The cost of credit risk is actually falling for investment grade borrowers, but it is rising for crossover borrowers (companies on the cusp of speculative-grade status) as shown in the Markit XO (crossover) index below. 

Much worse is the single-B side of the high yield market, reflecting very highly levered companies, including some involved in leveraged buyouts. The single-B credit protection index has climbed to LIBOR +1,500 basis points.

New companies with low credit ratings are shut out of the market, while established companies with high credit ratings have no difficulty getting funding. But established companies in general don’t need to go to the banks; they go to the public credit markets. During the past year, as I showed in other locations, a great deal of bank lending took the form of funding previously-concluded revolving credit facilities, as corporate borrowers found that they could obtain lines from banks at spreads negotiated in 2005 or 2006.

This anomaly led to a bulge in bank lending to higher-rated borrowers during 2008. But lower-rated borrowers are effectively shut out of the market. In a low-inflation or deflationary environment, few if any companies have the profit margin to pay 15 points for credit — and that is where the market for credit insurance on the single-B-rated universe now trades.

Part of the problem is that most of the single-B credits were packed into collateralized debt obligations during 2006 and 2007.  As I wrote to Asteri Capital clients in July 2009:

We are in the midst of a great re-leveraging of the corporate capital structure. The structured credit market is the main vehicle for managing this leverage, and financial intermediaries are the main providers of this leverage – banks, insurance companies, special purpose vehicles and hedge funds. At present rates of issuance, the market will have absorbed nearly a trillion and a half dollars of new Collateralized Debt obligations over 2005-2007.
The great paradox in this re-leveraging is that the vast majority of all the leverage is provided by investors who, at least in theory, are taking on no credit risk at all. By construction, nine-tenths or more of the proceeds of CDO’s are rated Aaa/AAA, because the rating agencies accept that a 7% band of protection (in the case of investment-grade credit) or some larger margin in the case of speculative credit is sufficient to protect the rest of the pool from defaults.

There never was sufficient risk appetite in global capital markets to absorb the speculative-grade issuance that fueled the LBO bubble. Wall Street repackaged the risk and sold off most of it as AAA’s (with ban ks stuffing their own Structured Investment Vehicles with paper they helped create). The hedge funds who owned the first- and second-default tranches that backstopped the AAA tranches have lost essentially all of their capital and no longer are in business. No-one will buy such structured instruments for a very long time, if ever.

Consumers don’t want to borrow; they want to save. So to whom are the banks expected to lend? The administration’s view of this is preposterous.

The market’s poor response to the Obama program(s) should come as no surprise. As I wrote Jan. 8, stocks will chop sideways forever.

This entry was posted on Thursday, February 12th, 2009 at 9:16 am and is filed under General. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.