Credit crisis: Long road to recovery

Market watchers expect credit problems to persist into 2008.

LONDON (CNNMoney.com) -- A new year, a new start. For the credit markets, that's wishful thinking.

Nearly six months since the credit crunch started, the situation is still grim - and there are few encouraging signs, which doesn't bode well for businesses and households next year.

Toxic debt keeps cropping up on bank balance sheets. The housing slump still hasn't found a bottom, and investors remain skittish. Market watchers expect the credit environment to remain challenging into the better part of 2008. That will take a toll on corporate profits and squeeze American consumers, not to mention put a drag on economic growth.

"We're pretty close to a point where the capital markets fail to function properly," said John Addeo, a high-yield fund manager at MFS Investments. "I believe the Fed has the ability and wherewithal to resolve that issue, but what we really need to see is a restoration of confidence in the financial system."

When the mortgage mess triggered a wave of turmoil in the summer, investors had hoped problems would remain relatively contained. Instead, they've seeped into all pockets of the debt market.

The culprit has been the loads of complex debt instruments tied to home loans given to borrowers with poor credit. From collateralized debt obligations (CDOs) to structured investment vehicles (SIVs), this alphabet soup of products has wreaked havoc on financial markets.

Financial firms have taken staggering writedowns, costing the CEOs at Citigroup (Charts, Fortune 500) and Merrill Lynch (Charts, Fortune 500) their jobs. The heavy losses, which are expected to continue into next year, have also forced banks to tighten their lending.

To be sure, pressure has eased in some parts of the debt market. The backlog of financing for corporate buyouts, for instance, has been reduced to about $200 billion from $300 billion right before Labor Day. That's an improvement but still a substantial amount of debt for the market to wade through.

There have been some big deals, including the sale of risky debt tied to the buyouts of TXU, Alltel and First Data. The unraveling of deals like the Cerberus takeover of United Rentals (Charts), which fell apart last month, has also contributed to the decline.

"It's tough to say whether we'll see more issuance. People just don't want to push it while there's still uncertainty," said Sabur Moini, head of credit strategy at investment management firm Payden & Rygel.

There were just 16 loans for private equity buyouts issued worldwide last month, the lowest number since September 2003, according to Thomson Financial. They raised $33.4 billion, with nearly three-fourths of that amount coming from a financing package for the takeover of wireless provider Alltel.

The unease of investors may be the biggest obstacle for credit markets next year. Investors have eyed anything tied to mortgages with skepticism, even in markets once considered safe.

The market for commercial paper, a sort of IOU that companies rely on to raise money for short periods of time, froze up in August. The problems facing the market have eased, but outstanding volume remains severely depressed.

"People are still waiting to see who's left holding the bag," Michael Englund, chief economist at Action Economics, said of the nervous tone in the credit markets.

As a result, companies are having a harder time securing money to operate and grow their businesses. Aggravating the problem is the fact that the credit squeeze comes as the fear of recession has shaped into a real threat.

Mortgage and credit card companies are tightening lending standards just when consumers need access to capital. As consumer pull back, corporate revenues are being pressured. "This does not bode well," Addeo said.

A steady stream of rating downgrades on risky mortgage debt has contributed to the fear in the credit markets. Moody's, citing "deteriorating credit and other market conditions," recently downgraded or placed on review about $130 billion of debt issued by SIVs.

Furthermore, there is about $500 billion of adjustable-rate home loans due to reset to a higher interest rate next year, which could trigger another wave of foreclosures, according to Standard & Poor's.

The outlook is not all bleak. In addition to what many consider the resilience of the global economy, sovereign wealth funds have piled up trillions of dollars for investment and have already ridden to the rescue of Wall Street banks like Citi.

The Federal Reserve is expected to keep cutting rates. Goldman Sachs economists expect the central bank's key short-term interest rate to fall to 3 percent by the middle of next year from the current rate of 4.5 percent.

The Treasury Department's move to stem the tide of foreclosures could also help. A bailout plan would not only lessen the pain for some troubled homeowners but also limit the impact of the housing downturn on the broader economy.

"The Fed and the federal government are very attuned to what is going on in subprime" and it looks less likely that this is going to bring down any of the big banks, credit strategist Moini said.

There are hopes that big losses at financial firms will slow to a trickle by the middle of next year. If that happens - and writedowns don't hang over the market - then calm could be restored, said Tim Drayson, international economist at ABN Amro.

But don't expect the road to recovery to be smooth. "Volatility will remain higher than what we've experienced before over the next year or two," Drayson said.