Commentary May 27, 2010, 5:00PM EST

When Banks Don't Trust Banks

Credit markets are misbehaving again. But having survived the panic of 2008, investors may no longer be so easily rattled

By Pierre Paulden

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As Europe's sovereign debt crisis shows signs of turning into a contagion, infecting everything from interbank lending rates in London to the U.S. junk bond market, credit markets are experiencing déjà vu. The almost $1 trillion pledged by European finance ministers this month to bolster the region's finances has failed to mollify investors who worry that euro zone trouble could cause another Lehman-like disruption in worldwide financial markets.

A primary cause for concern now, as then, is the banks. Independent Credit View, a Swiss rating company, estimates that global banks may have a capital deficit of more than $1.5 trillion by the end of 2011 and some may need state help to survive. Libor, the short-term rate at which banks lend to one another, has shot up to 0.538 percent, the highest since July; it was less than half that as recently as March. Other types of short-term IOUs also show strain, with financial companies having to pay an average rate of 0.47 percent on 90-day commercial paper, the highest in a year, Federal Reserve data show. "Failure is not off the table for large financials," says Brian Yelvington, head of fixed-income strategy at Knight Libertas in Greenwich, Conn.

Just a few weeks ago, the credit markets were almost back to pre-Lehman normality. Investors were asking precious little of the borrowers they shoveled money at. As of mid-May, 60 percent of high-yield borrowers were able to get away with weaker investor safeguards on new debt, according to Covenant Review, a New York-based research firm that analyzes bond offerings. Caps were removed on the amount of debt companies can carry, and fewer restrictions were placed on using assets as collateral for future borrowing, effectively reducing what's available to satisfy creditor claims in a bankruptcy. All of these were symptoms of a larger phenomenon that many viewed as healthy: An appetite for risk had returned.

That now appears to have been premature. Though Lehman-style panic has not set back in, market conditions are, to say the least, fraught. Issuance of corporate debt has slowed considerably, falling from $183 billion in April to $53 billion in May, the lowest monthly total since December 1999, according to Bloomberg data. More than 19 companies have delayed or postponed $5 billion of debt deals since Apr. 13, with immediate consequences for corporate spending. Allegiant Travel (ALGT), a Las Vegas-based passenger airline, was forced to put off a $250 million bond offering that it planned to use to pay for MD-80 and Boeing 757 aircraft already under contract. Jones Apparel Group (JNY), a New York-based retailer, pulled a $250 million bond offering that was going to help it acquire a majority stake in shoe designer Stuart Weitzman Holdings. Meanwhile, companies able to raise new debt have to pay a richer premium over benchmark government securities, adding up to 1.96 percentage points, an increase of 0.47 since the end of April. That's the biggest monthly jump since October 2008, a month after Lehman Brothers collapsed. There is carnage in the market for junk bonds, which slid 4.56 percent this month, their worst performance since dropping 8.43 percent in October 2008.

The silver lining is that while bond investors are fleeing credit markets, they are moving into Treasuries, pushing up prices and lowering the government's borrowing cost. The yield on the benchmark 10-year Treasury note fell to 3.06 percent this week, down from 4 percent in April. Among other felicitous effects, that has pushed down mortgage rates and aided the fragile recovery of the national housing market; homeowners can now get a standard 30-year mortgage at 4.85 percent, down from 5.26 percent in early April, according to Bankrate.com in North Palm Beach, Fla., spurring a new flurry of refinancing and boosting new-home sales by 15 percent to their highest levels since May 2008.