Forbes - "Running Scared", July 3l, 2007, 6:00 P.M. --
Sign of the times: On a day when another mortgage lender, American Home Mortgage, teetered toward liquidation, Standard & Poor's said the U.S. corporate bond market was officially speculative grade.
The big ratings agency said 50.7% of the corporate bond market is now rated speculative grade, the first time this has happened, marking a decade-long shift toward more aggressive finance strategies and the evolution of the leveraged finance market. S&P calls anything below BBB- "speculative," but most people just call it junk. These days, the market calls it scary.
The report came out as another mortgage company fell to the mercy of its lenders after a big financial shock in the subprime mortgage market. American Home Mortgage (nyse: AHM - news - people ) isn't a subprime lender, but it did underwrite loans that require little or no documentation of a borrower's income, so-called Alt-A loans.
The company said Tuesday it was getting margin calls from its banks because loans and securities it was holding as collateral against those loans have dropped in value because of the broader credit market turmoil that began over a week ago.
It said it had failed to pay $300 million in lending obligations on Monday, and it expected to miss additional payments of up to $500 million on Tuesday. It did not specify the nature of the obligations. It has hired Milestone Advisors and Lazard (nyse: LAZ - news - people ) to help it explore its options.
Shares of American Home plunged 90%, to $1.04. It had been halted for trading all day Monday and part of Tuesday. It was $10.47 when it last traded on Friday. The market took a nosedive at about the same time American Home resumed, with the Dow Jones industrial average losing 146.32 points for the day. The Dow has fallen 788.42 points, or 5.6%, since peaking at 14,000.41 July 19.
Other mortgage lenders also suffered on Tuesday. Impac Mortgage (nyse: IMH - news - people ) shares plummeted 13.2%, and Novastar Financial (nyse: NFI - news - people ) tumbled 25.4%.
Closely watched credit derivatives indexes reacted accordingly, while the yield on the benchmark Treasury rallied to 4.91%. The loan derivatives index, which tracks the creditworthiness of leveraged loans, fell to 92.6 cents on the dollar in the afternoon, from morning highs of 95.6 cents on the dollar.
The high-yield bond derivatives index was trading down to around 91.875 cents on the dollar, down from 93.4 cents in the morning.
The credit markets have expanded enormously in the last decade as banks create new products that slice and dice risk, package them and sell them off to yield-hungry investors like hedge funds, pensions and other institutions. Most of the time, even the riskiest slices of these securities perform as expected. But in times of market shock, even the safest harbors offer no comfort.
Bear Stearns' (nyse: BSC - news - people ) asset management division learned this the hard way in June, when it was forced to shut down two hedge funds that held investment-grade slices of subprime mortgage paper that got severely repriced to practically nothing.
This week, the bond markets claimed Sowood Capital as its victim, forcing it to sell its credit portfolio to Citadel Investment Group and wind down the rest of its positions. Sowood, a hedge fund founded by former Harvard endowment superstar Jeff Larsen, said losses were caused by "sharply wider corporate credit spreads" made all the worse by a "marked decline in liquidity."
"We are very sorry this has happened," Larsen reportedly told investors in a letter being circulated on the Internet Tuesday. "A loss of this magnitude in such a short period is as devastating to us as it is to you."
S&P said the ratings mix of corporate bonds continues to deteriorate as firms borrow to buy back shares and make acquisitions, but the key factor to the deterioration is simply the sheer number of lower-rated bonds coming to market. Through the first half of 2007, 70% of 158 new issues were rated B, according to S&P research.
"It would not be surprising to see even more new speculative-grade entrants this year," wrote Diane Vazza, S&P's managing director of fixed-income research, in a note Tuesday. "Though firms may have to curtail leverage" to find buyers.
So it's OK to be less than the most credit-worthy, as long as you're not loading up on debt. This would seem to confirm the widespread belief that the private equity buyout boom has reached a peak, and speculation that some deals, like Kohlberg Kravis Roberts' pending $37 billion leveraged buyout of TXU (nyse: TXU - news - people ), might not get done.
Thomson Financial circulated a report Tuesday suggesting lenders arranging the loan and bond offerings to finance the TXU deal were afraid of being left holding the bag, as they had been last week in two other huge deals, Alliance Boots (other-otc: ABOYY - news - people ) and Chrysler. The Thomson report, citing unnamed sources, said the lenders had offered to pay $1 billion to break up the deal.
Supply "overhang" in the credit markets--namely all these buyout-related loan and bond deals that have been pushed off to the fall because there are no buyers now--may keep the riskiest speculative-grade issuers out of the market altogether, Vazza writes. But there is demand for B-rated paper with its attractive 8.5% yields.
About 60% of speculative grade issues are in this B category, a shift downward from 1996, when most speculative-grade bonds were BB. That raises the risk of default, S&P said. "As the economy and corporate profit growth slows, firms rated B and below will come under more pressure," Vazza wrote.
The default rate is low, however. It is projected to be 1.4% by the end of the year, up from 1.2% at the end of June.
In its announcement on Tuesday, American Home said it was evaluating strategic options and advising about "the sourcing of additional liquidity, including the liquidity of its assets." Keefe, Bruyette & Woods analyst Bose George offered a translation: "It looks pretty much like they are done."
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