I am releasing the balance of the Butterfly Effect (see The Asset Securitization Crisis Part 27: The Butterfly Effect) to the public in anticipation of the next two installments of the Asset Securitization Crisis to be published to subscribers, probably sometime this week. Before we go on, I would like to thank the loyal supports of my blog. I think this as I sit up at 3 am (my standard blogging time) typing this post into the blog's text editor, slightly pissed off at some guy giving me a hard time because I won't give him what he wants for free. I was enthusiastically supported by readers who truly appreciate the value of actionable intelligence. I would like to put a few excerpts here, starting with an explanation from me (edited to take some of the passion out of the debate):

• Reggie (Me): The subscriptions are extremely under priced. There is a reason why many of the financial web sites and media probably wouldn't have the same results as this site's content. Very competent analytical talent is concentrated here. The type of talent that can only be had by paying significant sums. This is a byproduct of my own investment endeavors, thus is partially subsidized, but the cost of running the site, programming and very recently customer service adds even more to the tab. I don't have one reporter, professional pundit or editor working for me. All of us are financial professionals, MBAs, consultants, financial engineers, auditors, CPAs/forensic accountants and investors.

  Some of you are getting this expertise for as little as a few hundred or thousand dollars per year, or even as little as 75 dollars per month in summary form. Where other sites will use a journalism intern to look at a company's situation and produce an article (such as the recent Lehman Brother's CDS exposure piece - "I can tell you who's holding the bag"), I use an MBA from McKinsey, a CFA and a forensic accountant, all under the guidance of a successful proprietary trader (me). Thanks to all who understand and appreciate the value (it may not be priced this way forever) and to all those who don't appreciate it....

• User 1: Reggie has made all of his subscribers' money. They will gladly pay a reasonable fee for continued access to his work.

• User 2: Do you have any idea how much brokerage research costs??! and that stuff is GARBAGE compared to what is offered here, if you know of another place with better research for less money or free please let us know. i firmly believe that none exists. i'm 30K in debt from school (negative net worth) and make less than half of what most of you here make and i still think this is the best deal i have ever seen, it is both an educational goldmine for learning how to do quality research and this site is chock full of investible ideas. i will continue to make sacrifices in other parts of my life to afford the incredible value i see on this blog.

• Ditto. I am a 75.00 subscriber. Heck, GGP alone paid for three years for me at that rate. Of course I want to know the symbol. I am just not a micro vision whiner with an over blown sense of entitlement. Maybe Reggie should just let the big hitters in first without cluing us in at all. Reggie- I hope you do not waste another brain cell on this. This site is a free MBA.

• haha, YES, the sell-side DOES use interns to do their research!!! the guy even told me, "yea, i'll get my intern to look into that." talk about worthless...

• Reggie:
  I am a member of several worthy investors' sites some of which I pay for and others that are free. This site by far and bar none is the ultimate best value for anyone's buck. I don't have large sums to invest compared to many but I have already paid for my professional subscription for several years, thanks to your excellent insights. Its human nature for many people to want something for nothing.
  My father taught me ..you get what you pay for.
  Keep up the great work.
  5755hsa......a proud and happy subscriber.

I'd just like to say "thanks", fellas. Without your outspoken support, the negative comments probably would make me second guess the wisdom of the lowest paid tier, given the amount of work involved. Simply realizing how much it is appreciated and how much it helps the individual investor is more than enough reason to keep it going long and strong. Now, back to business...

The Butterfly Effect: part 2, the public edition

This is part two of the 27th chapter of the Asset Securitization Crisis Series to be released to the public, The Butterfly Effect - definition (adapted from Wikipedia): refers to the idea that a butterfly's wings might create tiny changes in the atmosphere that may ultimately alter the path of a tornado say from an open corn field to the center of a crowded urban populace; or delay, accelerate or even prevent the occurrence of a tornado in a certain location. The flapping wing represents a small change in the initial condition of the system, which causes a chain of (oft unforeseen) events leading to large-scale alterations of said events. Had the butterfly not flapped its wings, the trajectory of the system might have been vastly different. Of course the butterfly cannot literally cause a tornado. The kinetic energy in a tornado is enormously larger than the energy in the turbulence of a butterfly. The kinetic energy of a tornado is ultimately provided by the sun and the butterfly can only influence certain details of weather events in a chaotic (and unpredictable) manner.

Debt refinancing - a more expensive business

As debt refinancing is integral to the activities of industrial companies, they could be severely affected by an increase in interest rates. Credit crisis-related losses (totaled US$510 bn as of September 11, 2008) caused several large investment banks, such as Bear Stearns, Lehman Brothers, and Merrill Lynch, to go bust. Large asset writedowns and increase in provisions related to poor quality assets sapped the credit creating capacity of banks, forcing them to adopt stricter lending practices. In addition, the rise in inflation globally has forced the central banks of many countries to raise lending rates. The US consumer confidence index declined 46% y-o-y in August 2008. Similar trends were seen in other nations, driving up interest rates and (consequently) borrowing costs. Corporate bonds issued by industrial companies are now required to pay a higher interest due to greater perceived risk. The decrease in consumer confidence and higher default rate on bonds issued by industrial companies were the major factors behind the increase in perceived risk.

The rise in inflation globally has pushed interest rates higher in most major countries. Long-term interest rates in the US increased to 3.89% in 2Q 08 from 3.66% in 1Q 08, while rates in the UK rose 39 basis points to 4.91% from 4.52%; Europe too witnessed rate hikes. Higher lending rates have raised the cost of borrowing for the manufacturing sector. Finding it difficult to refinance their debt, manufacturing companies could soon start defaulting on loans.

