The illusory recovery

16.05.2008

by David Stevenson

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Credit markets may have rallied recently, but the worst is yet to come. And that will mean real pain for everyone, not just financiers, says David Stevenson

Is the credit crunch behind us?

The Bank of England recently made tentative suggestions in its Financial Stability Report that the credit contraction which began last July is nearly over. And the recent news that US money-market fund BlackRock has agreed to buy a $15bn portfolio of subprime mortgage debt from Swiss bank UBS has made investors hopeful that this could begin to draw a line under the crisis and see an appetite for risk return to the markets.

As Credit Suisse’s Jonathan Morton told The Daily Telegraph, the move “could suggest we’ve hit a low point”. Yet while it’s possible the banks have now taken the majority of likely hits on mortgages, buyout loans and structured credit exposures, other concerns remain.

What sort of concerns?

American house prices are still in free-fall and the collateral damage from the US housing horror story has yet fully to hit the corporate sector. Meanwhile, in Britain, the residential property market implosion is some 12 to 18 months behind the US. As consumers find it harder to borrow money against their homes, consumer spending will slow, which is bad news for British firms (see below). In short, watch out for some serious corporate credit problems. UBS credit analyst Geraud Charpin believes that “the inevitable consequences of the financial crisis on the real economy are bound to take centre stage again”.

But haven’t the credit markets rallied recently?

Superficially, yes. Barometers such as credit default swaps (CDS – a form of market insurance that investors can buy to protect themselves if a bond issuer defaults on its payments), which a few weeks ago were flagging ultra-stormy debt market conditions, are now indicating a slightly calmer climate following all that central bank bail-out action. The cost of buying default protection for European investment-grade debt has roughly halved since March, according to the iTraxx Europe derivatives indices. Investor demand for speculative-grade debt has recovered since the mid-March Bear Stearns affair.

Then why worry?

That recovery may be illusory. Remember that at the end of March, commentators were outdoing each other with Armageddon scenarios. The International Monetary Fund (IMF) forecast an aggregate financial system loss of $945bn. As the Bank of England has suggested, at the peak of the panic, cash-starved sellers dumped holdings at ‘fire sale’ prices, slashing valuations as “risk premia swung from being unusually low to temporarily too high”. But despite the recent rally, the cost of investment grade default protection has still almost quadrupled within the last year.

And last week risk returned to the markets’ agenda, with a big bounce in the iTraxx indices. Ratings monitor Standard & Poor’s (S&P) reported 17 global defaults in the first quarter, with a further six in the past two weeks, lifting the April high-yield default rate for the fifth time in as many months to 1.7%. In the whole of 2007 there were just 22 defaults. In Britain, first-quarter company administrations – the first stage of insolvency – rose 54% on the previous quarter and 23% on the year.

How bad could it get?

That depends on the coming recession. S&P expects the US speculative-grade default rate to advance sharply over the next year to 4.7%, from 2007’s 25-year low of 0.97%. “The difference with previous cycles is that there’s now a greater proportion of speculative grade issuers than at any point in history,” says S&P global fixed-income head Diane Vazza, “with two-thirds of non-financial debt issuing companies now ‘junk-rated’, compared with 50% ten years ago and 40% 20 years ago.” That low-credit quality means busts could be a lot harsher this time round, meaning CDS costs could triple this year, says Puneet Sharma of Barclays Capital.

Martin Fridson, CEO of researcher FridsonVision, believes the credit crunch has only just begun. After the last two big lending booms in the late 1980s and 1990s, default rates hit double-digits. Should even a relatively mild recession such as 1990/1991 develop, Fridson reckons defaults could hit 16% for two consecutive years. That would be the worst carnage since 1933.

Any glimmers of light?

At least many firms took on their debt at the height of the credit bubble, when terms were loose and the cost was cheapest. But more potential pain awaits the banks. JP Morgan analysts recently raised their 2008 and 2009 loan-loss forecasts for European investment banks on falling credit quality fears, noting corporate credit spreads are at their widest since March 2003.

After recent bail-outs, central banks are running out of financial ammunition unless they resort to borrowing to buy commercial banks’ questionable loans. That would increase the money supply, potentially creating further inflation.

Isn’t this just a financial market problem?

Sadly, no. Several analysts fear that the credit crunch will only really start hurting as the number of companies going bust accelerates. Consumer spending accounts for some two-thirds of the British economy. With less equity being released from houses whose prices are plunging as banks curtail their lending, less cash will be spent as consumers try to rebuild savings and pay off massive personal debts.

Lower spending means firms’ debt servicing abilities will increasingly be hit by squeezed sales, profits and cash flow. As more and more companies go to the wall, real jobs will be lost. That’s when the message from the markets translates into personal pain.

debt insurance cost vs corporate bonds