A crisis of solvency?
(John Kemp is a Reuters columnist. The opinions expressed are his own)
LONDON (Reuters) – Despite Fed assurances that the worst of the crisis has passed, and the banking system has been successfully “saved”, credit conditions are actually getting much worse, not better, for even mid-grade corporate borrowers.
Credit spreads have continued to flare out in recent sessions. Spreads for seasoned Baa-rated corporate issuers over U.S. Treasuries have widened from 337 basis points on Sep. 10 to 486 on Oct. 10 and 560 on Oct. 22.
Some of this may reflect an increased liquidity premium for the most desirable on-the-run U.S. Treasuries in the current environment — and a similar illiquidity discount for mid-grade corporate paper that may not be easy to value or trade at present.
But it also reflects growing fears about default.
Corporate earnings are clearly deteriorating. Fitch has already warned that default rates are rising — with $25 billion of U.S. high-yield bonds defaulting in Jan-Sep 2008 compared with just $3.5 billion in the whole of 2007. Default rates look set to surge in the remainder of the year and throughout 2009 as the economy slows.
Equity injections into the U.S. banking system (up to $250 billion) and purchases of troubled assets (up to $450 billion from the remaining Troubled Asset Relief Program funds) will help strengthen bank balance sheets.
But if home prices and defaults continue to rise, and default rates on other consumer lending as well as on corporate borrowing increase substantially, the banks will burn through this money very quickly.
As former Fed Chairman Alan Greenspan noted yesterday, the crisis is being transformed from one of liquidity (which TARP and the various Fed facilities are designed to address) into one of solvency (which TARP and the other facilities cannot solve).
So far, the rescue program has focused on the financial side of the economy, in the hope that restoring liquidity among the banks would get credit flowing again and avert a deep recession on the real side.
By supplying liquidity, the authorities hoped to forestall a problem of solvency.
But as the liquidity crisis proves prolonged, the real side of the economy is slowing, and the problem is becoming about solvency in any event.
Unless the federal government can find a way to arrest the slide in home values, and limit the rise in credit card and corporate defaults, the lending losses on these other books will overwhelm the banking system’s capital, even after the injection of extra government funds.
The government’s “Wall Street first” strategy has failed. Pumping more money into the system and pretending the problem is solely one of liquidity has failed to stabilize either Wall Street or Main Street.
The next phase needs to be targeted on Main Street to help stem sliding home values and prevent widespread corporate defaults that will ultimately wash back on Wall Street.
There are some signs the federal government is already moving in this direction. Federal Deposit Insurance Corporation (FDIC) Chairwoman Sheila Bair, who has emerged as one of the most prominent and competent regulators during the present crisis, indicated to Congress this week the government was urgently working on plans to forestall a further rise in foreclosures, and there have been reports of a bailout package of around $40 billion for homeowners.
But confidence in the government’s Wall Street first strategy is beginning to fray dangerously, as evidenced by the further drop in equity values over the last 24 hours and the continued surge in credit spreads, as investors anticipate a widespread deterioration in the outlook for households and businesses on the real side of the economy.
The government is now under intense pressure to develop a “Main Street” strategy aimed at forestalling a worsening solvency crisis.
The salvation of Wall Street lies through helping Main Street, not the other way around.
(At the time of publication John Kemp did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)