Source: Government Website

See who I have identified as being particularly susceptible to the banking lending induced downturn in the manufacturing and industrial sector (click here to subscribe):

SFD_Pro Report Final 240908 - Free to download with registration (286.98 kB 2008-09-30 09:58:48) Click here to register for a free account, then return to this link - or pay for a subscription to access all valuation and opinion content.

While the short-term interest rate decreased in the US and UK, it increased in the European region from the beginning of the year. In the US, the short-term interest rate fell to 2.76% in 2Q 08 from 5.02% in 4Q 07. Interest rates rose slightly to 2.79% in August 2008. The decrease in the short-term interest rate has not benefited industrial companies as most of them are not able to procure loans at these rates. In the UK, the interest rate decreased to 5.76% in August 2008 from 6.31% in 4Q 08. The short-term interest rate in the European region increased to 4.97% in July 2008 from 4.72% in 4Q 08. Since industrial companies mainly borrow at the long-term interest rate, higher interest rates impacted these companies by increasing the cost of borrowing. Both financing and refinancing of debt have thus become expensive. Trimming their capital expenditure, several companies have postponed their initial financing plans. Also, as manufacturing companies often resort to refinancing their existing debt, they are beginning to feel the heat of higher interest rates.

Source: Government Website

Final Encore Pro (452.14 kB 2008-08-30)

Due to growing recessionary fears, the Federal Reserve reduced the fed rate (short-term lending rate) through a series of rate cuts by 325 basis points to 2% in September 2008 from 5.25% in August 2007. The government also reduced the prime rate by 325 basis points to 5% in August 2008 from 8.25% in January 2007. The Fed took these measures to improve liquidity in the banking system and provide a thrust to the slowing industrial sector. However, the crash of Bear Stearns and related events rattled the banking system. Therefore, a decrease in the key interest rate by the Federal Reserve failed to provide the desired impetus to economic growth as banks did not decrease their respective lending rate. That the manufacturing sector was hit by higher interest rates was reflected in the increase in the corporate bond default rate. Moody's Bond Indices, which cover bonds issued by industrial companies in the US, showed that the default rate increased by 61 basis points to 7.19% as of September 4, 2008, from 6.58% as of January 1, 2008. A rising default rate is likely to push interest rates even higher in the coming quarters as the credit rating of defaulting firms would deteriorate. Therefore, it is difficult to anticipate how manufacturing firms would fare in the current high interest rate scenario.

Navistar Consolidated Pro report (326.7 kB 2008-08-30)
Navistar Update - pro (214.22 kB 2008-09-17)
Navistar Update - retail (335.47 kB 2008-09-17)
Navistar Variance sheet (1.02 MB 2008-09-04)

The consumer confidence index, which measures the outlook for the coming six months, dropped sequentially over the last one year in the US. Some reversal in trend could be seen during the last two months when the index rose to 56.9 in August from 51.9 in July. The decline in this index reflects the consumers' frame of mind in the current economic scenario. The Present Situation Index, which measures shoppers' confidence, fell 2.5 points to 63.2 basis points in August. These figures show that consumers are not comfortable in the current economic environment. The unemployment rate in the US hit a five-year low of 6.1% in August 2008. The high unemployment rate indicates that industrial companies are likely to face challenges, going forward. Any further increase in unemployment would soften demand, impacting the US manufacturing sector.

Source: Bloomberg

In the current financial crisis, top US banks are scrambling to refinance bills, which would mature in the coming months. Banks operate on the principle of rotating finance; however, as there are not enough buyers, it is becoming difficult to function on this premise. Banks are due to refinance debt worth US$208 billion by December 2008. Due to the poor quality of assets owned, these banks are finding it incredibly difficult to finance the bills. This makes short-term borrowing at a higher interest rate the next viable option; but, if banks borrow at a higher rate, they also lend at a higher interest rate to manufacturers, increasing the cost of borrowing cost for these firms.

USG Financial Model Pro (908.78 kB 2008-10-05)

§ Dwindling sales and rising costs affect industrial companies

The impact of the global economic slowdown and rise in inflation on industrial companies is reflected in declining sales and increasing costs. The growth in inflation worldwide is led by the rise in the prices of commodities, agricultural products and fuels such as gasoline and crude oil. The rising inflation has increased the expenses of industrial companies as commodities and energy are major inputs in production. In most countries, the (respective) central bank has stepped in by raising key interest rates as well as the minimum reserve requirement. Rising inflation is a double whammy for companies: as the central bank raises interest rates, sales tend to decline since borrowing and corporate investment become more expensive; concurrently, rising raw material costs also affect companies negatively and reduce sales.

To control inflation, the European Central Bank (ECB) raised the key interest rate by 25 basis points to a seven-year high of 4.25% in June. The ECB had been under increasing pressure to reduce the interest rate to give a boost to the sagging economy. However, the bank did not reduce the interest rate in September 2008, as it aims to bring down inflation further. The UK central bank's Monetary Policy Committee kept the key bank rate unchanged at 5% on September 4, 2008. According to the UK Chancellor of the Exchequer, Alistair Darling, the slowdown in economic growth could be the worst since World War II.

