Credit markets upended by widening worries

Since they first hit rough weather last August, the credit markets have seen a series of storms blow through — spurred by fears that the housing recession was worsening, that bank losses were bigger than feared and that the economic outlook was worsening. After each shock passed, conditions seemed to improve — only to take a turn for the worse months later.

One reason the credit markets have had trouble finding a footing is that unlike stock prices, which can react quickly to news of lower profits or sales slowdowns, the value of credit securities — especially those with maturities of decades — depend on a series of unknowns that stretch far into the future. Until there are strong signs that the worst of the housing and economic downturn have passed, uncertainty will continue to weigh on credit market investors.

Uncertainly in the credit markets is also heightened by the growth of a new breed of unregulated investment pools known as hedge funds. Unlike banks, which are required to report the value of assets on their books every three months, there are no such reporting requirements for hedge funds. So-called “special investment vehicles” — created by banks to bundle mortgage loans and sell them off to investors — are also not reported on bank balance sheets. The worry is that losses on mortgage-backed debt carried off the books may be larger than has already been reported. 

Hedge funds have also borrowed heavily from banks to buy debt securities on credit, increasing those funds’ returns when times are good — but substantially increasing their risk when times get tough. On Thursday, Carlyle Capital Corp. became the latest fund to announce that faced a credit squeeze, after banks called in loans on some of its $22 billion in bonds, forcing it to dump holdings to raise cash. The worry is that more funds may get caught in a similar squeeze. 

It’s also far from clear just how much money will be lost before the unwinding of the credit markets runs its course. So far, banks and other lenders have reported hundreds of billions of dollars in losses. But analysts and investors can only guess at how high those losses will eventually reach.

According to one estimate, the financial industry needs $1 trillion in permanent capital to help stabilize mortgage-backed bonds, but is unlikely to raise that much. Friedman, Billings, Ramsey & Co. analyst Paul J. Miller Jr. wrote in a research note Friday that it will take between six and 12 months for the credit markets to stabilize.

The risk of a deeper economic recession is also weighing on the credit markets. Just as homeowners who lose their jobs in a recession stand a greater chance of defaulting on their mortgage, companies and local governments become stretched too. Until investors in the credit markets see some sign of an economic turnaround, that fear that a company or local government may default will continue to loom large.

So far, signs of recovery are few and far between. Housing prices continue to fall, and mortgage delinquencies continue to rise. The latest jobs data reported Friday, showing a net loss in jobs last month, seem to confirm a wider economic downturn that some economists believe started in December. 

Recent signs that inflation is picking up steam has also sent a chill through the credit markets. The reason there is simple: inflation destroys the value of all forms of debt. That’s because borrowers pay back the lender with dollars that have less purchasing power than they did when they borrowed the money. If inflation rises to levels higher than the interest rate set at the original debt auction, investors lose money.

Perhaps the greatest uncertainty gripping the credit markets is the question of just who is on the other end of a loan transaction. When debt securities represented borrowing from a single entity — whether a corporation, a local government or an individual homeowner — it was fairly easy to know when that borrower got in financial trouble.

Today, widespread securitization of debt — originally intended to reduce risk of any given loan by pooling them with others, chopping them up as securities, and spreading them among hundreds or even thousand of different investors — means that it’s extremely difficult to know just how risky those individual securities are.

“It’s very problematic to get a line of sight to who is the actually borrower,” said Bethune.

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