As major players face rating downgrades, observers wonder if the problems in the credit market will cascade into the equity markets.

All eyes are turned towards the credit markets as the bears wait for the wheels to come off. It is the subprime mortgage markets that have drawn most attention, but other bad news may be waiting in the wings.

In the wake of subprime woes in the US, one after the other, the three major rating agencies cut their ratings on hundreds of collateralised debt obligations backed by mortgage loans. Last month, Bear Stearns, supposedly one of the smartest players in the subprime market, had the uncomfortable task of admitting that two of its hedge funds, heavily invested in subprime bonds are now practically worthless.

In July, JPMorgan posted decent Q2 returns but disclosed that it had had to double provisions for credit losses related to retail mortgages. Merrill Lynch, meanwhile, announced that Q2 profits jumped by 31% and stressed that subprime and collateralised debt obligation (CDO)-related fallout had been contained, yet analysts still questioned the quality of its balance sheet and the rigour of its underwriting standards. Merrill’s share price – which dipped at the time of the results announcement – reflects such jitters.

But the wobbles in the leveraged loan market may be an even more difficult problem for the banks to shoulder. Last month it became clear that several Wall Street banks had had to buy bonds that they could not sell in order to finance leveraged buyouts (LBOs) that they were committed to. With few leveraged buyouts these days containing get-out clauses allowing the buyer to escape if funding cannot be arranged, and the appetite for risky bonds drying up, this business appears ridden with pitfalls.

Brake on financing

Worse, it could start a domino effect. Underwriters committed to chunky deals could have capital tied up for a while. If this puts the brakes on cheap financing, the LBO conveyor belt may grind to a halt. This in turn could flip over into the equity markets, where prices have been buoyant, at least partly in the expectation that many public companies will be taken private at a premium.

At best, the road ahead looks rough. Small wonder a Punk Ziegel analyst has downgraded Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley from market perform to sell.

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