S&P Viewpoint

After a two-year binge of aggressive credit expansion and loosening underwriting standards, the credit markets abruptly changed direction this summer. Deepening worries about the U.S. subprime mortgage and leveraged loan markets triggered a reversal in U.S. market sentiment that quickly spread to Europe and parts of Asia. The correction is the sharpest since the spring of 2005, when worries over the fortunes of U.S. automakers temporarily ended a previous bull run in credit markets. But a more appropriate comparison might be the autumn of 1998, when the default of Russia and bailout of huge hedge fund LTCM (all in the aftermath of the Asian financial crisis) roiled the financial markets for several months and led to a long period of monetary easing. In contrast with the prior correction of May 2005, which turned out to be short lived, the current market adjustment and repricing of credit—in structured investments and leveraged finance in particular—will take longer to work itself out. The key question is whether the current seizing up of the markets and the credit squeeze will extend long enough to materially affect the underlying economy.

In the cash and credit derivative markets, the abrupt change in investor sentiment is clear. In fact, the correction is not particularly notable for the absolute level of risk premium reached. Spreads over the risk-free rate remain moderate by historical standards in both the investment- and speculative-grade segments (see Chart 1). As recently as 2003-2004, spreads in the U.S. speculative-grade bond market were 400 basis points (bps)-800 bps over Treasuries.

 Chart 1

Rather, the speed of this reversal sets it apart. In the cash bond market, the spreads on speculative-grade bonds widened to almost 450 bps over Treasuries at the beginning of August from a narrow point of 280 bps at the beginning of June 2007, and they have since remained flat. The trend line of credit default swap indices, which are more market sensitive and more volatile than the spreads in the cash market, shows even greater movement. The five-year high-yield credit default swap (CDS) index (North America) widened 260 bps from the beginning of June to the end of July (see Chart 2). Interestingly, in August, the high-yield CDS index narrowed somewhat, suggesting that the market might have eased its negative view on credit during the month.

 Chart 2

The correction has halted activity in certain segments of the debt markets. Perhaps the biggest logjam is in the high-yield and leveraged loan segments. New high-yield bond issuance in the U.S. came to a standstill in July 2007 (see Chart 3), and the pipeline in the leveraged loan market is indefinitely clogged. Standard & Poor's Leveraged Commentary & Data estimates that the blocked deal pipeline is $215 billion in the U.S. alone and perhaps as high as $500 billion in the U.S. and Europe when considering high-yield bonds as well. Only a trickle of deals are currently closing (see " Leveraged Finance Market Jitters Highlight Risks To Banks," published July 25, 2007, on RatingsDirect).

 Chart 3

Likewise, the issuance of structured finance securities has contracted, influenced by investor loss of confidence in U.S. subprime RMBS. New private-label U.S. RMBS issuance fell off in July 2007 compared with earlier months, even though July issuance was supported by the completion of deals started before the turbulence hit the markets. Transaction volume for the rest of the year likely will be lower still. RMBS issuance in Europe also faces a potential slowdown in autumn, even though European RMBS is much less weighted to subprime than that of the U.S.

The worry over U.S. subprime mortgages has spilled over to anything structured, including prime private-label RMBS, collateralized debt obligations (CDOs) with or without investments in subprime RMBS, and ABCP. Volumes of transactions in these securities have plunged as investors holding most structured securities wait on the sidelines for prices to stabilize. Since August 2007, investors in ABCP are requiring a premium to roll their investments or are shifting to safe-haven Treasuries, which explains the recent decline in yields on Treasury bills.

The depressed market values of private-label RMBS implied from ABX indices appear to be an overreaction to the bad news from the U.S. subprime market. We add that the imputed market values from trading in ABX indices can be volatile because of the limited number of observations and the great impact that short and long position taking of a few participants can have on the indices. The sale of $20.5 billion in primarily 'AAA' prime RMBS by U.S. REIT Thornburg Mortgage Inc. (B/Watch Neg/--) in the second half of August, done rapidly and under stress, provided the market with perhaps better quality information on current valuations of prime 'AAA' RMBS, which constitutes the great majority of outstanding RMBS. Thornburg's public statements note that the loss on the sale was $863 million, suggesting a discount of 4.2%.

