Corporate as "Sub prime Borrowers"

The Big Picture Citibank Receives Emergency Cash Injection:

In his blog, see link above, the Big Picture, Citi bank was called "sub-prime borrower". A fitting description given the cost it has to pay for the $7.5 billion investment from Abu Dhabi investment fund (ADIA), 11% interest. The 11% yield is akin to junk bond status.

If Citi is given the label of "sub-prime borrower", what can be said about all junk bond issuers. It got me thinking about other junk issuers and borrowers that borrowed heavily and depend on credit for their operations.

The economy was buoyant since 2002 and in good economic times junk bond issuance usually spikes. These bonds were issued for a low risk premium as investors assumed more risk in search for yield. Junk bond issuers took advantage of that and issued more than $800 billion in 2007 with little spread to treasuries. Now the market repriced all these issues and spreads have shot up. Moreover, Private equity funds were on a tear for the last few years. Their funding and deals are predicated on covenant lite borrowing and highly leveraged capital structure. So the market is littered with "sub-prime borrowers" with very leveraged balance sheets that leave little margin for error.

The situation can be a repeat story of the implosion in the housing market. Companies leveraged their balance sheets, bought more assets on credit and issued debt similar to consumers who bought larger houses on cheap credit, which they could not afford once rate started to move upwards. Junk bonds is named "Junk" for a reason. Default in junk issuers in recessions shoot up to 47% for issuers within 4-5 years of issue. If the economy softens coupled with tighter lending and ceased credit markets, it could mean defaults in corporate "sub prime" or junk issuers will increase. And this will lead to another implosion similar to the housing sub prime.

If this defaults in Junk Bonds occur, then banks, again, will have more write downs in all sort of places. One of these areas is the credit default swaps. Credit default swaps are used by purchasers of debt to hedge their purchases of junk bonds as the counter party in the swap will pay if the issuer defaults on their payments. Normally the counter party will receive a premium to assume the risk, similar to insurance companies, which pay insurance claims and receive premiums from insurers. Banks have been a counter party in this $45 trillion market for about less than half of that market. If defaults increase claims against banks will rise to pay investor for their insurance.

We hope banks will be hedged against this risk.