Credit chicks come home to roost

Credit chicks come home to roost
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First Published: Thu, Jul 26 2007. 12 27 AM IST
Updated: Thu, Jul 26 2007. 12 27 AM IST
Have equity investors finally lost their nerve? The precipitous fall in US stocks on Tuesday—the S&P fell 2%—certainly makes it appear so. After shrugging off the deepening woes in the credit markets, stock investors have finally looked over their shoulders and taken fright. Granted, the case for stocks remains reasonably strong. But unless the credit markets stabilize, problems there may begin to undermine equity fundamentals, as well as sentiment.
The evidence on Tuesday was unrelenting. A buyout loan for a strong borrower, Allison Transmission, was sent packing. Defaults on the so-called “Alt-A mortgages”, which are just slightly less creditworthy than loans, to prime home-buyers are reportedly starting to default at the same rate as subprime loans. Countrywide Financial, the biggest US mortgage bank, said earnings plummeted by one-third. And bond guru Bill Gross at Pimco said the buyout debt market was more or less closed for business.
That’s enough to make any investor jumpy. And it makes sense that Countrywide’s shares should lead the market down. But stocks aren’t down for the count just yet. The US market trades at 17 times this year’s expected earnings. That’s only slightly above long-term historical levels, and nowhere near the multiples seen in the dotcom era. Plus, buybacks and leveraged buyouts (LBOs) have pumped loads of cash into investors’ pockets. That cash takes a while to reinvest. So there should be technical demand for the stocks for a while, if the credit-induced panic subsides.
But there are a couple serious threats. First, much of the recap-driven buyback and LBO activity flooding the market with cash depends on healthy credit markets. If they close, that flood will dwindle. Second, there’s little sign of improvement in the subprime mess—indeed, if Alt-A loans are really starting to default like subprime, it would signal a serious escalation of the housing malaise. A big fall in consumer spending due to the housing downturn could tip the economy into recession, and set the equity markets on a downward trajectory.
This isn’t a fait accompli. If lenders and borrowers can grope their way towards reasonable risk-return equilibrium, the economy may be able to trundle forward and continue to escape the consequences of the mortgage market mess. But if the panic displayed by equity investors on Tuesday becomes endemic through all the markets, such a benign outcome is unlikely.
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First Published: Thu, Jul 26 2007. 12 27 AM IST
More Topics: credit | Money Matters | Global Markets |