Signs of Worsening Credit Conditions

Two UK columnists looked at the credit markets, and neither liked what he saw. And they wrote it up more colorfully than most of their American counterparts would have.

The first, Nils Pratley of the Guardian, tells us that that the idea that the credit crisis is on the wane is more than a tad optimistic:

Some say the credit crisis is over. Not Tom Attwood, managing director of Intermediate Capital Group (ICG), a firm which makes few waves outside financial circles. Its business is mezzanine finance, specialist high-risk lending to private equity firms. That puts it at the frontline of the financial turmoil and Attwood’s bleak assessment of conditions yesterday is worth quoting.

Sub-prime, he says, was merely a catalyst to the bursting of the credit bubble. It was going to happen anyway. “Credit disciplines across almost all markets were bypassed in favour of loan book growth at almost any cost.”

So far, so uncontroversial, and Attwood has been singing a similar tune for a while. The key point is that he can’t spot the break in the clouds that many bankers claim to see. “What was a liquidity crisis is likely to lead to a credit crisis,” he says. “Buy-outs structured in the benign credit climate prior to August 2007 were often over-geared with no margin for safety. This is likely to lead to an increase in default rates over the next year or two.”

A year or two? Well, yes. ICG assumes there will be a recession in the US, the UK, Spain – the markets most pumped up with credit – and a slowdown elsewhere.

His bottom line is: “There is no sign of a return to liquidity in debt markets as a whole. Raising new funds will become increasingly difficult across the board.”…

But the implication is that an awful lot of duff loans are still to surface. Attwood’s killer fact is that in 1999 ICG was one of three funds in Europe in the mezzanine and leveraged loan business; by 2007, there were 112. Some of the inexperienced losers are known already, but there’s surely more pain to be revealed.

Ambrose Evans-Pritchard of the Telegraph looks at the rise of credit default swaps prices on investment banks and increasing interbank spreads, both indicators of heightened concern about counterparty and systemic risk.

No wonder Mishkin resigned. He probably doesn’t want to go though another month like March. But his end-of-August departure date may not be soon enough to save him from more crisis management.

From the Telegraph:

The debt markets in the US and Europe have begun to flash warning signals yet again, raising fears that the global credit crisis could be entering another turbulent phase.

The cost of insuring against default on the bonds of Lehman Brothers, Merrill Lynch and other big banks and brokerages has surged over the last two weeks, threatening to reach the stress levels seen before the Bear Stearns debacle. Spreads on inter-bank Libor and Euribor rates in Europe are back near record levels.

Credit default swaps (CDS) on Lehman debt have risen from around 130 in late April to 247, while Merrill debt has spiked to 196. Most analysts had thought the coast was clear for such broker dealers after the US Federal Reserve invoked an emergency clause in March to let them borrow directly from its lending window.

But there are now concerns that the Fed itself may be exhausting its $800bn (£399bn) stock of assets. It has swapped almost $300bn of 10-year Treasuries for questionable mortgage debt, and provided Term Auction Credit of $130bn.

“The steep rise in swap spreads this week is ominous,” said John Hussman, head of the Hussman Funds. “The deterioration is in stark contrast to what investors have come to hope since March.”

Lehman Brothers took writedowns of just $200m on its $6.5bn portfolio of sub-prime debt in the first quarter even though a quarter of the securities had “junk” ratings, typically worth a fraction of face value.

Willem Sels, a credit analyst at Dresdner Kleinwort, said the banks are beginning to face waves of defaults on credit cards, car loans, and now corporate loans. “We believe we’re entering Phase II. The liquidity crisis has eased a little, but the real credit losses are accelerating. The worst is yet to come,” he said.

The jump in corporate bankruptcies has not yet been picked up by the usual indicators, which tend to lag the market, lulling investors into a false sense of security. The true losses are already known to specialists in the business, said Mr Sels.

Note the Fed does have ways to surmount its balance sheet constraints other than selling liabilities (which would be inflationary), but it is possible that the markets will react badly to any such move. The pushback would probably come in the form of higher interest rates on ten year and longer maturity Treasuries. Oh, wait, we’re seeing that already:

Treasurys were tripped up for a second day Wednesday, due to a poor auction and better-than-expected durable-goods data.

The selling pushed yields on the two and 10-year notes above the upper end of the trading range that has been in place since late April.

The 10-year note’s yield rose above 4% for the first time since early January, while yields on the two and five-year notes hit their strongest levels in four months on an intraday basis.

The benchmark 10-year note dropped 23/32 point, or $7.1875 for every $1,000 invested, to yield 4.009%. That is up from 3.923% Tuesday as yields rise when bond prices fall. The two-year note lost 7/32 point to 2.611%.

The government’s durable-goods report in April set off the selling, as it alleviated worries of a protracted recession. That bolstered speculation in interest-rate futures markets that the Federal Reserve may start tightening monetary policy by year end amid continued inflation concerns.

Note one bit of cheery news: this Journal piece did say the TED spread, another indictor of perceptions of interbank risk, was tightening.