This Credit Crunch Has Bite: Part II
It is important to note that the structured credit market in its current form is substantially untested.
The financial elements of the credit crunch are becoming clearer: higher credit costs, lower availability of debt, forced de-leveraging of hedge funds and conduits/ SIVs and significant capital losses for financial institutions. The real economy effects will be slower to emerge. Higher credit costs and tighter credit standards will affect all business.
The U.S. housing industry is badly affected with no immediate prospect of a quick recovery. The outlook for U.S. house prices is poor. Growth forecasts for the U.S. have already been lowered. The dreaded "R" word – recession – is now being talked about.
The fall in asset prices has "wealth" effects. Then there are employment and income effects: Wall Street has already issued "pink slips" by the thousands as banks and mortgage lenders shed staff. More will be issued in 2008 as the slowdown in the financial services business continues.
A slowdown in economic activity will affect many financial transactions. Corporations with significant debt face refinancing challenges. The shares of an Australian real estate firm – Centro – fell over 80% as a result of difficulties in refinancing its short-term debt secured over commercial property. Some of it in the U.S. Commercial property financing has slowed, the cost has risen significantly and terms have tightened affecting commercial property prices.
Private equity deals in recent years were predicated on a combination of a growing economy, cheap debt and a buoyant stock market allowing the quick resale of the company. Weaker earnings and more expensive debt could lead to losses and distressed sales over time. Recent private equity deals also face re-financing risk. Some U.S. $150 billion of leveraged loans come due in 2008. Financial engineering techniques – toggles, pay-in-kind securities and covenant-lite (lack of maintenance covenants) structures – will delay the problem but probably cannot forestall the inevitable rise in defaults.
Non-investment grade bond issuance over the last few years was concentrated in the weaker credit categories and is vulnerable to deterioration in economic conditions. Since 2003, 42% of bonds of high yield bonds issues were rated B- or below. In the first 6 months of the year that percentage rose to around 50%. Some commentators believe that the losses of corporate bonds will peak between 10% and 20% leading to significant losses.
The real economy effects will feedback into the financial markets, setting off new phases of the crisis.
CDS contracts used to hedge credit risk have significant documentation and operational problems. If actual defaults in markets increase and the contracts do not function as intended then there would be additional complexity. A significant volume of CDS contracts is with hedge funds and other investors secured by collateral agreements. The counterparty and performance risk of enforcing the contracts may be challenging.
It is important to note that the structured credit market in its current form is substantially untested. If defaults rise and the CDS contracts prove to be difficult to enforce then bank exposures to losses may well be much higher than anticipated.
Credit markets remain gloomy. Unlike their equity and emerging market cousins, they are waiting anxiously for "the shoes to drop," except it seems that the shoes are from Imelda Marcos' collection.
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