How quickly changing sentiment can affect behavior. For the past several years, no instrument seemed too risky for at least some investor somewhere. But now, as problems in the housing and subprime mortgage markets have spread, investors have a new mindset—which is much more focused on risk. In the U.S. credit markets, once-popular deals have gone begging, and investors have rejected new issuance with any innovative features or added risk. Responding to the investor pullback during the first half of August, central banks around the globe stepped in and injected liquidity into the financial markets.
"For at least two years, Standard & Poor's Ratings Services has argued that investors were too complacent about risk," said David Wyss, managing director and chief economist at Standard & Poor's. "Now, they are overreacting in the opposite direction. How much and how far they'll overreact remains to be seen. History suggests that the credit markets will normalize fairly quickly, but that could still be months away.
"Credit crunches seem to happen every five to 10 years," Mr. Wyss remarked, calling it a standard pattern. He cited credit squeezes spurred by high-yield bonds in the late 1980s, the savings-and-loan crisis of the early 1990s, Long-Term Capital Management and the Asian crisis in 1997 and 1998, and the bursting of the Internet bubble in 2000 and 2001. "What makes the current credit crunch unique is that it's more broad-based," he explained.
Fixed-income investors have turned to the havens of government securities and cash and cash equivalents—such as bank deposits, CDs, and plain-vanilla commercial paper (CP)—to avoid the current uncertainty. "Liquidity will re-emerge when the repricing of risk actually reaches a new level," commented Jean Michel Six, Standard & Poor's chief economist for Europe. "But for now, these investors are staying out of riskier assets."
Wider Spreads Across The Board
The securitized mortgage market has experienced the greatest investor pullback, but risk aversion has extended well beyond that. "Up until a couple of months ago, companies were able to refinance with unfettered access to the capital markets," noted Diane Vazza, managing director and head of Global Fixed Income Research at Standard & Poor's. "Now, all that has changed. Issuance in the U.S. has fallen off a cliff." (See table.)
Issuance Falls Off A Cliff In July
2007 U.S. monthly corporate bond issuance
—Investment grade—
—Speculative grade—
Issues
(Bil. $)
Average spread (bps)
Issues
(Bil. $)
Average spread (bps)
January
252
101
132
28
9
320
February
216
76
132
29
11
309
March
267
101
133
46
22
321
April
183
60
133
28
11
305
May
298
131
130
57
27
288
June
221
84
128
39
20
284
July
93
32
137
4
1
343
August*
19
8
156
0
0
419
*Data as of Aug 15. Source: Thomson Financial, Standard & Poor's Global Fixed Income Research.
As problems have moved beyond the subprime and mortgage sectors, they have broadly shaken confidence. Spreads widened across the board, from corporate issuance and structured products such as collateralized debt obligations to credit default swaps. "And anything that is nontraditional or risky isn't selling right now," Mr. Wyss said.
Although both high-quality and high-yield offerings have felt the chill in the markets, speculative-grade issuance that Standard & Poor's rates has nearly frozen, dropping down to four issues totaling $1 billion in July from 39 issues valued at $20 billion in June. Investment-grade offerings, while also lower, have fared comparatively better, declining to 93 issues worth $32 billion in July from 221 issues totaling $84 billion in June.
"The market will still consider more conventional, soundly structured deals at higher rates," said Ms. Vazza. Also, August is traditionally a slack month for debt issuance, and negative media coverage will likely slow it down even more. However, cautioned Ms. Vazza, "that doesn't necessarily mean that leveraged deals will be lining up after Labor Day."
Investors Reject Structural Concessions
Many of the debt offerings withdrawn or postponed over the last few months, some of them to finance major mergers and acquisitions and LBOs, featured aggressive financing achieved through structural concessions. Covenant-lite loans, for example, ease borrower performance requirements, making the instruments riskier for lenders. A payment-in-kind (PIK) toggle note allows a borrower to switch back and forth between making scheduled interest payments or increasing the interest rate. Investors have pulled away from both instruments.
Indeed, the dollar volume of covenant-lite loans has fallen dramatically. After reaching a high of slightly over $25 billion in February 2007, cov-lites leveled off to about $18 billion in March and then dropped sharply in June to $8.35 billion. By July, issuance had withered to a mere $150 million (see chart 1). During June and July, five of these loans were canceled, two more—both in the $3 billion range—were postponed, and 21 added covenants to make them more acceptable to investors. PIK toggle deals began falling out of favor too, with four withdrawn in June and July.
Chart 1
"Some of the offerings pulled back or postponed will resurface eventually as restructured deals that will include higher coupons," said Ms. Vazza. "They won't have structural concessions like the covenant-lite deals that had become so prevalent."
Borrowing Is Costlier And More Difficult
As investors chased whatever yields they could find, speculative-grade spreads in the second quarter of 2007 hit record lows. "Now they've widened out to more appropriately reflect risk," explained Ms. Vazza, adding that the low spreads were unsustainable. "They may be a bit overdone in terms of the widening, but that is part of repricing in the primary and secondary markets."
As a result, borrowing money has become more expensive and more difficult, for both individuals and institutions. "On the corporate side, midsize and small companies may experience the greatest impact," Mr. Wyss said. The investment-grade status of many larger companies lets them borrow more cheaply, and many of them have lots of cash on their balance sheets as well. "But the worry is that the higher cost of borrowing is going to further affect M&A," Mr. Wyss continued. Several offerings related to major LBOs have already failed to find investors. Mr. Wyss also observed that nonresidential capital spending has slowed to 3.4% over the last four quarters, down from 7.3% for the four quarters ending in June 2006.