The decline in consumer spending has compelled many companies to reduce production. Toyota Motors Corporation reduced its auto sales forecast for 2009 to 2.1% from 5.6%. The company projected auto sales to be 10.4 million vehicles in 2009, but rising gasoline oil prices are likely to dent demand. Toyota expects sales to decrease 10% in North America, its biggest market.

The cost of most inputs has risen sharply in the last one year. Although prices have come down from record highs and are declining m-o-m, they continue to remain high on a y-o-y basis. Prices of iron and steel, which are essential components of manufacturing, increased 16.1% y-o-y in August 2008. Prices of other commodities also rose globally, leading to a sharp rise in input costs. Various indices in the UK are pointing toward a trend of declining sales. The non-store retail & repair index fell 3.2% m-o-m in July 2008. Falling sales are further pressurizing the margins of industrial companies.

Source: Government Website

The price of crude oil, one of the major inputs for manufacturing companies, increased at a rapid pace in 2007. Although the price has cooled down (falling 44% from its all-time high) as of September 11, 2008, it continues to remain high (37.4%) on a y-o-y basis. The increase in crude prices has pushed the cost of production higher.

The high cost of production can be passed by the manufacturer to the retailer only in certain cases. Various companies are evaluating the extent to which they can pass higher prices to end-customers. However, industrial companies would be affected in both cases-higher prices would weaken demand, while the increased cost of production would hurt margins. In such a scenario, maintaining a fine balance between the two is an extremely challenging task for industrial companies. Decline in sales due to increased cost (input and borrowing) is exerting pressure on industrial companies.

Credit availability dries up with leverage loan market in distress

The leverage loan market had been highly active until the start of the US financial crisis, which led to the crash of large investment banks such as Bear Stearns, Lehman Brothers, Merrill Lynch, and AIG. With large financial institutions on the brink of bankruptcy, the global leverage loan market is in distress as investors are wary of entering it.

A primer to leverage loans

A leverage loan is offered by a group of lenders and is structured, approved, and controlled by one or more commercial or investment banks known as arrangers. These are loans made by banks to lower rated non-investment grade corporate borrowers. They are typically longer term loans with floating rates spread above LIBOR. Leveraged loans are normally made to companies that have outstanding debt and are rated below investment grade, i.e., a rating below Baa3 by Moody's and BBB- rating from S&P. These loans are also made to companies with leverage ratios (net debt/ EBITDA) of four or more. This loan is called a leverage loan even if the loan made to a company has a coupon rate of LIBOR rate plus 125 basis points or more. With the issuance of US$84.1 billion of leverage loans in 2Q 08, the total amount of leverage loans outstanding is at least US$200 billion worldwide, even as more banks write-off this debt from their balance sheet.

Benefits of a leverage loan

Financial markets have evolved over the last 20 years with the leverage loan market providing a platform for financial innovation. This market is an efficient primary market, which initiates syndicated credits, as well as a highly efficient secondary trading market where prices automatically adjust to reflect credit quality and market conditions. It provides the much-needed credit to lower-rated companies and has boosted the bankruptcy process in the US through debtor-in-possession (DIP) lending.

Banks benefit from leverage loan markets because during tumultuous market conditions, they have an option to liquidate their positions in syndicated credits in a relatively liquid secondary market and accordingly rebalance the risk in their loan portfolios. This permits banks to avoid much stricter lending restrictions when the economy contracts, and thereby, ensures credit availability even during tougher economic conditions. There are many variations of leverage loans, which are highly complicated and risky instruments. Some of these are second lien, mezzanine, payment-in-kind PIK loans, and toggles.

Growth path of leverage loans

Historically, banks were the primary lenders to lower-grade companies until the 1990s. These banks purchased leverage loans and held them until maturity due to the absence of a secondary market. During the late 1990s, insurance companies, hedge funds, and other institutional investors recognized the advantages of leverage loans, which could deliver high yields apart from risk-adjusted returns. Unprecedented demand for leverage loans led to the development of a secondary market with higher liquidity and transparency. Today, institutional investors arrange for more than two-thirds of the total leverage loans made worldwide.

RJR Nabisco's US$13 billion deal in 1989, one of the biggest leverage loan agreements, brought the leverage loan market to prominence. According to S&P Leveraged Commentary and Data, 2002 and 2003 are considered dry periods in the LBO market as the total deal value amounted to just US$138.7 billion and US$139.4 billion, respectively, compared to US$255.9 billion in 1998 and US$243.4 billion in 1999. Other major deals include the Georgia-Pacific (GP) LBO loan package worth US$11 billion, Alltel's US$4.2 billion deal, and Supervalu's deal worth US$4.0 billion. Among the latest transactions, Blackstone's bid to buy real estate investment firm Equity Office Properties Trust for a substantial amount of US$36 billion is considered one of the biggest LBO transactions in history.

Tremendous growth in leverage loan market in 2007

When the US economy started to show signs of a recession in 2007, the supply of lower-rated loans increased exponentially as the lure of high returns attracted many high-risk investors. According to Mark Gilbert, a Bloomberg news columnist, private equity firms declared a record US$736 billion of LBO deals globally in 2007 compared to US$696 billion in 2006 and US$270 billion in 2005. The huge success of LBOs, particularly before the credit crunch set in, created a lot of companies with the potential to go bankrupt. Due to a large number of buyers for a single company, the deals were finalized at much higher multiples of EBITDA. Deals priced at five or six times EBITDA were bought at nine times EBITDA. These inflated prices led to the downfall of several companies as it created unnecessary risk.

