The Pain Moves Beyond Subprime

The debt and leveraged-buyout markets have stalled, and more trouble lies ahead

by Matthew Goldstein and David Henry

The flu in the financial sector has sapped the U.S. stock market of more than $200 billion since the start of the year. The question on investors' minds is: How far will it spread?

On July 31 the stock market resumed a downdraft that had begun a week earlier, and once again bad news from a financial company triggered the sell-off. Shares of American Home Mortgage Investment (AHM) plunged 88% after the Melville (N.Y.) lender to homeowners with decent credit histories warned that it's facing serious liquidity issues and may be forced to close. For the year, the widely followed KBW Bank Index of the 24 largest lenders has fallen 10%, caused mostly by the meltdown in the subprime mortgage industry. And because financial shares make up 20% of the Standard & Poor's 500-stock index—its biggest component—the pain has spread. Without them, the S&P would have been up 5.6% in 2007 through July instead of the 2.6% it logged.

Yet as challenging as conditions have gotten for financial-services firms, signs point to even more trouble in the months ahead—trouble that may continue to weigh on the broader equity market.

Financing at Risk

Subprime woes have moved far beyond the mortgage industry. Already, at least five hedge funds have blown up. The latest worry is that a recent slump in the markets for corporate loans and junk bonds will deepen, jeopardizing the financing of leveraged buyouts, a big profit driver for investment banks. What's more, fears are growing that banks may be on the hook for some of the $300 billion in loan commitments they've made for buyouts already in the pipeline. The mood has gone so somber that derivatives traders are betting that bonds issued by major investment banks will tumble to near junk territory. Goldman Sachs Group (GS) and Lehman Brothers (LEH) are being seen as no more creditworthy than casino operator Caesars Entertainment, according to an analysis of derivatives trades by Moody's Credit Strategies Group.

The situation probably isn't that bleak for the nation's biggest investment banks and brokers. The major rating agencies, Moody's Investors Service (MCO) and Standard & Poor's (which, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP)), are sticking with their credit ratings for most financial institutions. Peter Nerby, a Moody's senior vice-president, says investment firms are good at managing risk and have ample resources to endure. "The key to risk management is avoiding body blows and big shocks, and that means staying very liquid," he says.

Even so, dark clouds loom over Wall Street. Nearly two dozen major financings for pending deals have stalled out, including already postponed issues for the buyouts of Chrysler Group (DCX) and General Motors' Allison Transmission (GM).

Falling Victim to the Turmoil

Wall Street is banking on the credit market improving in September after big institutional investors return from summer vacations. But that's hardly a given. Says Martin Fridson, CEO of Fridson­Vision, a high-yield-debt research firm: "Investment bankers and [private equity] sponsors say: 'Once we get past Labor Day, everything is going to be fine. We just need time for everyone to cool off a little bit, and then we'll be back in business.'" But given the new problems in the markets, he adds, "you can't have great confidence in that."

If debt investors remain wary, banks may have no choice but to reprice loans and junk bonds at higher interest rates—and eat the difference. Deutsche Bank (DB) analyst Michael Mayo estimates that lenders could lose as much as $6 billion for this reason alone.