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Credit markets: Leverage withdrawn

What exactly is causing weakness in the credit markets? The obvious answer is contagion from the sub-prime crisis – the fear is that there will be massive losses from the original securitizations of these poor-quality loans and the CDOs backed by these securitizations.

But it is not intuitive that fear of these future losses should cause such turmoil in other credit sub-sectors. There have been few actual losses on the underlying loans – although there is no reasonable bid for bonds backed by them. Nor have there been any corporate defaults, so the speed with which the booming leveraged loan buyout phenomenon has run into investor intransigence –some would call it a restoration of plain common sense – has caught lending banks by surprise.

Investors have apparently decided that the trend of aggressive loan terms and leverage ratios should end. Having seen first-loss positions in ABS (sub-prime) CDOs wiped out, equity investors in CLOs have understandably become more cautious. It should surprise no one that risk managers at investment banks are scaling back warehouse lines for CLOs – there is plenty of evidence that buyers are wary even of triple-A rated bonds. One can see how US corporates, especially lower-quality credits, might be challenged by a long-term hit to US consumer confidence. The fact is that the connections between sub-prime and leveraged finance, or any other part of the market, rely on real economic effects and these take time to work their way through.

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