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New Hitches In Markets
May Widen Credit Woes

By LIZ RAPPAPORT, CARRICK MOLLENKAMP and KAREN RICHARDSON
February 11, 2008; Page A1

A widening array of financial-market problems threatens to trigger a new phase in the global credit crunch, extending it beyond the risky mortgages that have cost banks and investors more than $100 billion in losses and helped push the U.S. economy toward recession.

In the past few days, low-rated corporate loans -- the kind that fueled the buyout boom of recent years -- have plummeted in value. As a result, banks are expected to try to unload some of those loans this week at fire-sale prices.

Nervous buyers also have retreated in recent days from the market for securities backed by student loans and municipal bonds, roiling some corners of the short-term money markets. Similarly, investors have recoiled from debt backed by commercial real estate, such as office buildings.

Over the weekend, the world's top banking authorities warned that the U.S.-led economic slowdown and continued uncertainty about securities could lead banks to further reduce their lending, and choke off economic activity. (Please see related article.)

One sign of investors' anxiety: Standard & Poor's said its index of the prices on high-risk corporate loans fell to a record low of 86.28 cents on the dollar at the end of last week.

Few market participants expect defaults on any of this debt to match the elevated levels seen in last year's rout in the market for risky, or subprime, mortgages. But collectively, they threaten to deepen the financial system's wounds and create a growing pileup of shaky assets on the books of banks.

Behind the latest problems are some common themes: Investors bought some of these debt securities with borrowed money, or leverage. As prices have declined, lenders have forced the sale of some of these securities. The cash being pulled out of the market by these sales has magnified the losses from rising defaults.

Meanwhile, the Federal Reserve's interest-rate cuts, which were designed to reinvigorate the slowing U.S. economy, may be having unintended consequences in some quarters: sending investors fleeing from investments that do poorly when interest rates fall.

After years in which banks and investors have lent money on especially easy terms, "You've had the biggest credit bubble -- probably the biggest credit bubble we have ever had," says Jim Reid, credit strategist at Deutsche Bank AG in London. Part of the bubble has already been unwound, he says. The problem is, "nobody quite knows where that ends."

Hard Hit

Especially hard hit: the market for loans to big U.S. companies with low credit ratings. Problems in this market have been percolating for months. These loans, known as leveraged loans, were a popular way to finance the multibillion-dollar private-equity buyouts of recent years that have wound down amid the credit crunch, like the takeovers of Freescale Semiconductor Inc. in 2006 and TXU Corp. last year. Investors started to shun buyout loans last summer, causing a buildup of the debt on bank's balance sheets.

During the past two weeks, prices on many of these loans have fallen to levels that in a normal environment would indicate that the market expected the corporate borrower to restructure or seek bankruptcy protection. But, though they are creeping up from record lows in 2007, the default rate on leveraged loans is still very low, at around 1% in January, out of the more than half-trillion dollars of these loans outstanding.

Investors are also fleeing leveraged loans because the payments they make to investors are tied to short-term interest rates. With short-term rates falling, thanks to the Fed's rate cuts, those payments are shrinking.

"The yields are just not all that attractive especially if you fear that [interest rates are] going to fall further," says Christian Stracke of debt-research firm CreditSights in London. "That just means that the yield you are going to be receiving is going to fall further."

The loans to Freescale and TXU are trading at around 80 and 90 cents on the dollar, respectively, after being issued at about face value -- large declines for these kinds of instruments.

Many types of investors have left the market for such loans, including individuals. According to AMG Data Services, investors pulled their money out of bank-loan mutual funds for the 18th straight week as of last Wednesday, an exodus that has withdrawn $4.26 billion from the market.

This, in turn, has created problems for securities called collateralized loan obligations, which are pools of bank loans bundled together and sold to investors in pieces. Like the mortgage market's collateralized debt obligations, these instruments were assigned high credit ratings and were touted as spreading the risk of default on the underlying debt.

This week, UBS Securities and Wachovia Securities will be trying to sell portfolios of loans that may be held by a class of collateralized loan obligations called market-value CLOs. Both investment firms were lenders to these CLOs, which depend heavily on borrowed money. Now, with the market value of the loans behind these securities falling, the firms are liquidating a total face value of more than $700 million of them.

Fitch Ratings last week cut the credit rating on pieces of 24 CLOs, putting several of them deeply into junk territory, with ratings in the triple-C or double-C range. Fitch also says it is reviewing its methodologies for rating market-value CLOs. These investments have triggers in place that force banks to liquidate loans being used as collateral when their prices fall by a certain amount.

Added Burden

Having to liquidate portfolios of collateral is an added burden for banks, which already had $152 billion of loans they were trying to sell from buyouts of recent years. As the values of the loans they are holding decline, they could need to take additional write-offs. Market-value CLOs account for about 10% of the estimated $300 billion market for CLOs, according to research by J.P. Morgan Chase & Co.

Related investments called total return swaps have also been hurt. These instruments are set up by banks for hedge-fund clients or other investors to buy loans with borrowed money. The loans serve as collateral, and when the values of the loans decline, the banks' clients can be driven into forced sales.

Citigroup Inc. is one of several banks affected by the upheaval. The bank structured nine of the 24 CLOs Fitch downgraded, amounting to about $4.5 billion of loans, according to a person familiar with the matter. Citigroup issued a statement Thursday saying the bank hasn't liquidated any loan collateral associated with its total return swap program.

Debt Fears

Problems are cropping up elsewhere in credit markets. Money-market investors in the past have been large buyers of short-term instruments backed by tax-free municipal bonds and student loans. But they have been shunning these instruments -- known by such names as auction-rate securities and tender-option bonds -- because they fear the debt used to back the instruments will default or get downgraded by rating services.

Thursday and Friday, Goldman Sachs Group Inc. held auctions of hundreds of millions of dollars in securities backed by student loans, all of which failed to drum up enough demand at their asking prices.

More than half of the nation's $2.6 trillion of municipal debt, meanwhile, is guaranteed by bond insurers like Ambac Financial Group Inc., MBIA Inc., and Financial Guaranty Insurance Co. Because these insurers are also on the hook for billions of dollars in troubled subprime-mortgage-related bonds, their guarantees are no longer worth as much. Concerns about the credit ratings of the bond insurers are filtering into muni markets.

Several sales of auction-rate securities have failed to draw sufficient interest from investors in the past two weeks. These include auctions held by Georgetown University and Sierra Pacific Resources Inc. The failures leave investors paying a premium to lenders who would rather let go of the debt.

Big banks are now working to pour new money into the bond insurers, which could help relieve some stress in the financial system. But the spreading turmoil suggests that might not be enough to benefit banks and investors.

Commercial real estate is another segment of the market that is showing cracks. There were no new offerings of commercial mortgage-backed securities in January, and the cost of protection against default on such securities issued in 2005 and early 2006 has more than tripled, according to Market Group's CMBX index. Goldman Sachs estimates banks could write down $23 billion from CMBS losses this year.

--Cynthia Koons contributed to this article.

Write to Liz Rappaport at liz.rappaport@wsj.com, Carrick Mollenkamp at carrick.mollenkamp@wsj.com and Karen Richardson at karen.richardson@wsj.com

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