The credit crunch in leveraged loan markets is being triggered by more than the recent collapse of the subprime mortgage markets, according to Tom Watters, Standard & Poor's senior director and team leader in corporate and government ratings.

"We have been in a bull market for the last four and a half years in the credit market. Leveraged buy-outs, private-equity firms and mega-merger and acquisition deals fueled the market. But this all came to a crashing halt in the third quarter," Watters told attendees at S&P's annual oil and gas industry conference in Houston recently.

"The collapse of collateralized debt and loan obligations, the negative news surrounding hedge funds and investment banks, the weak housing market and recession fears all combined to paint an ugly picture," he said.

Leveraged collateralized loan obligation transactions dropped off significantly in the third quarter, down some $14 billion, after a record high of $32 billion in the second quarter. Because much of the third-quarter deals were underwritten in the second quarter, further declines in the fourth quarter of these large market-funding transactions are expected. New-issue leveraged loan activity declined 64% in the second quarter.

S&P's liquidity survey reveals that companies with BB-credit ratings show benign risk, in large part due to the enormous amount of recently completed refinancings that allowed them to extend their maturities.

"But B-credit companies are vulnerable. As you know, capital markets are the lifeblood for B- credit. Even a slight increase in interest rates can have a dramatic effect on those companies," said Watters.

Meanwhile, there are signs of hope for 2008, he said. The Federal Reserve stepped in and injected liquidity to the system and has cut its rates. Still, some market pundits believe collateralized loan obligations could be down 50% in 2008, to about $50 billion, and there is a high backlog of underwritten deals.

For 2008, Watters expects spreads will remain higher and deal sizes to decline dramatically. He also expects other effects of the credit crunch will include more conservatively leveraged deals; a decline in M&A and leveraged-buyout activity; increasing default rates in the building materials, consumer durables and auto industries; and increased risk of a possible recession.

Also, "covenant-light deals are a thing of the past," he said.

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