Market participants await the third-quarter results with trepidation because of uncertainty over the potential markdowns of hung leveraged loans and structured finance investments, particularly private-label RMBS. (The news will come earliest from the U.S. broker/dealers, whose third quarter ends on Aug. 31.) Even a small-percentage markdown of private-label RMBS could have a large financial impact because of the several trillion dollars outstanding in the U.S. and Europe (the precise total is difficult to determine due to the variable rate of prepayments for different years of production). We emphasize that private-label RMBS excludes the MBS of U.S. agencies Fannie Mae and Freddie Mac, which the market turbulence has affected only slightly as of the end of August 2007.

The valuations of U.S. RMBS based on mortgage loans originated since 2005 are the most depressed; vintages from 2004 and earlier are less affected by the market correction. But because of the acceleration in production since 2005, the recent vintages constitute a significant proportion of the total outstanding. The cumulative issuance of U.S. private-label RMBS from January 2005 through July 2007 was $2.9 trillion, of which $900 billion is strictly subprime (see Chart 4). Valuations of European RMBS issued since 2005 also have declined—but not to the same extent as the U.S. vintages since 2005 because only a very small part of European RMBS is subprime.

 Chart 4

Pension funds, endowment funds, insurers, hedge funds, bond and money market funds, banks, and securities firms in all regions of the world widely hold private-label RMBS, including via ABCP programs and CDOs that invest in private-label RMBS. The global exposure of just the financial institutions sector is difficult to assess and subject to change. This is because in today's turbulent market, banks are taking RMBS back on the balance sheet by replacing investors and providing financing to ABCP programs, mutual funds, and alternative investment funds that they sponsor or back with liquidity lines. Moreover, some financial institutions use dynamic hedging strategies that significantly alter their exposures to RMBS as well as other classes of securities. Our estimate is that banking groups globally hold a significant amount—but not the majority of—the recent vintages of U.S. private-label RMBS.

Although the potential second-half markdown of RMBS is great, the impact on results of specific financial institutions will depend on both the trend in valuation of RMBS from now until the end of the reporting period and the accounting standards applied at each institution. Whether the value impairment is temporary or permanent will be a crucial determinant of the accounting treatment. We will closely analyze the impact and make adjustments according to whether the movements reflect a long-term economic loss as opposed to a temporary market gyration. The valuations of RMBS in the mark-to-market books of banks could fall to depressed levels in the third quarter and then move back up in the fourth, depending on the path of market values for the remainder of the year.

The sharp correction in the credit markets this summer could well serve as a test of the market's acceptance of more volatile results of banking groups under accounting standards that mark to market a greater proportion of the balance sheet. The financial sector is well positioned to absorb the volatility; profits in the first half were robust and provide a significant cushion to absorb potentially large markdowns in the second half of the year. Clearly, institutions with oversized concentrations of the recent vintages of private-label U.S. RMBS, particularly subprime, will suffer more in the second half and are vulnerable to headline risk that could affect funding.

The sharp repricing of credit risk has roiled the short-term debt markets to a troubling degree. Maturities have come in, and a high proportion of short-term funding is overnight or very short term as of the end of August. Investors have lost confidence in ABCP because of the depressed market values of certain assets (particularly private-label RMBS, referred to above) in the pools backing the ABCP programs. Structured investment vehicles (SIVs) are particularly out of favor, even though SIV portfolios on average include only 2% subprime RMBS and 21.5% prime (mostly 'AAA') RMBS (see " Structured Investment Vehicles: Under Stormy Skies, An Updated Look At The Weather," published Aug. 30, 2007 on RatingsDirect).

A consequence is that many ABCP programs are winding down. U.S. ABCP outstanding dropped $185 billion in the last three weeks of August, a 16% decline. During the same period, investors rushed to U.S. Treasuries, causing the yield on three-month U.S. treasuries to decline by more than 100 bps, to 3.8%, by the end of the month. Note that ABCP is not a major source of financing for global financial institutions (it's well under 5% of total borrowings), but it is sufficiently large to have an impact on other areas when it contracts to this extent. Banks generally are remaining liquid in the very short term but are perturbed by the exceedingly high risk premiums currently demanded by investors for borrowings of more than two weeks. As of the end of August, the global sector collectively was shoring up short-term liquidity and hoping for a return to normalcy in the markets.

Rejecting the widened spreads on ABCP, many large banking groups are taking over the funding of their ABCP conduits. HBOS PLC's (AA-/Stable/A-1+) decision to fund its conduit Grampion Funding Ltd. is only the most public of a clear trend of banks taking out ABCP investors. We expect this to continue into the fall, pushing bank regulatory capital ratios down moderately in the process.

