Credit market stress and rising risk aversion

11Jul07

The credit markets are under stress. The degree to which remains to be seen. Much has been made about the role the housing boom played in economic growth t0-date. The subprime mortgage market meltdown has certainly eliminated that source of demand for houses for some time to come.

While it may seem like mixing apples and oranges, the subprime mortgage mess and the larger leveraged lending stories are in a real sense connected. If risk aversion continues to rise both sectors are likely to see disproportionate selling. Therefore the bigger question is whether the credit markets will in a sense “seize up” and cut-off financing for leveraged transactions, like LBOs, and/or more mundane investment-grade transactions. For that only time will tell.

The WSJ.com and NY Times both report on the moves the rating agencies have made to downgrade some mortgage bonds.

Calculated Risk notes a passel of subprime mortgage-backed bonds are on sale as Moody’s downgrades a number of mortgage loans and a new S&P methodology effectively kills off the subprime mortgage market.

Greg Newton at NakedShorts is (shockingly) not surprised by the downgrade news.

Dennis K. Berman at Deal Journal unleashes, the ‘M’ word, meltdown to describe the problems facing leveraged loans.

Yves Smith at naked capitalism notes some hope in light of the Moody’s downgrade as there is some indication of bottom-fishing by distressed investors.

Whereas Felix Salmon at Market Movers is “baffled” by the market’s reaction to S&P’s call. He notes that the report “…tells us nothing that we haven’t known for months about the subprime market.”

Paul J. Davies at FT Alphaville reports on the transmission of this credit queasiness to Europe as the CDS market sells off quite noticeably. Further spillover effects should be watched for closely.

Randall W. Forsyth at Barrons.com looks to a Moody’s report on LBO lending and sees a growing fear of these leveraged transactions.

Whenever one sees substantial losses in a certain asset class, it is worthwhile asking is someone out there profiting from this turmoil? A report notes the extraordinary performance (100%+) of a hedge fund that had been betting on further subprime mortgage weakness.

As you can see there are investors out there profiting from the stresses inherent in the current credit markets. However the markets can be unruly beasts that move farther than any one really expects. The big risk is that the subprime mortgage turmoil is transmitted into additional asset classes, some of which have little relation to the original problem.

Credit markets are under some stress. Risk aversion is rising. The question is whether this situation is a transient or is more persistent and spreads amongst the further capital markets?

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