Credit Markets Brace for a Brisk Autumn
September May Reveal Depth of Crisis

By David Cho
Washington Post Staff Writer
Wednesday, September 5, 2007

The weeks after Labor Day for the credit markets are like the month after Thanksgiving for retailers: It's the shopping season for debt.

This September may be especially hectic, however, because of Wall Street's credit crunch, which began after skyrocketing mortgage defaults caused financial institutions to grow wary of all kinds of loans.

Major sectors of the credit markets stalled, and companies have been struggling to borrow money. Wall Street banks, which committed to lending hundreds of billions of dollars, have been unable to sell off that debt to bond traders and investment funds.

Economists say it is hard to tell whether this is just a passing storm or the beginning of a crisis. Part of the problem is that the credit markets are tremendously complex -- it is difficult even for Wall Street insiders to know basic facts, such as price, for many debt securities. And unlike stocks, which have the Dow Jones industrial average, there is no single, easily digestible way to gauge how sections of the credit markets are doing.

So far, the credit crunch has raised many questions: How will the Federal Reserve respond? Will homeowners cut back on spending? Are investment banks doing worse than they have revealed? Is another hedge fund blowup on the horizon?

The answers may be coming this month. Here is what to look for:

Bernanke's Big Day

It is no exaggeration to call the Sept. 18 meeting of the Federal Open Market Committee, which sets the financial system's benchmark borrowing rate, the most critical meeting of Federal Reserve Chairman Ben S. Bernanke's tenure. Entire segments of the debt markets are likely to be on hold until that meeting, when the Fed decides whether to cut interest rates.

"A lot hinges on what Bernanke does on the 18th," said Edward Rombach, senior analyst at Thomson Financial. "The Fed is like a snail crawling along a razor's edge. One false move and it gets bisected."

Bernanke made it clear in a speech last week that the Fed is closely watching whether the credit turmoil is spilling into the economy. The markets, as a result, may behave in funny ways in the next few weeks.

A bad economic report may cause traders to buy stocks, since it would increase the likelihood of a Fed interest rate cut. Better-than-expected reports on the economy may spark stock sell-offs and increase worries that the Fed will leave the federal funds rate constant at 5.25 percent.

That was what happened yesterday after an economic survey showed a worse-than-expected slowdown in manufacturing and construction spending in August. Bad report? Not for the markets. The Dow Jones industrial average closed up 91 points after the report was released.

A similar pattern is expected on other key economic reports slated to be released this month.

Today, the National Association of Realtors is to release its findings on pending sales of existing homes, while the Fed's "beige book" of regional economic conditions is to be published. Tomorrow, a report on U.S. productivity is to be released and several Fed officials are scheduled to give speeches, which will be dissected by investors for clues on the direction of interest rates.

On Friday, the Labor Department reports on jobs and salaries, a key insight into consumer spending, which makes up 70 percent of the U.S. economy.

Investment Firms' Earnings

The same week that the Fed makes its decision on interest rates, several major investment banks, including Goldman Sachs, Morgan Stanley, Lehman Brothers and Bear Stearns, are expected to release their earnings. These reports may open a window into just how bad the credit crunch has gotten for Wall Street's most important financial institutions.

That is, unless the banks choose to keep the blinds closed.

Some analysts worry that Wall Street brokerages will hide their losses from the credit crunch by re-classifying bad investments or shifting them to subsidiaries.

Over the past few years, these banks made massive lending commitments. But instead of requiring borrowers to agree to protective covenants in case these loans defaulted, the banks turned them into complex financial products called "collateralized loan obligations" and sold them to traders on the credit markets. That way, the risk of default was distributed across many partners.

Now credit-market traders are balking at buying any kind of collateralized debt. Some banks are selling the debt at steep discounts. Others banks, which do not want such losses to show up in their earnings, are holding onto the debt obligations in the hope that the credit environment improves.

Moody's Investors Service warned Wall Street banks last week to report these losses straightforwardly or risk credit downgrades. "If we see bloated balanced sheets on a continuing basis, that could be a rating issue for us," Peter Nerby, senior vice president at Moody's, said in a conference call with bond investors last week.

Edward Yardeni, an economist at Yardeni Research, said some banks hold financial instruments that are so complex that it could be difficult to quantify the losses. "The real risk is that financial institutions aren't sure what their exposure is to bad loans and decide it might be a prudent thing to cut back on lending activity," he said. "And that hits small businesses the most, which is a serious issue because small businesses create almost all the jobs in the U.S."

Corporate Loan Crunch

For companies, the most alarming development in the credit crisis was the freeze-up in the market for "commercial paper," a short-term loan that allows a firm to operate day-to-day. Without access to commercial paper, companies struggle to pay salaries, buy supplies and order goods.

Several prominent financial firms have been shut out of this crucial market. Countrywide Financial, the nation's biggest mortgage lender, and H&R Block, the country's leading tax-preparation firm, had to tap emergency funds because they could not get commercial paper.

Over the past three weeks, commercial-paper levels decreased by $243 billion, an 11 percent drop, according to Federal Reserve data released last week. If the trend continues, business spending could drop, damaging the economy.

Several other parts of the credit markets also are stalling, according to Thomson Financial. In August, leveraged buyouts, which rely on bank loans for financing, were at the lowest monthly level in two years. High-yield bond activity dipped to its lowest level since 1991.

Investors Remain on Alert

While the past few trading sessions have returned some optimism to the markets, investors remain on edge for blowups among hedge funds and financial institutions that made huge bets on bonds and securities backed by mortgage loans.

There have been several large hedge fund collapses this summer, most notably at Bear Stearns, the world's largest hedge fund brokerage. These breakdowns alone cannot drag the economy into recession, but they can cause investor panic and spark big sell-offs in the markets.

Part of the problem is that debt is sliced up, repackaged and traded around the world. It is difficult to know which institution might be exposed to losses caused by the credit crunch. For example, few knew that German banks held huge volumes of bonds backed by subprime mortgages until the firms reported massive losses.

"On one hand we've made the world safer so a single bank doesn't get clobbered if the loan falls apart," said David Beim, professor of finance at Columbia Business School. "But on the other hand, we've made the world a lot more uncertain because nobody knows where the risk has ended up until there is a problem."

That uncertainty is keeping investors on alert for the next headline to flash trouble.

"All the bad lending standards are now changed. People have gotten religion fast," said Rombach, the Thomson Financial analyst. "But we are one headline away from another meltdown."