Markets Face a Debt Déjà Vu

By RICHARD BARLEY Red lights are flashing in the credit market again. The revival in risk appetite seen at the start of the year has faded as government bailout plans have been deemed lacking. The common thread is renewed pressure in a banking system already weakened by 18 months of financial-market turmoil. A large part of the problem stems from a lack of clarity on how governments plan to inject new equity into banks and take bad assets off balance sheets. They need to provide details on their plans to stop the rot sooner rather than later. First, consider the spread between the U.S. dollar London interbank offered rate, the rate for interbank lending, and the overnight indexed-swap rate, which captures expectations for official interest rates. The spread has narrowed from October's peak of 3.66 percentage points, but the move has reversed, and the spread is now back over 1.0 percentage point versus a low of about 0.9 percentage point in January, leading to fears over bank funding and a further loss of trust in the system. Precrisis, the typical spread was under 0.1 percentage point. Second, look at the Markit LCDX index of default swaps on 100 U.S. leveraged loans. The index rallied in January to 82% of face value, but has returned to 73%, close to the low seen in December. Auctions to determine swap payouts are producing low indicative recovery rates: For the five most recent auctions on LCDX companies, the average loan price used to settle the swap is 40%. Moody's said the average recovery rate over the past 20 years for bank loans is 81%. Low recoveries will hit loss reserves hard. Third, spreads on nearly all tranches of the CMBX index, which tracks default swaps on 25 U.S. commercial mortgage-backed securities, have reached record wide levels in February after a January rally. Moody's on Feb. 5 said that it was considering cutting ratings on $302 billion of CMBS due to falling commercial-property values and rising delinquencies. Fourth, corporate defaults and ratings downgrades are accelerating, placing strains on bank capital. By Feb. 17, Standard & Poor's had recorded 31 defaults affecting $49 billion of debt in 2009, already one-quarter of the 125 defaults in 2008 and more than all the defaults recorded in each of 2007 and 2006. Behind the gloom lies the risk that while banks and policy makers still are grappling to cap exposure to toxic securitized assets, a fresh wave of turmoil may emerge from underlying, "traditional" lending. Corporate-bond issuance remains strong, offsetting some of the systemic worries, but fears are building that the issuance window could close as concerns over the banking system persist. That could signal a new phase of the credit crisis. Write to Richard Barley at richard.barley@dowjones.com