The tightening in short-term liquidity for financial institutions appears to be an overreaction to events, particularly in light of the generally healthy state of the global economy. Responding to the investor pullback, central banks stepped in and injected liquidity into the financial markets in August. Central banks also made other exceptional adjustments to policy in response to the turbulent market conditions, such as the Fed allowing U.S. banks to exceed lending limits to their subsidiary brokers. These actions are encouraging in that they have boosted liquidity at the very short end of the maturity curve. Further central bank actions will be a key factor influencing investor behavior, helping the blocked parts of the financial markets to disentangle and restoring order to the short-term money markets.

Since 2005, Standard & Poor's and many other credit-market participants have noted the overheated global residential housing markets, the increasingly aggressive practices in the leveraged loan market, and the excessively narrow risk premiums on corporate loans and bonds. Clearly, the current seizing up of the credit markets is linked to the aggressive credit expansion that preceded it. The sheer volume of activity leading up to the correction has amplified the shock of the reversal. But we believe that a collective reassessment of credit risk premiums and less-aggressive practices in subprime mortgage lending and leveraged finance will lead to more rational pricing in credit markets, meaning lenders and investors will be more appropriately compensated for and better protected against credit risk on new business. This ultimately will benefit the financial industry and the broader economy.

Viewed from the perspective of the end of summer, the first half of 2007 looks like a euphoric last hurrah of a long bull fixed-income and credit market. The credit market practically stopped discriminating among different classes of credit risk. For example, corporate bond spreads narrowed to 140 bps between average investment grade and average speculative grade during the first half, which is the narrowest differential since the beginning of the decade. Lending standards continued to loosen in some areas, illustrated by the rising proportion of so-called covenant-lite leveraged finance transactions during the half. Issuance of leveraged loans and high-yield bonds boomed (see Chart 5). Overall, the trend of greater tolerance of leverage in leveraged finance transactions and higher proportion of speculative-grade debt issuance to total debt issuance rolled on until the end of spring 2007.

 Chart 5

The financial sector flourished in the first half, benefiting from strong business volumes, robust trading profits, and continued low risk charges. Profits were sky high: For the largest European and U.S. financial conglomerates, the first half of 2007 was by far the best six months in history in terms of absolute profits and among the highest ever in operating margin (see table and Charts 6 and 7). The group of 20 global financial conglomerates illustrated in the charts earned $172 billion in pretax income in the first half. As a result, the nominal results for those six months exceeded the full-year pretax income for the same group of 20 institutions as recently as 2003.

 Chart 6

 Chart 7

Financial Groups In Charts 6 And 7
European banking groups	U.S. broker/dealers	U.S. banking groups
HSBC Holdings PLC	Bear Stearns Cos. Inc. (The)	Bank of America Corp.
Royal Bank of Scotland Group PLC (The)	Lehman Brothers Holdings Inc.	Citigroup Inc.
BNP Paribas	Goldman Sachs Group Inc. (The)	JPMorgan Chase & Co.
UBS AG	Merrill Lynch & Co. Inc.	U.S. Bancorp
Barclays Bank PLC	Morgan Stanley	Wachovia Corporation
Deutsche Bank AG		Wells Fargo & Co.
Banco Santander Central Hispano S.A.
Societe Generale
HBOS PLC
UniCredito Italiano SpA

Although sectoral consolidation contributed to the escalation of profits, an across-the-board significant improvement in operating margin during the current decade also played a large part. Banks' operating margins were wider than the historical average for 2005 through the first half of 2007, fueled in part by the booming segments of leveraged finance, subprime mortgage lending, and private-sector emerging market loans, among other areas. Worldwide, the rest of the sector's (except U.S. specialized mortgage lenders) operating performance for the first half of 2007 generally mirrored the strong performance of the largest 20 groups.

This robust performance started to fade in June and stopped cold in July 2007, when credit markets collectively suffered a nervous breakdown. Financial results in the second half surely will contrast poorly with the buoyant first half (summarized above). Losses are already surfacing in some areas, most notably in alternative investment funds. In the first half of 2007, the decline of the U.S. subprime mortgage market had already taken its toll on specialized mortgage lenders, the most significant case being the default of New Century Financial Corp.

Earnings in the second half of 2007 are vulnerable to:

• Markdowns of inventory on hung deals in leveraged finance.
• Exposure to subprime mortgages.
• Downward repricing of private-label RMBS, CDOs, and corporate bonds.
• Cornered trades (forced liquidations of positions at losses).
• Higher funding costs.
• Lower revenues from the blocked segments of the credit markets: leveraged finance, RMBS, CDOs, and ABCP.
• Drop in prices of equities.

