Trimingham

LONDON (Reuters) - The second half of 2008 looks like it will put the “self-reinforcing” into “self-reinforcing credit spiral.”

Banks in the U.S. are cutting back savagely on credit to individuals, making mortgages and consumer loans tougher to get and more expensive.
Borrowers in turn are missing more payments, prompting more writedowns and leaving the banks still less to lend.

Securitization, once celebrated as the shadow banking system where lenders could pass on repackaged debt to eager investors, is little more than a memory with the exception of the government-supported Fannie Mae and Freddie Mac markets.

All of these factors are magnifying one another.

And the banks themselves say it is going to get worse.

The Federal Reserve’s July Senior Loan Officer survey, one of the best indicators of on-the-ground conditions, showed broad and deep tightening across a range on consumer and housing loans, even in the face of slackening demand.

About 75 percent of domestic lenders tightened their standards for housebuyers, even the best borrowers, in the second quarter. That’s a huge majority and up from 60 percent of lenders in the April survey.

And if you want a home equity loan: forget it. About 80 percent of domestic banks have raised their hurdles for making loans.
But the most striking tightening was in consumer lending, where about 65 percent of domestic banks made it tougher to get credit card loans, more than double April’s 30 percent.

Many banks said they would continue to tighten for the rest of this year and into 2009.

“It looks both worse and more broad-based than the crunch in the early 1990s,” said Peter Possing Andersen, senior analyst at Danske Bank in Copenhagen. “You are seeing a second round now where credit tightening is showing up strongly in consumer and business loans.”
And of course this will make it worse for consumers and for banks, and demonstrates that the Federal Reserve’s unprecedented measures to try and break the cycle have yet to work.

The Fed has cut rates, it has orchestrated bailouts and it has provided huge amounts of liquidity through new lending programs. But liquidity and capital are two different things, and what banks lack, and can see dwindling further, is capital.
Meanwhile recent news from financial companies show that, even putting their constrained capital positions aside, banks are absolutely right to be making credit more scarce and expensive.

NO GOOD DEBTORS ANY MORE

Consumers are struggling to pay interest on their debts as well as high food and energy prices, house prices are still falling and borrowers thought to be better bets than subprime are going bad at alarming rates.

JPMorgan Chase & Co (JPM.N: Quote, Profile, Research, Stock Buzz) said it had lost $1.5 billion thus far this quarter on mortgage-linked assets, as credit markets deteriorated. JPMorgan also said that it sees further credit deterioration in its consumer portfolio, during the rest of 2008, which will mean they must take more reserves against losses.

It also said charge-offs on home equity loans could keep rising this year, while prime and subprime mortgage charge-offs were likely to rise “significantly.” The bank was aggressive in buying market share in 2007, when many competitors were forced to draw back, a gambit that clearly did not work out and has been noted by other lenders.

Fannie Mae (FNM.N: Quote, Profile, Research, Stock Buzz), which last month needed government assistance, said last week it would wind down its Alt-A business that makes loans to borrowers just above subprime in creditworthiness. The lender, which recorded a $2.3 billion loss in the second quarter, said it was being hit hard by increasing defaults and by the increasing costs of those defaults, as falling property prices, especially in bubble markets like California, leave them less to recover through foreclosure sales.

Fannie said its Alt-A foreclosures have doubled in southern California, while almost two percent of the loans in its Florida book are now referred for foreclosure.

Not an economy most banks would like to lend into, at least not until housing shows signs of bottoming.
It is just about possible at this point to construct an argument that says that most of the losses have been concentrated among either foolish overstretched borrowers or ones unlucky enough to get involved in housing markets that were hugely inflated.
But credit is not just tightening for the foolish or the Floridians, it’s tightening for everyone, and into a weakening economy in which it’s harder to keep a job.

“If you compare households now and the early 1990s … this time you have the same type of problems but much worse: a bigger increase in energy prices, a bigger housing downturn and a bigger financing crisis,” said Andersen at Danske Bank.

It won’t last forever, but the worst part of the crunch is still to come.

