When Banks Don't Trust Banks

As Europe's sovereign debt crisis shows signs of turning into a contagion, infecting everything from interbank lending rates in London to the U.S. junk bond market, credit markets are experiencing déjà vu. The almost $1 trillion pledged by European finance ministers this month to bolster the region's finances has failed to mollify investors who worry that euro zone trouble could cause another Lehman-like disruption in worldwide financial markets.

A primary cause for concern now, as then, is the banks. Independent Credit View, a Swiss rating company, estimates that global banks may have a capital deficit of more than $1.5 trillion by the end of 2011 and some may need state help to survive. Libor, the short-term rate at which banks lend to one another, has shot up to 0.538 percent, the highest since July; it was less than half that as recently as March. Other types of short-term IOUs also show strain, with financial companies having to pay an average rate of 0.47 percent on 90-day commercial paper, the highest in a year, Federal Reserve data show. "Failure is not off the table for large financials," says Brian Yelvington, head of fixed-income strategy at Knight Libertas in Greenwich, Conn.

Just a few weeks ago, the credit markets were almost back to pre-Lehman normality. Investors were asking precious little of the borrowers they shoveled money at. As of mid-May, 60 percent of high-yield borrowers were able to get away with weaker investor safeguards on new debt, according to Covenant Review, a New York-based research firm that analyzes bond offerings. Caps were removed on the amount of debt companies can carry, and fewer restrictions were placed on using assets as collateral for future borrowing, effectively reducing what's available to satisfy creditor claims in a bankruptcy. All of these were symptoms of a larger phenomenon that many viewed as healthy: An appetite for risk had returned.

That now appears to have been premature. Though Lehman-style panic has not set back in, market conditions are, to say the least, fraught. Issuance of corporate debt has slowed considerably, falling from $183 billion in April to $53 billion in May, the lowest monthly total since December 1999, according to Bloomberg data. More than 19 companies have delayed or postponed $5 billion of debt deals since Apr. 13, with immediate consequences for corporate spending. Allegiant Travel (ALGT), a Las Vegas-based passenger airline, was forced to put off a $250 million bond offering that it planned to use to pay for MD-80 and Boeing 757 aircraft already under contract. Jones Apparel Group (JNY), a New York-based retailer, pulled a $250 million bond offering that was going to help it acquire a majority stake in shoe designer Stuart Weitzman Holdings. Meanwhile, companies able to raise new debt have to pay a richer premium over benchmark government securities, adding up to 1.96 percentage points, an increase of 0.47 since the end of April. That's the biggest monthly jump since October 2008, a month after Lehman Brothers collapsed. There is carnage in the market for junk bonds, which slid 4.56 percent this month, their worst performance since dropping 8.43 percent in October 2008.

The silver lining is that while bond investors are fleeing credit markets, they are moving into Treasuries, pushing up prices and lowering the government's borrowing cost. The yield on the benchmark 10-year Treasury note fell to 3.06 percent this week, down from 4 percent in April. Among other felicitous effects, that has pushed down mortgage rates and aided the fragile recovery of the national housing market; homeowners can now get a standard 30-year mortgage at 4.85 percent, down from 5.26 percent in early April, according to Bankrate.com in North Palm Beach, Fla., spurring a new flurry of refinancing and boosting new-home sales by 15 percent to their highest levels since May 2008.

Lower rates have also brought down borrowing costs for companies fortunate enough to live at the top of the credit food chain. Abbott Laboratories (ABT), maker of the lucrative arthritis drug Humira, sold $3 billion of bonds on May 24, its first offering in more than a year. The coupon on the biggest portion of the deal, a $1.25 billion slice due in 2040, was 5.3 percent, a full percentage point lower than similarly rated bonds due in more than 15 years, based on Bank of America Merrill Lynch (BAC) index data. "There is a flight to quality, to solid investment-grade companies," says Nicholas Pappas, co-head of flow credit trading in the Americas at Deutsche Bank (DB) in New York.

Even high-yield debt still has fans—or at least bargain hunters willing to swoop in when they spot an attractive price. After junk bonds gained a record 57.5 percent in 2009 and 7.1 percent through April of this year, the market is "correcting," says Jeff Peskind, founder of hedge fund Phoenix Investment Adviser in New York. He scooped up the bonds of credit-card processor First Data and other large leveraged buyouts as prices tumbled this month, anticipating a rebound. First Data, bought by KKR & Co. for $27.5 billion, has seen its bonds decline 17.5 percent this month through May 25, raising concerns among investors about the Atlanta-based company's ability to roll over the $14.3 billion of loans and bonds it has coming due by 2014.

First Data is not alone. Junk-rated borrowers, some of whom were taken private at the height of the leveraged buyout boom in 2007, have $1.25 trillion of debt coming due through 2015. Their prospects are, at best, mixed. "LBOs need growth to de-lever. They also need access to capital markets to continue pushing out maturities," says Jason Rosiak, the head fund manager overseeing $2.7 billion at Pacific Asset Management, an affiliate of Pacific Life Insurance in Newport Beach, Calif.

As for the ol' Libor, well, it could get worse before it gets better. Deepening concern about the quality of banks' collateral and attempts to regulate the banking industry could force it as high as 1.5 percent by September, says Neela Gollapudi, a strategist at Citigroup Global Markets (C) in New York.

That's still a safe distance from its peak. Thus far, market participants tend to agree on one point—if the European debt crisis is a contagion, it will probably not lead back into full-blown panic. The recent experience of a brutal, worldwide, coordinated market plunge left calluses, as well as a resolve not to be left out of the next buying opportunity of a lifetime. A lesson from 2008 is that those with the nerve to wade back into markets at their scary lows can reap remarkable profits; just because some investors head for the exits doesn't mean there will be a mad scramble. As Morgan Stanley (MS) strategists Laurence Mutkin and Elaine Lin put it in a May 26 report: "The repricing of spreads in financing markets, sharp and swift though it has been, still does not amount to evidence of anything like the levels of stress during 2008. Nor, given that central banks have already revived their backstop measures, do we think that it will. Financing markets remain orderly and open."

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