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HOW FAR THE CREDIT CRUNCH WILL GO

The financial markets are right to be worried about the potential for a credit crunch.
In a credit crunch, lenders stop lending and credit becomes tough to obtain.
A credit crunch can bring down everything from weak, deeply indebted
companies to overextended lenders to over-leveraged borrowers to an economy as a whole.

So the question is: Are we in the midst of a credit crunch?

In the market for mortgage-backed bonds, leveraged-buyout loans and
high-yield, or junk, bonds, yes, the crunch is upon us. The absolute paucity
of buyers for those classes of assets -- what I described as a buyers strike
in my July 31 column, "Stocks feel the pain of a buyers strike" -- has led
lenders to cut way back on putting their capital at risk in leveraged loans
or junk bonds. In these markets, not only have prices collapsed, but deals
are being scrapped because of a lack of new credit.

But in the general economy where consumers live and spend, the credit crunch
hasn't yet materialized. Banks are still lending, credit card issuers are
still issuing, and mortgage lenders are still refinancing. Until a credit
crunch hits the consumer, the damage will remain confined to the most
leveraged sectors of the financial markets, and there the damage could be
severe. But the economy as a whole will keep perking along at a growth rate
of 2.5% to 3% -- and perhaps better -- for the rest of 2007.

A crisis that feeds on fear and uncertainty
We've certainly got some of the raw ingredients for a credit crunch right
now. To create a credit crunch you need fear. Because they're taking a
beating on existing loans, lenders fear that they will book big losses on
future loans -- which makes them reluctant to lend.

But fear isn't enough. To create a credit crunch you also need uncertainty.
A lender can compensate for fear by raising interest rates, tightening
credit standards or writing more protective covenants into the terms of a
loan. But if the size of the losses is uncertain enough, lenders can't
compensate for the additional risk because lenders don't know how large that
risk might be. Lenders become afraid to make any loan because they fear that
any additional return that they ask for will turn out to be inadequate to
cover the actual risk, whatever it may turn out to be.

The market for buyout loans fits this recipe to a T right now. Banks have
been willing to lend to buyout funds to finance these deals because they've
been able to resell those loans to other buyers. That limited the banks'
risk in any deal.

No ready buyers for the loans
But the market for buyout loans has shrunk rapidly in recent weeks.
Investors with portfolios of existing loans have discovered that they
couldn't sell their loans at any price during a market drop like that of the
week of July 23 through July 27. They were stuck owning loans that were
losing big hunks of value by the hour. And they couldn't find an exit.

With buyers for these loans in short supply, in recent deals banks have had
to keep more of these buyout loans in their own portfolios than they would
like. For example, in the $22 billion buyout of Alliance Boots (ABOYY, news,
msgs), a Kohlberg Kravis Roberts deal, banks offered an extra 0.5 percentage
point in yield to buyers to clear $4 billion in loans off their books. But
the banks have struggled to place an additional $10 billion in loans from
the deal.

The cash spigot is being turned off for hedge funds, buyout deals and
junk-bond financings. Things could go from bad to worse, MSN Money’s Jim
Jubak says, because banks are hoping to sell $300 billion in new junk bonds
and loans by the end of the year.

Or how about the delay in selling a $12 billion syndicated loan to finance
the purchase of the Chrysler division of DaimlerChrysler (DCX, news, msgs)
by buyout fund Cerberus Capital Management? The deal had to be postponed
during the market turmoil of the week that ended on July 27 because banks
feared that they couldn't resell enough of the loan unless they offered
sweetened yields and took huge losses on the deal. They had good reason to
worry: $6 billion in separate loans were sold on July 25 only after
increasing yields by 1 percentage point. The parties to the Chrysler deal
say it's still on track to close in the third quarter of 2007, but the
underwriters -- JPMorgan Chase (JPM, news, msgs), Bear Stearns (BSC, news,
msgs), Goldman Sachs (GS, news, msgs) and Morgan Stanley (MS, news, msgs) --
and DaimlerChrysler will hold the $12 billion loan on their own books in the
meantime.

Implications for financial markets
Keeping these loans on a bank's books in a market where prices can plunge in
hours and where buyers can vanish is a recipe for a credit crunch: There's
no way to price risk in a market without reliable prices and without a
potential exit from positions.

A credit crunch in the market for buyout loans wouldn't exactly be good news
for the financial markets. The pipeline is stuffed with about $275 billion
in leveraged loans, up from $60 billion at the same point in 2006. Unwinding
a substantial portion of those deals would send tremors through the stock
and bond markets.

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