Financial markets are still turbulent, but there are signs that the waters are becoming a little calmer. Credit spreads remain unusually wide, however, and this has raised the cost of borrowing to individuals and corporations. The financial sector has been more affected by the problems than nonfinancial companies. The losses in mortgage-related securities have eroded capitalization of the banks. Although banks have been able to replace that capital more easily than many feared, they still need to add more, both to replace the capital lost and to increase their capitalization to allow expansion of their loan portfolios. The weakness in securitization markets means that bank must operate in a more old-fashioned manner, making loans and taking in deposits. That requires a larger capital base, but it could be more profitable in the long run, since it reduces competition from non-banks.
We believe most of the write-downs have been taken, but note that "most" does not mean "nearly all." Credit default swaps, the cost of ensuring against default of a bank, have become very expensive. The Counterparty Risk Index from Credit Derivatives Research now shows an average cost of 125 basis points (bp) to insure debt of major banks, up from only 30 bp a year ago. Risks remain less than at the peak of Bear-Stearns' problems in March, when the index rose to 250, but the fact that it has been rising again over the last two months makes us nervous.
Nonfinancial companies have not been as directly affected by the mortgage problems as financial companies. However, the losses in the mortgage-related securities reminded investors that risk is still a four-letter word. Spreads in corporate loans rose as investors got scared of credit losses, even though credit losses in commercial loans and bonds remain near record lows.
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Last May, the spread between speculative-grade corporate bonds and U.S. Treasury securities of similar maturity narrowed to a record-low 270 bp, compared with an average of 435 bp from 2002 through 2006. The then-record-low default rates (1.0% for a 12-month lagging period) justified a low spread, but no one expected default rates to remain that low. In fact, they have doubled since, to 1.9%, and are expected to double again, to 4.75%, by year-end. This is not an unusually high default rate; it is still slightly below the 1999-2006 average of 5.3%. The default rate averaged 9.2% during 2001 and 2002.
Spreads have widened to more normal levels, as investors went from being unconcerned about risk to being obsessed with it. The spread widened to 771 bp in March, but has slipped to 653 bp in June. Don't expect much further decline until the markets are sure the recession is over. In 2001 and 2002, the spread averaged 676 bp. Certainly don't expect the spread to go back to the record-low spread of spring 2007.
Investment-grade spreads have also widened, to 247 bp in June from 132 bp last June and the 2002 to 2006 average of 142 bp. The investment-grade spread is tied more to financial institutions, since financials are mostly investment grade while few nonfinancial firms are anymore. Although the widening has been less than for speculative-grade firms, a 100 bp move is enormous for this sector by historical standards – larger than occurred in the last recession.
Part of the rise in spreads has been offset by lower interest rates, especially at the short end of the maturity range. The Federal Reserve has lowered the federal funds rate by 325 bp to 2% since last September. Unfortunately, this has had less impact on long-term bond yields. The five-year Treasury note is yielding 3.7%, 140 bp lower than a year ago, when the funds rate was 5.25%. For investment-grade corporations, this more than offsets the widening of the spread, so that the actual cost of borrowing is slightly lower than a year ago. However, for speculative-grade corporations borrowing costs remain much higher, about 10% currently compared with 8% a year ago.
Along with higher borrowing costs has come an increased difficulty in borrowing. Banks are short on capital, and thus short on the ability to make loans. They are restricting their lending to the most credit-worthy borrowers, making it difficult for mid- and small-sized firms to borrow even at the higher rates. The problems for corporate issuers go beyond bank reticence. In recent years, the vast majority of non-investment grade loans – those rated BB+ or lower by Standard & Poor's – has gone into securitization vehicles called collateralized loan obligations. With CLO issuance down 85% in the first half, it's not for nothing that the average non-investment trade loan spread spiked to an all-time high of Libor+741 in March. Since then, the average has retreated to Libor+552 by June, still higher than at any point prior to 2007.
Money is harder and more expensive to get than it was a year ago. There are some encouraging signs in the markets, but this recession is still closer to its beginning than its end. Banks are restricted by their loss of regulatory capital, and are not eager to lend. The difficult borrowing environment will restrict firms for at least another year.
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