Bundle up for a deep credit freeze

By Jon Markman

An eerie calm descended over the stock market in the first part of this week, or at least what passes for calm lately. Beneath the relatively placid surface, though, dangers continued to boil in the mysterious and savage world of credit, where companies get financed when they're not on federal welfare rolls.

The disconnect between the two worlds stems in part from the fact that, even after a year of living dangerously, most stock market participants still don't understand how terrible the bond market has become. And bond people are so despondent they don't have the heart to explain.

I hate to be the one to break the news, but here it is: Despite everything you've heard about how massive infusions of hot new money printed by the Federal Reserve and other central banks have thawed the chill in interbank lending, veteran credit analyst Brian Reynolds says credit markets have just experienced their worst two weeks of all time and show no signs of improvement. None.

Unless they improve soon, you'll have to brace yourself for new lows in stocks as equity investors begin to anticipate the same severe recession that bondholders envision.

A loss of appetite

Last week, I expressed hope when U.S. and European financial policymakers finally got their act together and ganged up to inject capital directly into banks and backstop their deposits. It was a smart step that was supposed to boost confidence among credit buyers right away and help money start flowing to companies and banks that are gasping for breath.

• Talk back: Are you concerned about a credit deep freeze?

But it hasn't worked, because credit buyers in the private sector are disappearing in a puff of smoke. The London interbank offered rate, or Libor, which is the benchmark for lending rates, is falling just as the central bankers had hoped, but this has sparked little interest in debt.

It's as if your school held a half-off bake sale for day-old cakes and enticed no buyers. So sellers cut prices by half again, and customers still didn't show up. Then they cut prices again and again, to no avail. Why no takers? Well, maybe it's because your cakes are so disgusting that there are simply no buyers at any price. Plus, most of your former customers are sick or dying from the last round of junk food you sold them and have no appetite for more.

Financing for corporate debt might be cheaper, but no one is buying, in part because there are simply fewer players left alive in the market and because there continues to be little transparency to the ingredients. Credit-focused hedge funds are closing down at a rate faster than anyone can remember, and their clients among the wealthy are in such bad shape, staggered by margin calls of their own, that they couldn't buy now if they wanted to.

It's getting so bad that Joe the Bond Manager may soon be asking Joe the Plumber for a job.

Some data: From July 2007 to Oct. 1 of this year, "junk spreads" -- the difference between what lowest-rated companies pay for money and what the government pays -- rose from 240 basis points to 1,124 basis points. (The difference between a 2% interest rate and a 12% interest rate would be 1,000 basis points.) That was already the widest spread ever seen. Yet from Oct. 1 to Oct. 9, the spread surged to 1,391 basis points, or 13.91 percentage points. And in the past 10 days, it has surged to 1,595 basis points. That's like pricing a $30 sheet cake at 10 cents and still finding no buyers.

Reynolds points out that the junk market has never seen anything like this, as even after the Sept. 11 terrorist attacks, spreads widened only from 822 basis points, or 8.22 percentage points, to 1,025 basis points.

Fear trumps Buffett

Though that may sound bad only if you're a corporate treasurer, it actually has profound implications for everyone. It means that the credit market believes more ugliness lies ahead: more bankruptcies that will throw workers out of jobs, more states that may be unable to pay off bridges and hospitals, and more bondholders in enough trouble to imperil mutual fund redemptions.

Whenever things have gotten really bad in the past, some authority who has the confidence of investors shows up to calm everyone down. A hundred years ago, it was J.P. Morgan. In the early 1980s, it was Fed chief Paul Volcker. That person now is Warren Buffett, who published an op-ed column in The New York Times last week titled "Buy American. I am." In the column, he reiterated his famous phrase that it pays to be greedy when other people are fearful, and fearful when others are greedy.

Continued: When the 'smart money' loses

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