New Fears as Credit Markets Tighten Up Article

By LIZ RAPPAPORT and SERENA NG The credit markets are seizing up again amid new anxieties about the global financial system. The fear and uncertainty that sent stocks to 12-year lows is now roiling the market for corporate bonds and loans, which have given back much of the gains they chalked up earlier in the year. Short-term credit markets are still performing better than they did last year thanks to government programs to buy commercial paper and guarantee short-term debt. But Libor, the London interbank offered rate, a common benchmark interest rate, has crept up over the past weeks, from 1.1% in mid-January to 1.3% on Friday, reflecting banks' concerns about being paid back for even short-term loans. It is still well below its peak of 4.8% last October. This time around, the economy is slipping deeper into a recession, and bond investors worry the government's repeated modifications to its financial-rescue packages are undermining the very foundations of bond investing: the right of creditors to claim their assets first if a borrower defaults. Without this assurance, bonds of even the most stalwart institutions are much riskier to own. After what seemed like the beginning of a thawing of debt markets early in the year, sentiment has deteriorated, analysts say. The markets remain open only to the strongest companies. A rally in U.S. Treasury bonds last week reflects another bout of flight-to-quality buying. Junk bonds now yield 19 percentage points more than safe Treasury bonds, up from a 16-point spread in February, according to Merrill Lynch. The spread is still narrower than the 21-percentage-point premium reached last December, but any widening shows investors are becoming more fearful. Part of the problem is that investors are still waiting for key details from the government about its plans to bolster U.S. banks and unfreeze the credit markets. After launching a $1 trillion program to kick-start consumer lending last week, the Obama administration is considering creating multiple investment funds to purchase bad loans and other distressed assets. The intent of the funds is to stabilize the prices of good assets and restore investor confidence. Without more clarity from the government on its bailout plans, the market could continue to drop, say analysts. That would further harm the economy and the institutions the government hopes to help, compounding its task of shoring up the financial system. "The credit markets are a mess because the economy is a mess," says Thomas Priore, chief executive of ICP Capital, a New York fixed-income investment firm. "There's fear out there that's driving down every asset class simultaneously. It illustrates a lack of investor confidence in the government's plan for fixing the financial infrastructure." Bondholders have so far remained mostly unscathed by the intervention. But investors are now worried that if the crisis worsens, some of the government's efforts to salvage financial institutions such as American International Group Inc. and Citigroup Inc. could end up hurting the interests of debtholders. The concern is that further modifications of bailout plans could place the government's interests ahead of creditors. Though the government switched from holding Citigroup preferred shares to common shares, putting taxpayers at greater risk, the move did little to ameliorate debtholder's worries. Many investors believe the government may change course again. The government's moves may also push down credit ratings of some securities, causing another wave of forced selling. That would further weigh on prices and increase the likelihood of pension funds, banks and insurance companies needing to take more write-downs. Investors say the prospect of such a scenario is deterring them from buying mortgage-backed securities and corporate bonds. "The only way to invest is to guess at which way the winds in Washington are blowing, so capital is frozen," says Sean Dobson, chief executive officer at Amherst Holdings LLC, a mortgage-market trading and investment firm. Additional government aid to financial institutions hasn't prevented price declines among many of these companies' senior bonds. In a report over the weekend, analysts from J.P. Morgan Chase & Co. said they had expected government intervention to help protect the interests of bondholders at financial institutions. However, they noted that "in the extreme, losses can be so large that the political willpower to continue bailing out banks and insurance companies evaporates, forcing senior creditors to share in losses or producing other unorthodox outcomes." At AIG, bonds of the insurance giant's subsidiaries last week traded at prices ranging from 38 cents on the dollar to around 81 cents, from more than 50 cents on the dollar a month ago, according to data from MarketAxess. As AIG's bailout package has swelled to over $170 billion from $85 billion last September, investors have grown worried that future restructurings could cause cash generated by AIG's units to be diverted to pay off the government before its bondholders, say analysts. Responding to such concerns in an earnings call last week, AIG's chief restructuring officer, Paula Reynolds, said, "There is no plan here to breach any covenants of the debt we have in place." Long-term bonds of triple-A rated General Electric Co., which with its GE Capital Corp. unit, is the largest U.S. corporate debt issuer, last week dropped to as low as 63.5 cents on the dollar as investors fretted about the possibility of not getting all their money back. GE's chief financial officer, Keith Sherin, tried to dispel those concerns last week, saying GE Capital will be profitable in the first quarter and full year and its capital position is strong. The bonds of Citigroup are trading at just over 70 cents on the dollar, despite its still-high single-A credit rating and government support. Such anomalies make it impossible to accurately determine the value of other bonds in the marketplace without any connection to a government bailout, say analysts and investors. Traders last week saw multiple offers for blocks of securities for sale, known as "bid lists," circulating in the credit markets, as banks and brokers tried to sell chunks of structured bonds backed by mortgages and corporate debt. Big groups of sales suggest investors are desperate to unload their investments quickly, even if it means getting lower prices than if they waited. Some traders say they only trust securities that have the explicit backing of the government. Bonds issued earlier this year by Goldman Sachs Group Inc. and General Electric without the government's backing have dropped to 96 cents on the dollar and 73 cents on the dollar, respectively, in recent days. Their government-backed debt trades at or close to their full value of 100 cents on the dollar. The government has said it plans to expand its program to lend to investors to buy debt backed by mortgage loans that do not conform to government agency standards. But that market remains frozen. Mortgage bonds are also falling in value as the government reworks its plans to bail out homeowners. The new bill, called the Helping Families Save Their Homes in Bankruptcy Act, is intended to stem the tide of home foreclosures and reduce homeowners' debt by allowing bankruptcy judges to alter the terms of mortgage loans. The alterations mean some of the securities tied to those loans will suffer losses, and their ratings could be slashed. Bank of America Securities estimates the bill could affect holders of some $500 billion of mortgage securities who believed they were protected by holding the highest-rated portions of the bonds. Some of these investors are now trying to unload their stakes in order to avoid massive losses or write-downs. Write to Liz Rappaport at liz.rappaport@wsj.com and Serena Ng at serena.ng@wsj.com