The impact of these negative developments on financial institutions' earnings will depend on how long the correction lasts. The business lines most exposed are investment banking (underwriting, origination, and M&A), debt trading (particularly structured investments), and U.S. residential mortgage finance. These lines will suffer from lower revenues, write-downs of RMBS and affected CDOs and ABCP as well as increased credit losses in U.S. mortgage lending, specifically subprime mortgages and home equity lines of credit (HELOCs). Certain areas within structured finance might remain out of favor for an extended period, and consequently, institutions that depend on the affected areas for revenues or funding will need to look elsewhere to compensate.

Not all is likely to be negative in the second half of 2007. The pressure points on revenues cited above could be offset partially by the positive effect of increased volatility on trading results and by wider spreads on new credit underwritten in the half. Overall, the depressed prices in some segments of the market could translate into opportunities for patient investors.

The correction already has eroded the credit standing of several companies, such as Countrywide Financial Corp. (A-/Watch Neg/A-2), one of the largest originators of subprime mortgages in the U.S., and Landesbank Sachsen Girozentrale (Sachsen LB; BBB+/Developing/A-2), a midsize wholesale lender in Germany with outsized ABCP programs that could not roll over.

Investment banking and trading businesses likely will suffer more than commercial and retail banking and wealth-management lines. But we believe the leading broker/dealers have the credit strength to absorb a stress worse than the one suffered in the fall of 1998. We recently conducted a stress test on the investment banking and trading business lines of the largest global securities firms based on a somewhat tougher scenario than in the fall of 1998. The result was a drop in revenues of 47% and a narrowing of the pretax margin in these lines to 21% in the second half of 2007 from 36% in first-half 2007. The results of the stressed-1998 test do not reflect our expectations for the earnings of these firms but rather a potential outcome based on a stressed and unfavorable operating environment (see " Investment Banking and Trading: Stressing For A Tougher Environment," published on Aug. 28, 2007, on RatingsDirect). The hypothetical results in the second half of 2007 under the stressed scenario are much lower than in the first half but do not threaten the creditworthiness of the securities firms, which have a high proportion of flexible costs because of bonus compensation structures.

Although the financial impact of the numerous negative influences listed above could be material, the financial sector has sufficient earnings and capital strength to absorb a significant loss in revenues and income without lasting damage to its fundamental creditworthiness. We emphasize that a change in market psychology rather than a decline in the economy has driven the repricing of risk and the liquidity squeeze.

The underlying credit fundamentals of the financial sector are unchanged and remain positive. Global economic expansion remains relatively strong, corporate earnings in mature markets are good, and the corporate default rate remains at historical lows (see Chart 8). Economic growth prospects for the leading emerging markets are robust, notably for the large economies of China, India, Brazil, and Russia. This means that if the markets can collectively untangle the blocked markets and work out the right pricing for subprime RMBS and other structured securities, the correction could be short-lived and less painful. If, however, the credit squeeze is prolonged and negatively affects the real underlying economy, the financial sector will face a more difficult 2008 and beyond.

 Chart 8

A last point is that in severe market corrections such as the one we are experiencing, stronger institutions usually acquire firms weakened by the correction. Market downturns facilitate sectoral restructuring and consolidation. Thus in Germany, the problems of IKB (unrated) and Sachsen LB—both damaged by the inability of their ABCP conduits to roll maturing paper—could accelerate the restructuring of parts of the German banking industry, notably in the state-owned and savings bank and landesbank subsectors. As if playing to the script, in late August, Landesbank Baden-Wuerttemberg (A+/Stable/A-1) announced its intention to acquire Sachsen LB in early 2008.

Countrywide's recent $2 billion of preferred shares issued to Bank of America Corp. (AA/Stable/A-1+) could be the first step in a takeover. Kaupthing Bank (unrated) of Iceland recently made an offer to purchase NIBC Bank NV, a midsize Dutch wholesale bank that has suffered significant losses marking down its proportionately large structured credit portfolio. Likewise, market turbulence and de-leveraging likely could spur restructuring and consolidation in the hedge fund industry.

Clearly, creditors should not always count on stronger entities mopping up the credit problems of institutions weakened by turbulent markets. But it's often a positive rating factor that the strength and attractiveness of a franchise encourages acquisitions and can offset the financial damage wrought by market corrections. The fundamental strength of the global financial sector remains sound, and the sector has good medium-term growth prospects. Consequently, financial groups that have the necessary strength and financial resources will continue to look for acquisition opportunities, particularly at the more distressed prices to be found during this turbulent correction in the credit markets.