Homebuyers are also feeling the squeeze, with mortgage lenders raising interest rates and tightening the lax lending standards that helped spark the current credit crunch. "But so far there isn't much impact in the other consumer debt markets such as auto loans and credit cards," Mr. Wyss noted, attributing this to wider spreads and low loss rates in these subsectors.
Will History Repeat?
Putting the current credit squeeze into perspective, Ms. Vazza compared investor reaction to the ongoing subprime problems to what happened in spring 2005, when Standard & Poor's took ratings actions on Ford Motor Co. and General Motors Corp. (see chart 2). During a one-month period when the outlook on Ford was revised to negative, followed by downgrades of Ford and GM to speculative grade, spreads on high-yield debt climbed almost 100 basis points (bps). As market anxiety dissipated, the spreads began to decline. "It took about 75 days for spreads to return to where they had been before the ratings actions," Ms. Vazza said.
Chart 2
Similarly, since the latest round of negative subprime news started this summer, spreads on speculative-grade issuance have widened about 130 bps. Although they may come down a bit, suggested Ms. Vazza, they won't narrow to where they were in the second quarter, before the most recent subprime woes hit the market.
Ms. Vazza also noted a downward shift in overall credit quality that has occurred over the years. "About 20 years ago, speculative-grade offerings accounted for about one-third of all Standard & Poor's rated issuance," she explained. "By the end of 2006, speculative-grade issues had jumped to more than half of all Standard & Poor's ratings." (See chart 3.)
Chart 3
The View From Europe
The current credit problems have highlighted the global nature of markets. However, Mr. Six noted that "the real economies of Europe have been largely isolated from the turmoil in the U.S. housing market," although in several countries, a handful of institutions, including some big ones, have been affected and booked losses. With corporate investment and exports leading the way, European economies have continued to perform satisfactorily, he pointed out.
"But there is downside risk because of the current turbulence," Mr. Six cautioned.
Even so, he expects that investment-grade companies generally should be able to finance their capital expenditures and expansion plans. Speculative-grade companies facing higher borrowing costs, however, may find that lenders have become more discriminating. "This is a return to a more normal situation, where spreads more accurately reflect the difference in ratings," he said, echoing Ms. Vazza.
Referring to the recent European Central Bank (ECB) intervention in the money markets, Mr. Six called the €120 billion-plus (about $161 billion-plus) infusion significant in size. "It was designed to show that as the lender of last resort, the ECB will restore confidence, whatever it takes," he stressed. "The net result might be that the ECB is closer to the end of its tightening cycle," he added. Before the intervention, the general expectation was for two more hikes by the end of 2007. Now, just one more increase in September or October seems likelier. "That would bring the rate to 4.25% and keep it there for a while," Mr. Six said. "That's good news for corporations and households."
What's Ahead In The U.S.?
So far in the U.S., where subprime-related issues first received attention, actual losses on mortgages remain low—well within historical bounds, according to Mr. Wyss, but Standard & Poor's expects them to rise. "The question is how high," he stressed. "We're now assuming that losses in the subprime adjustable category will hit 11%-14%." That figure is more than double losses for mortgages originated in 2000, a previous high-water mark for losses. But the current slump in home prices and sales is more significant than the one in 2001 and 2002, when the Federal Reserve rate cuts kept housing strong in spite of the national recession. And while the current slump, as deep as it is, is mild compared with earlier housing cycles, the presence of adjustable-rate subprime loans in this market presents challenges not previously encountered.
In addition to the Fed, the ECB, and other central banks pumping money into the credit markets to restore liquidity in an attempt to bolster confidence, the U.S. economy's fundamentals remain strong. "Outside of housing, the economy is chugging along at a steady pace of about 3%," stated Mr. Wyss, noting that the housing woes have subtracted about 1 percentage point from GDP.
The Fed just lowered its discount rate—what banks pay when they borrow directly from the central bank—by 50 bps to 5.75%. The Fed has also temporarily given banks up to 30 days to repay these loans, which provides some breathing room until the next Fed rate-review meeting. Given the current turmoil, Mr. Wyss expects the Fed will accelerate its plans to cut its target for the more closely watched Federal funds rate, currently at 5.25%. This short-term rate is what banks charge each other to borrow Federal funds.
Believing the foreign exchange markets have already factored in a Fed funds rate cut, Mr. Six predicted that the U.S. dollar would probably stabilize at roughly $2.00 to the British pound and $1.37 to the euro. That will help the U.S. economy too. But if a major lender were to default, it would raise fresh concerns.
"The liquidity in the market before the credit squeeze began staved off defaults until a later time," Ms. Vazza noted. "There is risk on the horizon, but we think corporate defaults will be slow to materialize." Right now, the default rate is at 1.2%. Standard & Poor's has forecast a modest increase to 1.4% by the end of 2007.
For now, the markets remain volatile, as news alternately alarms or calms investors. "We have to wait and see what happens," Mr. Wyss advised. "But market illiquidity, if it forces one or more major failures, could easily turn this slowdown into a full-blown economic recession."
Writer: Libby Bruch
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