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Fitch: Low Default Rate, Growing Risk Receptivity

Fitch Credit Desk April, 2013 Report

"Banks Loosen Up: The persistently low interest rate environment is having a more pronounced impact on risk receptivity: 66% of 'CCC' or lower rated volume was recently trading above par, and the equity value of a group of 172 'B' rated companies had expanded 22% since the beginning of the year...

"...the second-quarter edition of the Federal Reserve's 'Senior Loan Officer Survey' revealed the most accommodating conditions for borrowers in two years. The surge in asset values provides a strong support for the low default rate environment. However, the same easy money conditions that have been an aid in the recovery can also begin to contribute more significantly to risk buildup. While debate rages on regarding the timing of the Fed's exit strategy, history cautions that the impact of easy money policy can linger and the default rate can remain deceptively low even as credit quality deteriorates. The last episode of Fed loosening and tightening offers insight into this dynamic...

"This year's surge in asset values provides a strong support for the low default rate environment - recently 66% of 'CCC' or lower rated volume was trading above par, and the equity value of a group of 172 'B' rated companies had expanded 22% since the beginning of the year. However, the same easy money conditions that have been an aid in the recovery can also begin to contribute more significantly to risk buildup. While not in the league of 2005 - 2007 trends, the growing volume of covenant-lite loans illustrates that post credit crisis conservatism is waning. In addition, corporate profit growth is decelerating while debt is rising.

"From Stemming Crisis to Checking Excess: The Fed's last tightening campaign began in June 2004 and continued for two years until the summer of 2006:

"Despite the Fed's best efforts to tame speculative behavior, the accumulated impact of loose monetary policy in the aftermath of the 2001-2002 downturn persisted, and transactions continued to come to market with aggressive terms and leverage levels. This occurred even as credit quality was deteriorating. In 2007 especially, corporate profit growth was under significant strain but that year, 'CCC' rated issuance soared to, at the time, a record high. Given the heated funding environment, the default rate remained below 1% in 2006 and 2007.

"The low default rate perpetuated the cycle of aggressive transactions and was in the end a red flag of systemic risk rising rather than shrinking.

Context Is Key: While not in the league of 2005-2007 trends, the growing volume of covenant-lite loans (year over year, up seven-fold to $93 billion, according to Thomson Reuters LPC) illustrates that postcredit crisis conservatism is beginning to evaporate. Debt is also rising as corporate profitability slows and investment remains sluggish.

Full 28 page report with charts:
http://www.leasingnews.org/PDF/CreditDeskReport_5302013.pdf

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.