirmish in a little known, far away land.

How curious that so many in the financial community should remain blissfully oblivious to live grenades scattered around the high-yield playing field. Amid all the asset bubbles that we've seen in recent years -- emerging markets in 1997, Internet and telecoms stocks in 2000, perhaps emerging markets or commercial real estate again today -- the current inflated pricing of high-yield loans will eventually earn quite an imposing tombstone in the graveyard of other great past manias.

In recent months, lower credit bonds -- conventionally defined as BB+ and below -- have traded at a smaller risk premium (as compared to U.S. Treasuries) than ever before in history. Over the past 20 years, this margin averaged 5.42 percentage points. Shortly before the Asian crisis in 1998, the spread was hovering just above 3 percentage points. Earlier this month, it touched down at a record 2.63 percentage points. That's less than 8% money for high-risk borrowers. . . .

. . . . The low spreads have been accompanied by less tangible indicia of imprudent lending practices: the easing of loan conditions ("covenants," as they are known in industry parlance), options for borrowers to pay interest in more paper instead of cash, financings to deliver large dividends to shareholders (generally private equity firms) and perhaps most importantly, a general deterioration in the credit quality of borrowers.

In 2006, a record 20.9% of new high-yield lending was to particularly credit-challenged borrowers, those with at least one rating starting with a "C." So far this year, that figure is at 33%. No exaggeration is required to pronounce unequivocally that money is available today in quantities, at prices and on terms never before seen in the 100-plus years since U.S. financial markets reached full flower.

Why should so many theoretically sophisticated lenders be willing to bet so heavily in a casino with particularly poor odds? Strong economies around the world have pushed default rates to an all-time low, which has in turn lulled lenders into believing these loans are safer than they really are. Just 0.8% of high-yield bonds defaulted last year, the lowest in modern times. And with only three defaults so far this year, we've luxuriated in the first default-free months since 1997. By comparison, high-yield default rates have averaged 3.4% since 1970; higher still for paper further down the totem pole.

Like past bubbles, the current historical performance of high-yield markets has led seers and prognosticators to proclaim yet another new paradigm, one in which (to their thinking) the likelihood of bankruptcy has diminished so much that lenders need not demand the same added yield over the Treasury or "risk-free" rate that they did in the past.

The five most dangerous words in the English language – “it is different this time”.

But to think that corporate recessions -- and the attendant collateral damage of bankruptcies among overextended companies -- have been outlawed would be as foolhardy as believing that mortgages should be issued to home buyers with no down payments and no verification of financial status.

Some portion of this phenomenon seems to reflect tastes in Asia and elsewhere, where much of the excess liquidity resides: Foreign investors own only about 13% of U.S. equities but 43% of Treasury debt. In search of higher yields, these investors are moving into corporate and sovereign debt. Today, the debt of countries like Colombia trades at less than two percentage points above U.S. Treasuries, compared to 10 percentage points five years ago.

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