In 2006, 62% of new leverage loans in the US and 70% in Europe were sold in the form of collateralized loan obligations (CLOs). CLOs are a pool of bank loans divided into various tranches, providing investors with diversified exposure to leverage loans. In view of the current problems related to structured credit's exposure to the subprime sector in the US, concerns have emerged about the CLO market, since it carries the same risk. Most of the deals closed in 2007 in the industrial sector were utilized to fund working capital needs and, in some cases, expansion plans. If the default on these loans increases, industrial companies would be in trouble.

Market plummets in 2008

The leverage loan market in the US has changed considerably since 2007. The US economy is at a more advanced stage of the economic cycle and is under increased stress. The auto and airline sectors were the first victims of the economic slowdown, followed by the housing market due to defaults on subprime debt. US companies have seen their leverage multiples rise. The debt ratio of an average leverage loan deal, measured as a debt multiple of cash flows, has gone above 6.5% from the historic levels of 4.5% in 2001.

Source: Bloomberg

The graph above represents historical prices vis-à-vis volatility of the DLJLVAL Index, a prime leverage loan index in the US. There was a sharp dip in the price and volatility metrics during December 2002 due to the debt crisis. In 2007, the 10-month historical volatility went up to 6.4% with the price touching 275 levels as many capital-intensive sectors raised loans from leverage markets. In 2008, prices and volatility have dropped as fewer loans are being raised and lower volumes are being traded in the secondary market. This trend is expected to continue during the coming months of 2008 and the first half of 2009 as leverage loans dry up. Therefore, capital intensive companies in the industrial sector face a high risk of going bankrupt due to credit unavailability and heavy exposure to leverage loans. Servicing these high interest loans in the tough market environment would be a challenging task for industrial companies.

Leverage loan issuance subsides in FY 2008

Negative macroeconomic factors, which include declining GDP, escalating inflation, higher default rates, and soaring interest rate in the economy, have weighed on the leverage loan market as reflected by decreased loan issuance. The negative macroeconomic environment worsened with the collapse of a number of financial institutions, mounting write-offs in leveraged loan portfolios, total rate of return (TRR) CLO unwinds, tightening liquidity, a sizable loan overhang and negligible new issuance.

Total syndicated loan issuance in the US declined 60.5% y-o-y in 2Q 08 to US$229.6 billion. This slowdown indicates that investors are hesitant to buy new loans due to weakness in the secondary market. However, syndicated loan issuance increased 38.4% q-o-q in 2Q 08 from US$165.9 billion in 1Q 08, thereby showing some signs of improvement. The total leveraged loan issuance in the US was US$84.1 billion in 2Q 08, down 61.6% from US$219.0 billion in 2Q 07 but up 39.2% from US$60.4 billion in 1Q 08. The sharp y-o-y drop in US leveraged loan issuance was largely due to the steep decline in LBO and institutional issuance as the credit crisis continued to tighten its grip on capital markets. Merger & acquisition (M&A) issuance in the US totaled US$50.3 billion in 2Q 08, up 47.5% from US$34.1 billion in 1Q 08. LBO issuance in the US was just US$7.9 billion in 2Q 08, up only slightly from US$6.5 billion in 1Q 08.

Institutional issuance (including refinancing and new money) declined 86% in 2Q 08 to US$20.0 billion from US$143.4 billion in 2Q 07, while second lien issuance fell 77% to just US$3.5 billion during the same period. New issuance during 2Q 08 was led by industry sectors including healthcare, utilities, oil & gas, beverage, food, and tobacco, although surprisingly automotive and automotive-related borrowers were one of the largest issuers of new facilities. The automotive sector borrowed these funds mainly out of financial necessity and liquidity needs as the sector continues to experience rising raw material costs, labor issues, and softening demand.

In line with general expectations, Moody's considers the US construction industry to be the most vulnerable followed by the industrial sector. According to Moody's index, which uses market prices to assess how much of the speculative-grade market is at distressed levels, the debt of 21.3% of borrowers was trading at junk levels in April 2008, up from just 1.3% in June 2007. The recent weakness in the US loan market is likely to dampen the growth of industrial companies. The key loan index in the US saw its implied spread widen from 105 basis points to 295 basis points on a y-o-y basis in June 2007.

Rising default rates in leverage loan market

The number of borrowers defaulting on their debt obligation is gradually going up as expected by a few credit rating agencies such as Moody's and S&P. As the latest figures show, default rates, which were as low as 0.2% in August 2007, have gone up almost 13 times to 3.3% in August 2008. Insiders say this is just the tip of the iceberg, with default on bigger loans anticipated. According to sources, companies in the real estate and auto sectors accounted for more than half the defaults this year, closely followed by the gambling sector. Moody's expects that this rate would rise to 5% by the end of 2008 and 6.1% by 1H 09 as loan issuers anticipate the economy to slow down further and loan recoverability from lower-rated companies to reduce.

The last period of high default rates was December 2000 (see chart above) after the leverage loan boom in 1998 and 1999. With the dotcom bust, most telecom companies that had taken these loans, crashed and defaulted on their payments. Furthermore, the graph shows an upward trend from almost no defaults in December 2007 to about 3.0% in 1H 08, indicating a steep rise in the number of defaulters. This increasing trend is expected to continue until the end of 2009 as most of the loans would mature by the end of 2008 or 2009. Manufacturing and industrial companies are expected to be the worst hit as majority of them would default due to falling margins with the slowdown, rising input costs, and falling consumer confidence. In addition, increasing interest rates would lead to higher borrowing cost, negatively impacting the margins of companies.

