New players, new products changing the credit markets.

• Author: Cockey, James D.
• Position: Banking

The state of the credit markets most often move in tandem with the general economy, so when the economy softens, as it appears to be currently, the availability of credit typically tightens. As a result, companies need to pay special attention in order to manage risks that arise from the uncertainty during downturns in the credit cycle.

We've recently been riding quite a wave: The last trough in the credit cycle occurred during the first quarter of 2002, when defaults of bonds and loans peaked. Since then, default rates have declined to what many believe are unsustainable lows. Along the way, several dynamics have affected the character of the credit markets and will certainly influence the next downturn:

* Increased Financial Leverage

Since 2002, financial leverage has increased dramatically. The flood of liquidity created by a period of very accommodative monetary policy pursued the yields available from income-producing assets, namely loans and bonds. With so much excess debt capital available, buyers--particularly the leveraged buyout (LBO) funds, which are also flush with capital--have used increasing amounts of financial leverage. This has spilled over to the non-LBO market as well.

* Different Sources of Capital

The overall sources of capital for loans have changed dramatically. Today, institutional investors provide $2 for every $1 provided by more traditional lenders, including banks. In 2002, traditional lenders provided approximately $4 for every $1 provided by institutional investors. Many institutional investors--prime funds, collateralized loan obligations (CLOs), hedge funds, etc.--have never managed portfolios of loans through a credit cycle trough, and the jury is out as to how they will act when credit tightens. These institutional sources require liquidity in the debt paper, and as a result, the trading of loans has expanded rapidly.

* Increased Financial Innovation

This flood of liquidity in the unregulated institutional sector has spawned new debt capital products, allowing investors to capitalize on gaps in the traditional credit risk continuum. The "second lien loan," in which investors seek to exploit an issuer's "unmargined" collateral or enterprise value, is a prime example. While there was less than $1 billion in total outstandings of this paper in 2002, 2006 will likely see issuance top $24 billion. Again, because many investors in this type of paper have never managed portfolios through a downturn, there is...