The Pain Moves Beyond Subprime
The debt and leveraged-buyout markets have stalled, and more trouble lies ahead

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 Corp. (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.

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 Inc. (GS ) and Lehman Brothers Inc. (LEH ) are being seen as no more creditworthy than casino operator Caesars Entertainment Inc., 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 (MHP ) (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' (GM ) Allison Transmission (GM ).

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.

There's a good chance that some pending buyouts simply won't get done, analysts say. That would be bad for investment banks for another reason: They collect their mergers-and-acquisitions advisory fees only after deals are completed. In the first half of 2007, private equity firms paid a record $9.6 billion in investment banking fees, a 35% jump over the first six months of 2006, according to M&A tracker Dealogic. Now, Wall Street firms are facing the prospect of some of those revenues drying up. Says analyst Brad Hintz of Sanford C. Bernstein & Co.: "The Street faces an earnings headwind as it enters the second half of 2007."

The turmoil in the credit markets, meanwhile, is likely to continue to claim new hedge fund victims both in the U.S. and overseas. Two big Bear, Stearns & Cos. (BSC ) hedge funds imploded in June, and a third ran into trouble in late July. Meanwhile, the $11 billion Raptor Global Fund, managed by James Pallotta, posted a one-month loss of 9%, while two hedge funds run by Australia's Macquarie Bank Ltd. were off 25% this year. And Sowood Capital Management is throwing in the towel. The onetime $3 billion fund lost nearly half its value in recent months after making bad bets on "credit spreads"—the difference between the yields on Treasurys and corporate debt.

'TOO MUCH LIQUIDITY'
The ultimate worry is that the trouble in the junk-debt markets will spread to the traditional corporate bond market and create a full-fledged credit crunch that would threaten the economy. That scenario may be unfolding. Issuance of investment-grade corporate bonds fell 72% in July from June's level and 34% from July, 2006, according to Dealogic. And some say the subprime-mortgage and leveraged-loan markets are harbingers of wider credit troubles. Greg Jensen, co-chief investment officer for money-management firm Bridgewater Associates Inc., wrote in a July 31 client note: "Both problems are just the symptoms of...a significant financial fragility built on too much liquidity for too many years." Adds Leslie Rahl, president of Capital Market Risk Advisors in New York and former co-head of Citibank's (C ) derivatives group: "Nothing stays rosy forever. We've been in a rosy world, with credit spreads at historically tight levels for some time now. But we seem to be leaving it."

The blowup at American Home is a reminder that the mortgage market remains a major threat as well. American Home's customers, after all, were borrowers with generally good credit histories—an indication that the mortgage mess is no longer confined to risky subprime borrowers. Through the rest of this year and into next, a raft of adjustable-rate mortgages will begin adjusting to higher interest rates. The higher monthly payments could squeeze even borrowers with good credit histories, leading to a new round of mortgage defaults.

All this could mean more pain for the financial sector—and for the broader stock market. Warns Bradley Golding, a managing director at Christofferson, Robb & Co., a money manager that invests in bonds: "The stock market has not caught up to the severity of the situation."
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