The S&P/LSTA Index shows the trend in all kinds of loans in the US market for the last 11 years. The level of B loans, also known as subprime loans extended to borrowers with tainted or limited credit histories, took a hit during the dotcom bust in 2002-03. Since then, there was a surge in demand for all types of loans before the retraction that started in December 2007. This trend is seen to continue into the next year.

Fractured deals and broken structures

The leveraged loan market showed signs of panic recently, following the failure to syndicate US$14 billion of debt used to finance the US$30 billion buyout of Harrah's Entertainment. Another instance of panic was when the group of banks assisting buyers Apollo Management and Texas Pacific Group were having problems with selling the LBO debt to third parties. In fact, every deal made in the past few months is trading well below 90 cents on the dollar, with most market watchers concluding that the bottom is still out of sight.

The current dismal conditions have dragged the markets back into the price finding mode. Due to these conditions, underwriters are cutting back, modifying, or in some cases, delaying loan offerings that showed much promise during 2003-07, when the markets were on an upswing. Many industrial companies have postponed their issues as a majority of the investors expected higher returns than the company's estimates or there is no more investor confidence left in the market for these companies. Some instances where deals have been modified or postponed are AllteF's loan syndication, which was downsized in early November 2007 from an original target of US$6 billion to US$3.2 billion. Chrysler Automotives' US$4 billion loan and Energy & Industrial Utilities' US$425 million loan were also postponed. These are just some of the industrial companies whose deals collapsed.

Leverage loan volumes declined in the European region in 1Q 08

The European leveraged loan market opened its doors to non-bank participants in 2003. Since then, the market in terms of outstanding loans has grown dramatically as investors were lured by high-yield bonds. Demand for leverage loans has been very high with most corporate borrowings being executed in the loan market. This strong demand was matched by increasing supply in the form of private equity sponsors financing the recent LBO boom. Against the backdrop of this strong growth, a number of recent developments have been the cause of increasing concern for the market as leveraged finance issuance nosedived to €11.1 billion in 1Q 08 from €89.4 billion in 1Q 07. The decline in demand for these products is due to the greater underlying risk. Besides, due to huge writedowns during the current credit crisis, investors expect riskier assets to default.

Signs of rising default risk in the European market

Default risk in the European leverage loan market has been low historically. However, in the current credit crisis, defaults are likely to surge once lenders and sponsors shy away from companies that need capital for financial restructuring, according to S&P Ratings Services. In its recent report, S&P listed 52 global publicly rated companies that defaulted (from June 2007 to June 2008), driving up the TTM speculative-grade default rate to 1.8%. This compares with only 22 publicly rated companies globally for the whole of 2007, with a record low default rate of 1.0%. Among the 52 companies, the only rated European company to default was the French drinks manufacturing company Belvedere S.A., which voluntarily filed for bankruptcy in July 2008.

In Europe, as more activity takes place in the unrated private leveraged loan market, it would be inadequate to review defaults of only high-yield issuers that are publicly rated. S&P's private credit estimate database of 648 entities (as of June 2008), comprising mainly private leveraged loans held in institutional investors' portfolios, says a different story. Over the 12-month period until June 2008, 10 defaults were recorded in Europe, representing a default rate of 1.5%. Going forward, S&P's analysis suggests that the private European leveraged loan default rate is likely to reach 5.8% by mid-2009, and majority of the defaulters would be in the industrial and consumer goods sectors.

According to Moody's, FMCG companies are likely to be the most risky in the European region. With the latest figures showing retail sales dropping 1.6% in March 2008 in the region, most retail companies, which were LBO targets, look increasingly vulnerable. For instance, Coltrane CLO Plc held an auction to sell €394 million of loans. Nine banks paid an amount totaling 86.7% of face value for the securities, according to KPMG LLP. Deutsche Bank AG said recently that it bought about a third of that debt. With the European leverage market showing signs of a slowdown due to rising default rates particularly in the industrial sector, it would become more difficult for industrial companies to raise capital.

The industry-wise breakup of leverage loans made in Europe shows a gradual rise in leverage loan transactions from 2003 until 1Q 08, with the biggest of around €230 billion recorded in 2007. In 2003, no particular sector/ industry held the highest share of loans taken. With the telecom boom, most of the loans from 2003-06 went to the telecom sector. However, in 2007, the general manufacturing industry accounted for the highest share of leverage loans made on a y-o-y basis. According to Reuters, in 1Q 08, borrowings were highest in the real estate (€1.5 billion), telecom (€1.1 billion), and general manufacturing (€0.8 billion) sectors. With huge loans on their capital and slowdown in the European economy, most of these leveraged manufacturing companies are likely to default on their repayments. Defaults would increase as the companies would be under increasing pressure to refinance their loans, which has become difficult due to stricter lending practices and higher interest rates.

Negative impact on industrial/ manufacturing units

With the current scenario looking extremely gloomy, industrial and manufacturing units in the US, Europe, and around the world are likely to find it exceptionally difficult to keep up with their capex projections. The market turmoil in the US, expected global economic slowdown due to the credit crisis, rising input costs, and dwindling consumer spending would adversely affect the capex plans of these industrial companies. The option of internal funding is looking grim as companies' reserves are depleting due to diminishing profit margins resulting from the slowdown. Moreover, higher borrowing rates are keeping companies away from banking institutions. Lastly, leverage loans are getting out of their reach as investor confidence declines with rising default rates. As the credit crunch plagues the industry making credit availability difficult in the light of worsening macroeconomic conditions, demand is set to decline. Going forward, we believe the impact of the failure of financial companies and ongoing credit crisis would trickle down to the real sector and negatively impact industrial and manufacturing companies.

