Financial Engine Failure

With problems spreading from Wall Street to Main Street, America's credit crisis will get worse before it gets better.

When a British Airways Boeing 777 crash-landed just short of the runway at Heathrow Airport a few weeks ago, there was a lively debate about why its twin engines had suddenly lost power at the same time. People might well ask the same question about the twin engines of America’s credit system—the capital markets and the banks—whose simultaneous misfiring has helped drive the country close to, or into, recession.

The extent of America’s economic woes was underlined on February 5th when signs of abrupt shrinkage in service industries in January helped push the S&P 500 stock market index down by 3.2%, its worst one-day fall in almost a year. The previous day, the Federal Reserve published its latest quarterly survey of bank-lending officers, which showed that the credit crunch was getting even crunchier. According to the Fed, a good number of banks had imposed stricter lending standards and higher rates on loans since the previous survey, carried out in October.

Although bankers are always stingier in a downturn, the Fed noted that lots of banks said they had also cut back lending because of a slide in their current or expected capital and liquidity. For that, blame the chaos in markets for leveraged buy-out (LBO) debt and complex mortgage-backed securities. Blame, too, the state of such bread-and-butter businesses as consumer and commercial-property lending, which are blowing new holes in banks’ balance sheets.

Hopes that the stalled capital-markets engine might roar back to life in early 2008 have been dashed by grim news from, among other areas, LBOs. Until recently, banks had lent merrily to finance huge private-equity deals and then unloaded all or part of the debt into a deep and liquid secondary market. Often they accepted ropey loan covenants that offered little protection against default. Now, with recession looming, the number of borrowers defaulting on these loans is almost bound to increase. Appetite for LBO debt has dried up, as a group of banks discovered this week when they failed to syndicate $14 billion of debt used to pay for Las Vegas-based Harrah’s Entertainment.

This hiccup means other big deals, such as a sale of the $15 billion of debt linked to the buy-out of Clear Channel Communications, are now in jeopardy. That could leave banks choking on a glut of loans whose value is falling fast. According to Standard & Poor’s LCD, a unit of S&P, a rating agency, even relatively liquid leveraged loans are trading at roughly 88 cents on the dollar, compared with face value in the middle of last year. Some large loans syndicated last year, such as those used in the $29 billion buy-out of First Data Corp., are also trading at big discounts to face value, which will further put off potential investors.

Put that in your pipeline

How much of this unwanted debt could banks be saddled with? S&P LCD reckons $148 billion of LBO loans are in the syndication pipeline, most of which belong to banks, plus another $64 billion of high-yield bonds. If they are unwilling to accept bargain-basement prices, bankers may have to increase their provisions against the debt they keep. “This zombie cohort will trouble the markets for a while,” reckons Mark Howard, head of credit analysis at Barclays Capital.

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