The Credit Crunch Eases for Now... But is There More to Come?

Global credit markets are enjoying a bounce this week, along with stock indexes world wide in the wake of the Fed’s decision Tuesday to cut its benchmark rate by a full-fifty basis points. Bankers and brokers at trading desks around the globe are breathing a bit easier – at least for now -- after the Fed came to the rescue. But there’s good reason to believe that this respite may not last long.

To recap the sorry state of credit markets following the recent sub-prime crunch, let’s take a quick look back. Short term lending markets in both the U.S. and in Europe virtually ground to a halt in July and August as uncertainty spread about the extent of lending losses on debt securities backed by risky U.S. subprime mortgage loans.

Although the dominoes began to fall with adjustable rate subprime loans made by aggressive lenders in the U.S., the repercussions were felt far from Main Street USA, owing to the fact that Wall Street banks and brokers did such a wonderful job slicing and dicing these loans into any number of asset backed securities and derivatives. These were then packaged and sold globally to any investor in search of slightly higher than normal market yields, but without any additional risk – such was the “free lunch” promised by Wall Street.

Trouble is, globalization means that financial markets are intricately connected in many ways, shapes and forms. Take for instance the gridlock in commercial paper (CP) markets. Why, you may ask would U.S. sub-prime loan problems spill over into the corporate CP market? Good question, here’s the simple explanation.

Commercial paper is a key source of day to day funding for companies and financial firms both large and small. According to the Financial Times, “more than half of the commercial paper outstanding is issued to fund portfolios of securities backed by mortgages and other loans.”

So when U.S. subprime mortgage loans began to default this spring and summer in much higher than expected numbers, the market for commercial paper also locked-up, as lenders (or investors) in the CP market backed away from the new-found uncertainty. The crisis that ensued “made banks reluctant to lend to each other and pushed interbank lending rates above central bank target rates.”

For example, LIBOR rates for 3-month US dollar loans soared to a peak of 5.725% in early September, more than half-a-percent higher than fed funds at the time. UK LIBOR rates went even higher, to nearly 7%, before backing off recently, after the Fed cut its discount rate, followed by the Fed funds rate this week.

But according to the Financial Times article, there’s still something of a “standoff” between potential lenders and borrowers, as markets are still jittery in this environment. So a credit market conundrum has developed: “If you are not a top tier bank, you are not getting the money. If you are a top tier bank, you are not going to want to pay the current rates.”

Reminds me of the old saying that a banker is someone who offers to loan you his umbrella when the sun is shining, but demands it back the instant it clouds up! The semi-dysfunctional state that credit markets are still in doesn’t bode well for big banks and brokers going forward – and could well lead to fresh market shocks.

For one thing, investment banks are now sitting on about $300 billion of high-yield bond and loan deals tied to announced leverage buyouts, that they still have been unable to sell to investors. Another potential wild-card – and it’s a very big one indeed – is the sad state of affairs that continues in sub-prime USA.

There are about $900 billion worth of adjustable rate mortgages that will reset to much higher rates in the next 18 months. Naturally, this could trigger a tidal-wave of increased defaults – threatening commercial paper, and credit markets globally all over again.