Default risk of companies continues to rise as depicted by rising CDS spreads

The notional outstanding value of credit default swaps (CDS) grew at an exponential pace from US$900 billion in 2000 to US$45 trillion in 2007 and US$62 trillion in 2008, which is more than four times the US GDP. The recent cataclysmic events in US financial markets changed the face of Wall Street as two of its investment banks evaporated in the heat of the credit crisis. The bankruptcy of Lehman Brothers (Lehman), fire sale of Merrill Lynch, and nationalization of AIG has seen CDS spreads rise not just in financial sectors. Though AIG was bailed out, Lehman's bankruptcy would have a far-reaching effect on the CDS market as settlement issues surface in the near future. The worst fears on Wall Street have come true as distrust among financial institutions has frozen credit markets in the last few days. Central banks across the globe are injecting liquidity to soothe financial markets.

The spike in CDS spreads reflects the rise in perceived risk and loss of investor confidence as the strain in the financial sector continues. The rise in insurance cost reflects the increased probability of default by companies, further dampening the credit situation. The rise in default rates would send ripples across the financial system as more companies are anticipated to be in trouble and possibly fail in the near future.

The US Government two-year note rates declined 31 basis points from September 15 to 19. This is the highest decrease since February 2008 as investors opted for the safer government debt. The bankruptcy of Lehman and nationalization of AIG, Fannie Mae, and Freddie Mac have made financial markets skeptical about the safety of corporate bonds. With investors hoarding safe treasury bonds, the CDS of corporate bonds skyrocketed in the past week.

The financial turmoil in mid-September 2008 led to a surge in the CDS spread of financial giants as liquidity froze and perceived credit risk increased. The fact was evident in the case of AIG as the credit spread of the five-year bond began to increase since the start of September 2008. This spread increased 529.2 points to 902.5 basis points on September 12, 2008, from 373.3 on September 1. This was the time when the company declared its business was in trouble. As AIG's requirement of US$40 billion came to light, spreads increased to 3500 basis points on September 16, 2008. Subsequently, the insurer was bailed out by the Federal Reserve, which provided US$85 billion of bridge loans for an 80% stake in the company. Washington Mutual, which has written down losses totaling up to US$14.8 billion and is looking to save itself from liquidation, has seen its spread rise. The CDS spread for a five-year period soared 88% as of September 17, 2008, since September 1.

Source: Bloomberg

CDS spreads widen mainly in banking and industrial sectors

The US dollar-denominated CDS year-to-date (YTD) movement until July 2008 showed that all industries reported wider spreads except the building & materials sector, which expanded more than 400% in 2007. The worst-performing sectors were transportation, automotive, insurance, gaming, banking & finance, lodging & restaurant, and broadcasting & media, with the spread of each widening by greater than 90%.

The banking and finance sector bore most of the brunt of the credit turmoil as around 40% of outstanding CDSs are held by this sector. Top investment banks saw their spread rise in the last few months as they reported increasing losses led by asset writedowns and increase in provision. As losses mounted for these institutions, the CDS spread also gained as the risk of default rose. The spread of Bank of America, which has written down US$21.2 billion in the current credit crisis until September 11, 2008, increased as the company acquired Merrill Lynch. The spread increased by 99 basis points to 223.3 points on September 17, 2008, from September 1. This rise indicates that as the riskiness of companies' increases, the CDS spread also moves upward, reflecting greater default risk. The spike in CDS spreads is an indicator of the deteriorating health of financial institutions. Goldman Sachs' CDS spreads also rose considerably to 443.3 basis points on September 17, 2008, from 129.6 on August 1, 2008.

Source: Bloomberg

Morgan Stanley (), one of the last two independent US based investment banks, is (was) in merger talks with Wachovia Corporation. Morgan Stanley registered further losses of US$1.3 billion in 3Q 08 to record total losses of US$15.7 billion. As illustrated in the charts below, the CDS spreads of both Wachovia and Morgan Stanley widened considerably in the past week. The CDS spread of Morgan Stanley increased to 997.9 basis points on September 17, 2008, from 225.1 basis points as of August 1, 2008. Similarly, Wachovia Corp., which wrote down assets worth US$22.7 billion as of September 19, 2008 (Source: Bloomberg), saw its spread increase to 756.7 basis points as of September 17, 2008, from 108.3 basis points at the start of the year. The tremendous increase in the perceived risk of the asset in 2008 led to the rapid widening of its CDS spread.

Source: Bloomberg

The turmoil in the financial markets is spreading across the general economy as the perceived risk has increased and chances of corporate failures are on the rise. Spreads have widened across the industrial and manufacturing segments as investors believe the likely recession in the US economy would lead to more bankruptcies. Tight credit market conditions, rising inflation and unemployment, declining consumer confidence, flagging consumer sales, and increased interest burden would cause distress among industrial and manufacturing companies.

In the transportation sector, airlines such as AMR Corporation, JetBlue Airways Corp., and Continental Airlines, Inc. were the worst hit. Trucking companies YRC Worldwide Inc. and USF Corp. saw their spreads almost double to 912 and 957 basis points YTD, respectively, through July 2008. Since production has declined due to falling consumer demand, the transportation sector's profitability has dropped, increasing the CDS spread for these companies.

