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The Makings of a Vicious Debt Cycle

By Michael Wallace Is a debt crisis on the horizon? Warning signs are appearing. Credit spreads -- the difference between the yields on debt issues and the benchmark 10-year Treasury note -- have widened to eye-popping levels since late summer. And the trend has accelerated dramatically over the past few weeks. The widening gap, which indicates sharply higher borrowing costs for already-squeezed U.S. businesses, isn't a healthy sign for the U.S. economy.

Exhibit A: After narrowing last summer, Standard & Poor's index measuring the difference in rates between

investment-grade credit issues and Treasuries has vaulted from below 200 basis points in late August to above 275, a historically high level. That's nearly 1.25 percentage points above its level of three years ago. Likewise, in the past six months, S&P's speculative-grade (i.e.,

junk) credit index exploded from 950 to 1,567 basis points. The gap has widened nearly 1,000 basis points in the past three years.

The conundrum, for credit markets and Federal Reserve policymakers alike, is that even as yields on benchmarks like the federal funds rate and the 10-year Treasury note continue to fall, borrowing costs for Corporate America are

persistently rising. On top of that, falling stock values have basically closed equity-financing avenues for U.S. corporations. And with profits down, internal financing -- i.e., cash flow -- becomes more difficult as well. This is a

vicious cycle that feeds back on itself, squeezing corporate profits and causing credit spreads to widen even further.

RATE CRUNCH. Chalk the developing crisis up to a number of factors. As investors pour money into the relative safety of government debt issues, the yield on benchmark Treasury issues has dropped to levels not seen in four decades. (This has resulted in a flattening of the

yield curve,

whereby yields on longer-maturity Treasury issues have fallen faster than those on shorter-dated ones.) And that's on top of the fresh multiyear lows in stocks, a faltering rebound in corporate profits, and the world of troubles facing

investment banks -- which have led to fears of a squeeze in lending and corporate bond issuance.

Indeed, the rising pressures on the giant financial institutions that provide corporations so much capital in the form of loans and bond underwriting serve only to worsen the credit crunch on businesses. With so many investment banks

staring at huge losses from a slew of crippled corporate customers, they become not only more reluctant to lend to business but the banks also find their own credit-worthiness downgraded because of those losses.

And while low interest rates have proven to be a lifesaver for overextended consumers, the same cannot be said for businesses. Higher borrowing costs for Corporate America weren't the result the Federal Reserve was aiming for when it undertook the most aggressive easing cycle in the central bank's history.

BURNED FANNIE. Businesses are already suffering from one of the most debilitating crises of confidence in history. Investor patience is paper-thin after successive debacles in the energy, telecom, accounting, and

investment-banking sectors, and skepticism has now turned toward the pillars of U.S. economic strength -- the housing and auto sectors.

Even seemingly bullet-proof borrowers such as housing agency Fannie Mae, which has an implied government guarantee on its debt, are getting burned. Fannie's duration gap -- a measure of the mismatch in maturity dates between its assets and liabilities measured in months -- has surged, thanks to another boom in mortgage refinancing. The gap widened to -14 months in August, before narrowing to -10 in September. But that number is still way outside of the agency's target range of plus or minus 6 months.

Fannie has been able to narrow the gap somewhat through asset additions to its mortgage portfolio. But despite its judicious risk management and proactive steps in managing its portfolio, Fannie still finds itself in the thick of the same deteriorating credit environment as other borrowers. The proof: The spread between agency debt such as Fannie's and the 10-year Treasury has widened 27 basis points since June to +81, the widest in 14 months. Of course, a sharp corrective upturn in Treasury yields would help close the gap.

EMERGENCY AMMO. The 10-year interest rate swap spread, a measure of the credit risk among AAA-rated banks, has shifted out to its widest point in over seven months, to +68, some 20 basis points more than its narrowest levels of the past summer. In historic terms, though, this is a good deal

narrower than the gap during the Long Term Capital Management hedge-fund crisis in 1998.

This is in keeping with Fed chief Alan Greenspan's contention that the 1998 capital market seizure provided a warning for banks. Back then, they tightened controls and spread risk via derivatives, helping boost capital and reserves before running into the first shallow recession of the millennium. (These swaps

are also used to hedge rate risk by mortgage institutions -- which may have actually prevented spreads from going even wider.)

Amid the current climate of market fear -- of credit-derivatives losses, withdrawn credit lines, and high-profile debt downgrades of some big financial institutions -- it could take just one large bank failure to fracture the financial system. And the Fed is keenly aware of that as it holds monetary

policy steady, keeping its powder dry in case of such an emergency. Make no mistake: Greenspan, and his central bank brethren in other countries, are standing close vigil, ready to cut rates again should the need arise. Wallace is senior market strategist for MMS International

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