Moody’s Investors Service warns that several recent developments point to a sharp increase in defaults among vulnerable issuers of U.S. speculative-grade debt. In a new report, the credit rating company forecasts that the U.S. junk bond default rate will rise to 4 percent at the end of 2008, quadruple the rate from the end of 2007, when the default rate stood at roughly 1 percent.

Moody’s explains that low rated issuers face increasing refinancing risk and liquidity pressures. Further, a persistently tight lending environment is narrowing options for these issuers as debt matures and available credit lines dwindle.

At the same time, covenant cushions are thinning for issuers whose earnings are under pressure amid deteriorating economic conditions in the U.S., or because of scheduled tightening under credit-agreement terms. “These risk factors often function in combination, and the default risk is particularly acute for issuers facing multiple pressures simultaneously,” Moody’s warns.

For example, deteriorating cash flow is likely to put pressure on covenants, which can further reduce liquidity and make refinancing more difficult, says the report. The upshot: Credit quality has declined for five consecutive quarters, as measured by the ratios of rating downgrades to upgrades and negative outlooks to positive outlooks. “The decline in credit quality increased in severity in the first quarter of 2008,” the report asserts, pointing to the fact that downgrades exceeded upgrades by 2.9 times in the first three months of 2008, compared with 1.9 times in the fourth quarter.

The negative trend in ratings is most pronounced among speculative-grade companies. Examining first quarter results, Moody’s reported that more than four times as many junk bond issuers were downgraded than were upgraded. By comparison, this multiple was less than two times for investment-grade issuers.

Rating outlooks also signal a negative credit trend, according to Moody’s Negative outlooks currently exceed positive outlooks by 3 times, compared with 2.1 times at year-end 2007, and 1.9 times at the end of the third quarter. “The change in this ratio was affected as much by a reduction in the number of positive outlooks as an increase in the number of negative outlook,” Moody’s explained. What’s more, the credit rater said that downward revisions of rating outlooks have been particularly likely for issuers that are sensitive to reduced consumer spending or tighter lending conditions.

As a result, Moody’s currently forecasts that the U.S. speculative-grade default rate will rise to 5.7 percent at the end of 2008. However, Moody’s believes that the year-end default rate will likely be lower than the model suggests, rising to around 4 percent.

In all, 13 non-financial corporate issuers defaulted in the first quarter of 2008, compared with 19 in all of 2007. Key factors in 11 of the 2008 defaults included weakness in consumer discretionary spending, companies’ difficulty passing through higher commodity costs, and/or the slowing economy. “We expect these factors will precipitate more defaults of low-rated issuers over the next few quarters,” added Moody’s.

Chapter 1

Cannondale Bicycle was one of America’s leading manufacturers of high end mountain and road racing bicycles. The company’s price points at retail ranged from $750 to $8,000, and Cannondale’s dealer network was very proud of the company’s reputation for quality and craftmanship.

Revenues in 2001 had surpassed $140 million, with robust gross margins in the bicycle businss. However, the company’s robust EBITDA was dampened by a dramatic ramp - up in CAPEX for a new line of ‘Made in USA’ motorcycles and high performance all terrain vehicles. Within 18 months, the company’s liquidity had deteriorated by nearly $100 million.

In 2001 - 2002, the price of Cannondale’s stock had plummeted from a peak of $25 per share, and the company was facing a liquidity crisis.

Chapter 2

In October, 2002, Trimingham was engaged by Cannondale to develop a survival plan to see it through the liquidity crisis. In conjunction with management, Trimingham negotiated the sale of the motorcycle and ATV assets, and Cannondale’s clothing business.

In January, 2003, Cannondale filed Chapter 11 bankruptcy, with Pegasus as the stalking horse. The face amount of Pegasus’ subordinated debt was $25,000,000. In May, 2003, Pegasus purchased Cannondale’s assets through a 363 sale.

Epilogue

Today, Cannondale Bicycle has regained its positioning as one of America’s leading mountain and road racing bicycle companies, and has expanded into a very profitable line of clothing.