| The credit cycle in the U.S. may be nearing its peak after a bull run prolonged by an influx of international funds, while continuing strong liquidity in the leveraged finance market will help extend its length, according to speakers at Standard & Poor's Ratings Services' 2006 Bank Loan & Recovery Ratings conference. Conceding the difficulty in predicting an end to the cycle--and whether this end will come in the form of a hard or soft landing--a number of speakers at the Dec. 7 conference said a fundamental evolution in leveraged finance is differentiating this cycle from past years. In addition to the increased fund flows into the U.S. from abroad, there are no signs that a traditional macroeconomic catalyst will cause a surge in defaults in 2007--with the number of failures merely drifting higher as the result of company-specific problems. An increase in the number of domestic market participants, in the form of institutional investors, has also boosted liquidity, giving borrowers access to unprecedented capital. "Even companies that are having trouble are able to refinance their way through," Henry Higbie, managing director of the Capital Structure Advisory & Solution group at J.P. Morgan Securities Inc., told attendees at the conference. Higbie's colleague at J.P. Morgan Securities, Peter Nolan, who is managing director for Syndicated & Leveraged Finance Loan Capital Markets, agreed. "There's just a lot more liquidity out there to supply companies if and when they have a hiccup," Nolan said. "What the long-term ramifications are, we'll see." This strong liquidity has kept spreads on leveraged transactions at historical lows, even as the size of the market grows beyond most expectations, especially for second-lien and other riskier loans. With this growth has come greater risk assessment and management, or what Martin Fridson, CEO of FridsonVision LLC, called the "professionalization" of markets. At the same time, "the distinction between a hedge and a bet on the market is a lot less clear than it would appear," Fridson said. One consequence of liquidity is that there may be less of a traditional credit cycle and more of an underwriting cycle, said Greg Stoeckle, managing director and head of bank loans at Invesco. He added that deal type will contribute as much to the next set of defaults as macroeconomic factors will, at least in the short term. "Beyond 2007, it's hard to prognosticate where things will go," Stoeckle said. And whether economic strength in the U.S. will be as determinative of an end to the credit cycle as it has in the past may be a moot point for 2007. While economic growth has slowed to below trend, after strong expansion in 2004 and 2005--primarily the result of 17 consecutive quarter-point interest rate increases by the Federal Reserve, starting in June 2004--Standard & Poor's Chief Economist David Wyss expects trends to remain solid, even through a decline in the housing market. "The U.S. economy is slowing--that's no surprise," Wyss said. "When you whack the mule over the head 17 times with a two-by-four, it gets the idea." Still, "the drop in housing prices is happening at the same time as the drop in oil, so that gives the consumer back more purchasing power," he said. "When you come right down to it, the U.S. economy is going to be supported by the consumer. This is still pretty darn good" and "fairly supportive for markets." Craig P. Russ, vice president and portfolio manager at Eaton Vance Management, said at the conference that he thinks default rates are unlikely to be materially different from past cycles, with no huge increase in the next year. At the same time, he said the landing may start soft and get harder, as what he called "artificial liquidity" begins to dry up. "Liquidity in this market could come to a pretty quick halt," Russ said, adding that the use of instruments such as credit derivatives as bets rather than hedges is worrisome. "Leverage on leverage is disconcerting." Most panel speakers agreed that the catastrophic failure of a large market participant, such as occurred with Long-Term Capital Management (LTCM) in 1998, might spark or accelerate a downturn in the credit cycle. "I think it would take quite a large shock to turn the market around," said Linda Pace, a portfolio manager for the Carlyle Group. She added that classic balance sheet and liquidity issues may ultimately be the driver for the turn in the cycle. "The market breadth is much larger" to buy companies and to invest in debt, distinguishing it from past cycles. At the same time, the failure of a large hedge fund or institutional investor has moved down the list of potential catalysts for a turn in the cycle, as leveraging and risk management are more controlled, said Fridson, adding that there is little likelihood that such a collapse would cause a meltdown in leveraged finance. Some compared the LTCM crisis with the recent collapse of Amaranth Advisors, which shut down after losing more than $6 billion on energy trades. Whereas with LTCM, many market participants scrambled for the door, Amaranth's collapse whet some players' appetites for investment. "Here we are with Amaranth, looking at it as a buying opportunity," said J.P. Morgan Securities' Nolan. Still, Standard & Poor's has seen some classic early-warning signs that we are at the top of the credit cycle. Leveraged loan originations are rising sharply, with the simultaneous narrowing of credit spreads, especially at the low end of the recovery rating spectrum. And while liquidity may remain very high in the short term because of global investment, it may soon dry up amid a shift to other investment opportunities. Standard & Poor's believes the turn in the credit cycle has simply been delayed, which may mean an intensification of the eventual downturn--in other words, the proverbial "hard landing," or at least an atypically large spike in defaults. Writer: Joe Maguire Click here to see other articles included in "Special Report: Why Recovery Ratings Are More Important Than Ever." Click link for Special Report Archive | 
