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Corporate Defaults to Further Pressure Banks

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Many experts see a new credit cycle beginning.

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Yesterday's abysmal ISM Survey sent bulls and bears alike back into the woods, and for good reason. The service industry makes up 80% of the American economy and investors worry companies will begin to further ratchet back hiring and expansion plans, and may soon start defaulting on their debt.

The Wall Street Journal reports that NYU finance professor Edward Altman projects defaults on high-yield, or "junk" bonds will increase 9-fold from the historic lows of 2007. Altman expects a default rate on junk bonds of 4.64% in 2008, representing $53 billion in unpaid debt. He also notes that in 2010 there will be a sharp increase in companies forced to roll over existing high-yield debt, leading to the potential for more defaults.

Many experts see a new credit cycle beginning, as tighter lending conditions and higher default rates feed on each other to increase borrowing costs for good credits and push poor credits into restructuring or bankruptcy. During previous credit cycles, defaults reached much higher levels – almost 10% in the early '90s and over 12% at the beginning of the 2001 mini-recession.

Further complicating the situation is the $45 trillion market for credit default swaps, which are issued to protect holders of corporate and other debt. The CDS market is already under pressure from the potential downgrades of bond insurers Ambac (ABK) and MBIA (MBI), and Pimco Investments bond guru Bill Gross sees the potential for as much as $250 billion in additional losses for banks resulting from just a 1.5% - 2.0% corporate default rate.

But before the credit market can address any of this, it will need to slog through the backlog of leveraged loans, or debt used to finance buyouts that banks have yet to unload to investors. Wall Street brokerages such as Lehman Brothers (LEH) and Goldman Sachs (GS) are struggling to offload loans as low demand for subordinated debt has pushed bond prices well below par.

Although JP Morgan Chase (JPM) CEO James Diamond told investors these loans may be "terrific long-term assets to hold," already stressed balance sheets may not afford opportunistic banks the opportunity to find out.
No positions in stocks mentioned.

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