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The Eye of the Credit Storm?

Author: Lee Hudson Teslik
June 2, 2008

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Leveraged loans aren't commonly known outside finance circles. That could change soon, writes the FT's Gillian Tett, who also broached the possibility of major subprime-loan losses well before the mainstream media caught whiff of trouble. Leveraged lending is the process of offering new loans to high-risk companies, already saddled with debt. For a lender, this means potential for higher returns. It also means higher default risk. Just as banks found themselves in trouble when their holdings of subprime debt and its derivatives began to implode, they could face similar problems if the firms that took out leveraged loans start to default. It's unclear just how much exposure banks have to these kinds of loans, but experts say leveraged finance has experienced a major boom in recent years. And, much like the subprime market, Tett says the explosive popularity has come with a "commensurate fall in lending standards."

Leveraged loans aren't the only landmine still out there. The broader credit markets show lingering weakness, particularly in the United States. Housing losses continue to pose a major problem. Even as markets stabilized following rapid rate cuts by the U.S. Federal Reserve and sweeping market reform plans by the Treasury, housing indices continued to decline. The S&P/Case-Shiller house price index, which tracks the U.S. housing market, fell 14.1 percent (AP) in the first quarter of 2008, the worst single-quarter performance since the index was created twenty years ago. Global housing prices, too, are starting to waver (Economist).

Weighed down by the housing market and the possibility of yet more credit defaults, U.S. banks set aside $37.1 billion (MarketWatch) to cover losses on real estate loans in the first quarter of 2008, stoking fears that banks could again fall into the vicious cycle of debt implosions and loan write-offs. "While we may be past the worst of the turmoil in financial markets, we're still in the early stages of the traditional credit crisis," said the chairwoman of the FDIC, the U.S. federal agency that insures banks, in an interview with the Financial Times.

Just what this means for banks—and the broader economy—remains anyone's guess. Nouriel Roubini, an economics professor at New York University and a well-known pessimist who has put forth some rather dire predictions about the credit crisis, recently held a panel discussion on credit markets with experts from finance, consulting, and academia. Roubini mused on his blog that all but one of the panelists was equally or more pessimistic than he was himself. Given that 47 percent of all assets at major U.S. banks are related to real estate, and 67 percent of assets at smaller U.S. banks, the panel agreed that the risks of a "systemic banking crisis" are genuine. Other experts warn against jumping to conclusions. Tett notes that one of the factors that makes leveraged loans troubling—the fact that ratings agencies haven't produced good models to predict defaults accurately—also makes it hard to foretell mayhem.

Still, the situation merits close attention. Should other major lending institutions fall prey to the same troubles that brought down Bear Stearns earlier this year, the effects would stretch beyond Wall Street. For starters, the U.S. economy could sink emphatically into a recession, with potential knock-on effects globally and geopolitically. Alan Greenspan, the former chairman of the U.S. Federal Reserve, told the Financial Times in late May that he thinks a U.S. recession remains likely. Greenspan's outlook isn't wholly negative. He says Fed action has probably lowered the likelihood of a severe recession, but adds that it's "too early to tell" how much more credit trouble looms.

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