Tighter credit rules may fuel debt, defaults, observers warn

Even as New York state marches toward a record job total, financial experts are voicing fears that tightening credit standards may spark an increase in business debt delinquencies and defaults in the second half of 2007 ”“ possibly leading to future job losses.
New York increased its job count to 7.2 million in June, and is on pace to break the record total of 7.24 million set in December 2000.
While the strong economy has companies seeking additional credit to expand, some see signs that middle-market companies are overextending themselves and may be unable to meet their debt obligations. 
At the close of the first quarter, the U.S. speculative-grade corporate default rate fell to its lowest level since April 1997 according to Moody”™s. More ominously, the Euler Hermes Business Failures Index recently predicted a 12 percent increase in corporate bankruptcies in the second half of the year.
In a January survey, loan officers surveyed by the Federal Reserve Bank said they expected between 5 percent and 7 percent of banks to tighten credit standards; in its analysis of the local market, the New York Federal Reserve has observed a steady tightening of standards.
The Fed last raised interest rates in June 2006, and in theory it can take a year for interest rate increases to wash through the economy.
Add to that businesses taking on debt to fund business projects in an expanding economy and uncertainty on how the sluggish housing market will affect consumer spending, and experts are growing wary.
“Bankruptcies should increase in the first and second quarter of 2008,” said Jake Renick, chairman of the bankruptcy and corporate reorganization of the New York State Society of Certified Public Accountants. “Some business people think there is so much money out there that this (economy) is going to last forever.”
One in five members recently surveyed by the Turnaround Management Association (TMA) predict a rise in debt default rates during the last half of 2007, particularly among home builders and other construction companies, as well as manufacturers. Another 65 percent predict “a blowup” in debt defaults by the end of 2008.
As early as last October, TMA noted an increase in staffing among member firms that assist companies in resolving debt crises, an indicator of a worsening market by the close of this year.
Compared with the past two recessions, banks have more options today to sell off portfolios of troubled loans if a blowup occurs, due to the proliferation of hedge funds and private equity investors willing to take on the risk by purchasing loans at a discounted price.

Half of those surveyed by TMA believe the influence of hedge and private equity funds will continue to increase, particularly involving businesses on the precipice of a late decline; another 30 percent foresee an increase in second lien and junior tranche lenders participating in corporate renewal.
“There is a new type of lender in market that has appeared in the last ”¦ year and a half, and that is the hedge funds,” said Renick, who heads the bankruptcy practice at Eisman, Zucker, Klein & Ruttenberg in White Plains. “They are providing capital to corporations where banks are not. There is all this new money in the marketplace that is keeping companies afloat.”
Still, while hedge funds are more risk-tolerant than banks, they are nimbler too, and the risk is real that they may find more profitable pastures for investment. And there are some who fear Congress, mindful of hedge fund debacles like Greenwich, Conn.-based Amaranth Advisors L.L.P., may impose rules restricting that industry.