Among auto manufacturers, the worst performer was General Motors Corp as its CDS spread increased to 2486 basis points as of September 18, 2008, from 726.6 basis points at the start of the year. Due to the bleak outlook for the auto sector, it is not surprising to see spreads of companies rise. General Motors has been in trouble as its losses have been mounting. The company reported a net loss of US$15 billion in 2Q 08 as sales in North America decreased 20%. This decline mainly increased the CDS spread raising the company's perceived risk.

Source: Bloomberg

The average spread on CDSs increased in all but one industry in 2008. This factor indicates that the market may be bracing for more corporate defaults. Fitch Ratings said spreads have widened the most this year in industries badly hit by the housing and subprime crises. These industries include banking, insurance, transportation, gaming, and media. Of the 23 business segments that Fitch covers, only one sector - building and materials - has seen spreads tighten. Spreads in this sector dropped almost 50% to about 504 basis points through July 2008. Spreads in the construction-related sector had skyrocketed in 2007, rising around 400%. Surging spreads make it difficult for many companies to refinance debt. Increasing spreads raise the perceived risk, pushing the insurance cost higher. This in turn is expected to further increase borrowing costs in the bond and loan markets.

Wider spreads across the board indicate that the market would be preparing for a rise in defaults. According to Fitch, the high-yield corporate default rate rose to 3.1% at the end of June 2008 from 0.5% at the end of 2007. One can expect greater defaults in the future as spreads increase and investors seek greater reward for taking on credit risk.

Major CDS indices are falling as credit market turmoil touches nadir

The current credit crisis has resulted in an increase in spreads across regions. The rise in asset writedowns, surging global inflation, and deteriorating macroeconomic conditions have worsened the outlook for the economy. The rise in input prices led to an increase in cost of production, slowing down growth in companies. As a result, there is greater pressure on companies across sectors, leading to increase in credit spreads. Furthermore, considering the crumbling financial sector, large number of bankruptcies, and a few companies looking for a suitable buyer, the spread is bound to increase. Overall, the situation ahead looks challenging and murkier for companies.

The US CDX NA IG index spread widens at a rapid pace by over 200 basis points from April 1, 2008, to 469.2 basis points as of September 16, 2008. This index's spread could rise further as an increasing number of financial institutions, including Washington Mutual and Morgan Stanley, are looking for a possible buyer. The US financial system, which looked resilient until now, seems to be crumbling as investors are wary of the current turmoil.

Source: Bloomberg

The popular index in Europe, know as Itraxx Europe index, which covers 125 investment-grade entities from six sectors - auto, consumer, energy, financials, industrials, and TMT - has seen its spread widen in the last one month. The Itraxx Europe index rose 43.8% to 143.75 as of September 16, 2008, from September 1, 2008. With the rise in the number of companies defaulting, the credit spread is increasing rapidly as revealed by the index. This could raise the insurance cost as well as the default risk of companies.

The US financial crisis has impacted the entire globe, widening the CDS spread in all markets. The spread of the Itraxx Asia index rose, leading to increased default risk. The index rose 25.7% to 699.61 as of September 16, 2008, from September 1, 2008.

Japan's economic health has deteriorated as indicated by its GDP, which fell 3% (annualized) in 2Q 08. The Itraxx Japan index spread expanded by 49 basis points to 179 basis points as of September 16, 2008, from April 1, 2008. Furthermore, the increasing spread increases the probability of default, which is rising worldwide.

Source: Bloomberg

CDS spread widens in Europe

Following the trend in the US, the spread of companies in the European banking and finance sector more than doubled in July 2008. The financial crisis impacted the banking and insurance industries the most, as reflected by the increasing spreads in these sectors. In 2008, other than these two sectors, the retail, automotive, and transportation sectors had the highest average spread levels in absolute terms, while the spreads of automotive, broadcasting & media, and building & materials sectors widened the most on percentage terms. While all companies in the transportation sector had greater spreads this year, the high average value is largely due to Scandinavian Airlines. This company's spread rose to 529 basis points, whereas that of British Airways jumped to 395 basis points, up 167 and 242 basis points, respectively, from the start of the year. Spreads of retail companies widened substantially during 2007. The trend continued in 2008, with the spread increasing by an average of 119 basis points to nearly 225 basis points YTD through July. The spreads of most companies widened, with some underperforming considerably. On a nominal basis, DSG International's spread increased the most, expanding 338 basis points from 122 basis points to 460 basis points as of September 18, 2008. Stalwarts such as Tesco Corp and Carrefour SA saw their spread widen by 43 basis points to 73 basis points and 41 basis points to 71 basis points, respectively, as of September 18, 2008, from the start of the year. The increase in the CDS spread of all these companies indicates the rising default risk. Consequently, the extra charge for the insurance of the debt is rising.

Industrial/ manufacturing companies, which had not witnessed a large increase in spread, have begun to feel the pressure of rising spreads. All companies in the automotive sector performed poorly. On a small scale, auto parts suppliers fared the worst, with spreads of Continental AG and Valeo SA widening by 219 basis points to 252 basis points and 201 basis points to 236 basis points, respectively, as of September 18, 2008, from the start of the year. Two companies led the rise in spreads in the Broadcasting & Media sector. SEAT Pagine Gialle S.p.A.'s spread rose 1028 basis points to 1375 basis points YTD, the highest spread in the industry, while ITV Plc's spread widened 198 basis points to 308 basis points. The increase in the CDS spread has increased the default risk. This is because borrowing cost increases with the CDS spread, making debt refinancing costlier. As industrial production decreases (as shown by the Index for Industrial Production), industrial companies are likely to feel the pinch of a higher cost of borrowing. This situation is likely to result in the closure of many companies.

