The credit gods last year were angry and lusting for blood. They wanted a live sacrifice but were not satisfied with the painful, public deaths of Bear Stearns, Lehman Bros. (LEHMQ, news, msgs) and Washington Mutual.
They demanded more, and for a while in February it looked like they wanted no less than the entire financial system to burn as punishment for all the hubris and crimes of leverage that lenders and borrowers had committed for a decade.
Instead, the U.S. government threw itself in front of the banks and tossed two industrial companies into the line of fire: Chrysler and General Motors (GMGMQ, news, msgs). And that appears to have done the trick, because by all appearances the great credit crisis of 2007-08 ended with the two carmakers' bankruptcies and is now on the path toward a real recovery. We're not talking just "green shoots" here but flowers and trees.
The automakers' bankruptcies are major milestones in the recovery of the markets for a very strange reason, according to credit analysts. Investors had come to expect that Chrysler debt holders would lose their legal rights at the front of the line and be annihilated in a prepackaged bankruptcy -- humiliated, ground into meatballs and fed to sharks -- and instead, in a shocking development, they were treated with a respect almost amounting to decency.
That led to a thaw in the corporate credit markets, to the surprise of virtually everyone involved, and snowballed into what one veteran called "euphoric buying" two months ago. That was only accentuated when details of General Motors' bankruptcy began taking shape in late May.
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Did Chrysler bondholders kill the bear?
Most investors had come to believe that the government was trying to steal what belonged to the debt holders and give it to the United Auto Workers. Credit markets believed the union and bondholders should be treated roughly equally, but the government wanted to give the union 39% of GM and the bondholders 10%.As it turned out, institutional bondholders agreed to a deal in which the union got 17% of the company plus debt while the bondholders got 10% of the company with warrants for 15% more -- and the secured lenders were paid 100%. That was the way that credit market believed it should be, and then the bond guys really began to buy distressed debt, helping companies recover in a truly fundamental way that has provided the foundation for the equity rally.
Veteran analyst Brian Reynolds has observed that by facing down the government and defending the rule of law, in short, Chrysler and GM debt holders deserve a medal from fans of capitalism and possibly even credit for ending the bear market.
Don't believe it? Well, it's hard for people focused on equity markets to get good visibility on the debt markets due to their opacity, but veterans say they have never seen a credit rally of such magnitude and speed. It's almost as if the stock market had already gone back to the 1,200 level of the S&P 500 Index ($INX), instead of the 940 level, where it is now.
A good way to see the recent change is through the price of insuring bonds through credit default swaps. Without going into the gory details of how they work, consider that to insure a distressed company in difficult times in the credit-default-swap market, you must pay 1,000 basis points, or 10 percentage points, over what you would pay to insure U.S. Treasurys. When credit investors think a company won't make it past the end of the week, you need to pay 2,000 basis points. If they think a company won't make it past sundown, the cost goes to 3,000.
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What's ahead for corporate creditGreg Peters, Morgan Stanley's global head of fixed-income research, expects a multiyear cycle with several years of outperformance on the horizon.
In early April, according to Reynolds, the credit default swaps of insurer Lincoln National (LNC, news, msgs) traded at more than 3,000 basis points. The markets were saying they thought Lincoln had virtually no chance of survival. But since the Chrysler and GM bankruptcy resolutions goosed the credit markets, the Lincoln credit default swaps shot all the way back down to 400, reversing all the pain that had been embedded since early 2008.
Reynolds says it's important to realize that there was no pause or retracement in the credit derivatives, no investors staring at their feet and grumbling that it was a bear market rally. The pros just took the value all the way back to where they believed it should be if the rights of bondholders were enforced and the bear market were a thing of the past.
Continued: Waiting for stocks to catch up
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