A CREDIT CRUNCH OVERVIEW

August 15, 2007
By seadmin

What the heck is going on in the corporate debt market? Well, let me give you a general overview. First off, after years of stable interest rates and low bond market risk, corporate debt had become cheap. Too cheap, in fact, and the risk in corporate bonds had been under priced. Their yields have been low, close to government bonds, and the liquidity has been deep.

But in recent weeks things have changed. The subprime mortgage market (the junk end of the corporate debt market) has caused a re-pricing of risk. There is about $4 trillion of U.S. corporate bonds, and about $600 billion that is exposed to the subprime mortgage market. As of this writing, something like $120 billion of that subprime debt has gone bad.

Big investors, i.e. mutual funds and hedge funds, have finally realized that they don’t want to be holding any subprime mortgage market exposure, so they have undertaken the process of selling. Unfortunately for them, no one wants to buy. They can’t sell, and hence the liquidity in this market has in essence dried up.

The individual investors who put money into these big mutual funds and hedge funds have all heard about the problems in the subprime market and they want their money returned. So, they put in redemption requests. The funds exposed to the subprime mortgage market can’t meet those redemptions. So they freeze redemptions instead.

Now people who are invested in any hedge funds are worried about those funds and their exposure to the subprime mortgage market. So those investors request redemptions even if the fund doesn’t have, or says it doesn’t have, exposure to the subprime segment.

Now all funds in the corporate debt market are getting redemptions. This has caused nearly everyone to sell nearly everything to meet redemptions and expected redemptions. All of the investors in corporate debt now want out. Even the quality funds and the big banks sense the problem and want fewer corporate bonds and more government bonds, and hence the current flight to quality in bonds. Funds are selling junk and buying quality. This is why 10-year Treasury notes suddenly started to improve as the credit crunch hit.

Now the selling has spread from those selling from necessity to those selling to make money from the event. Yields on corporate bonds are rising, just as yields on government bonds have fallen. Liquidity now is largely gone in the corporate bond market.

This is what I’ve been warning you all could happen with the subprime mortgage market and its potential to induce a credit crunch in the whole debt market.

In the short term, I think things are going to get worse. Over the long term, the net effect will be that corporate debt is re-priced against the bond market. This situation will make it harder, i.e., more expensive, for companies to raise capital, and that really could hurt corporate growth, the job market and earnings.

Hang on people, the ride isn’t over yet.

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