Bankruptcy of Lehman to raise settlement issues in the CDS market

The CDS market has grown at an extremely fast rate but the rules governing it have not kept pace. The default of one party to the transaction increases the potential risk to the entire financial system. The default of Lehman, which has led to an increase in the CDS spread of all financial players in the system, makes this clear. To avoid a similar situation, Bear Stearns was bailed out by the Federal Reserve. The complete failure of Bear Stearns would have impacted the entire financial system, compelling the Federal Reserve to intervene and save the company from bankruptcy. However, since Lehman has filed for bankruptcy, the effect of its presence in the CDS market would lead to a cascading effect of huge defaults. Though the Federal Reserve has stated that Lehman does not have much presence in the CDS market, Fitch has listed Lehman among the top 10 largest CDS counterparties in terms of number of trades and debt value of contracts. As CDSs are sold and resold creating an entanglement between institutions, Lehman's default is likely to have far-reaching effects on the entire financial system. Therefore, the domino effect arising from Lehman's fall raises questions regarding CDS settlements. Update: I have done some digging into this since the Butterfly Effect was originally published. See "Do you who's going to screw who next week?" and "I can tell you who's holding the bag" for some hard numbers and facts relating to this.

According to Fitch, Lehman acted as the CDS swap counterparty in 27 Fitch-rated public synthetic CDOs and 35 private CDOs. Of the 27 public CDOs, 12 are in Europe and 15 in Asia. Among the 35 Private CDOs, 17 are based in Europe, 15 in Asia, and 3 in the US. The impact of CDS transactions and CDO note ratings, in which Lehman acted a swap counterparty, would rely on a number of factors. Some of these factors include the swap being transferred to another counterparty; the status of the CDO transaction - whether or not it faces an automatic unwind in view of Lehman's bankruptcy; and the extent to which CDO note holders would be subject to the market value risk of eligible securities in the event of early termination of the transaction. This is similar to earlier cases in which Aon Corporation (Aon) booked a huge loss on its protection sold to Bear Stearns. The failure of Lehman highlights the counterparty risk of global financial institutions. The International Swaps and Derivatives Association (ISDA) needs to come up with a mechanism for settlement in the CDS market. Accordingly, the credit default instrument should be exchange traded rather than OTC. A regulated exchange with proper mechanisms in place would be better equipped to take care of the counterparty risk and operational inefficiencies in the CDS market.

The deteriorating financial market coupled with worsening macroeconomic conditions are expected to result in a significant rise in defaults in the near future. Highly volatile market conditions along with considerably higher spreads are increasing investors' concerns regarding financial services companies and non-financial enterprises such as automotive and manufacturing companies. The trouble in financial markets has begun to impact the manufacturing sector and is likely to have a significant effect on the global economy. The considerable rise in default rate in the US economy points to the worsening scenario. The US high-yield corporate default rate rose to 3.1% at the end of June 2008 from 0.5% at the end of 2007. For the moment, we believe that economies around the globe are in for difficult times as the financial turmoil worsens and impacts growth in the real economy.

The Asset Securitization Crisis Analysis road-map to date:

1. Intro: The great housing bull run - creation of asset bubble, Declining lending standards, lax underwriting activities increased the bubble - A comparison with the same during the S&L crisis
2. Securitization - dissimilarity between the S&L and the Subprime Mortgage crises, The bursting of housing bubble - declining home prices and rising foreclosure
3. Counterparty risk analyses - counter-party failure will open up another Pandora's box (must read for anyone who is not a CDS specialist)
4. The consumer finance sector risk is woefully unrecognized, and the US Federal reserve to the rescue
5. Municipal bond market and the securitization crisis - part I
6. Municipal bond market and the securitization crisis - part 2 (should be read by whoever is not a muni expert - this newsbyte may be worth reading as well)
7. An overview of my personal Regional Bank short prospects Part I: PNC Bank - risky loans skating on razor thin capital, PNC addendum Posts One and Two
8. Reggie Middleton says don't believe Paulson: S&L crisis 2.0, bank failure redux
9. More on the banking backdrop, we've never had so many loans!
10. As I see it, these 32 banks and thrifts are in deep doo-doo!
11. A little more on HELOCs, 2nd lien loans and rose colored glasses
12. Will Countywide cause the next shoe to drop?
13. Capital, Leverage and Loss in the Banking System
14. Doo-Doo bank drill down, part 1 - Wells Fargo
15. Doo-Doo Bank 32 drill down: Part 2 - Popular
16. Doo-Doo Bank 32 drill down: Part 3 - SunTrust Bank
17. The Anatomy of a Sick Bank!
18. Doo Doo Bank 32 Drill Down 1.5: Wells Fargo Bank
19. GE: The Uber Bank???
20. Sun Trust Forensic Analysis
21. Goldman Sachs Snapshot: Risk vs. Reward vs. Reputations on the Street
22. Goldman Sachs Forensic Analysis
23. American Express: When the best of the best start with the shenanigans, what does that mean for the rest..
24. Pt one of three of my opinion of HSBC and the macro factors affecting it
25. The Big Bank Bust
26. Continued Deterioration in Global Lending, Government Intervention in Free Markets