Tight credit markets continue to impact a borrower’s ability to raise new capital for debtor-in-possession (DIP) and exit financings. Despite the extraordinary steps by the U.S. and European governments to provide stability and liquidity in global financial markets, banks and other financial institutions continue to hoard cash and U.S. dollars instead of lending to credit worthy borrowers. Lenders, borrowers and turnaround practitioners are trying to make sense of it all and identify the market inflection point and return to normalcy. How will we know when the grim credit market picture begins to brighten? Here are five indicators to watch.

Primary Debt Market
Many investors are avoiding the primary market altogether, expecting an opportunity to buy debt for less in the secondary market post close. Limited availability of new money financing is anticipated in the first quarter of 2009, with defensive transactions and “club” syndicates continuing to be the most likely path for borrowers to obtain new capital commitments.

Nevertheless, the primary market remains open for business on a limited basis. Investors are focused on leverage in addition to structure, pricing and borrower credit quality, making it harder for banks to place and determine a market-clearing price for tougher asset-based deals.

Market Depth
One of the main challenges in raising new capital for DIP and exit financing has been the lack of market depth for both asset-based loans and cash flow/institutional term loans. Despite the ability of lenders to obtain super-priority lien status via DIP financing, the lender universe remains small. Traditional banks continue to pull back available capital, which results in an investor either passing on a deal completely, or committing at a much lower level. These trends make it more difficult to fill out syndicated transactions, particularly for revolver tranches. It is not surprising that many recent financings were not fully underwritten, but arranged on a “best efforts” basis.

FILO Tranche
Market depth for revolvers can in some cases be expanded through the use of a First-in, Last-out (FILO) tranche. Similar to a traditional term loan, a last-out tranche is fully funded at close and remains funded until maturity--subject to specific provisions in a credit agreement regarding mandatory and voluntary prepayments. The facility typically benefits from the same first lien on current assets but is subject to a waterfall repayment structure behind the first-out lenders.

Buyers of this paper are typically hedge funds and pricing for this tranche will be well north of the first-out tranche. Typically, the facility is documented as a single class of debt under a single credit agreement that eliminates the need for an intercreditor agreement. Eliminating the ability for this tranche to become a fulcrum security in the event of a subsequent restructuring provides real value to the borrower and mitigates the impact associated with a higher LIBOR spread.

Rising number of Defaults
The S&P/LSTA Leverage Loan Index default rates continue to climb higher with the index currently at 4.11% (based on the number of outstanding loans, December 2008), a five year high. This level, although dramatically higher than the all-time low of approximately .25% at year-end 2007, is somewhat higher than the normal U.S. historical average of approximately 3.0%. With continued deterioration in the U.S. and global economy, it is likely that default rates will be significantly higher over the next 12-18 months, particularly for businesses that are dependent on consumer discretionary spending. It’s likely that issuer default rates will increase across nearly all industries for the balance of 2008 and 2009, with a heavier concentration in auto, retail and restaurants.

Five Key Measures
Restoring investor confidence is the linchpin to improving market fundamentals. To get some sense of the loan market recovery, here are some of the key signs to watch:

1. Improved secondary trading spreads--particularly for 2008 vintage deals. Throughout the fourth quarter 2008, overall secondary spread levels skyrocketed to all time highs. By contrast, post-close trading levels for the 30-35 deals completed in 2008 have generally traded 5 to 8 points higher than the overall market. The difference is in part driven by relative value, with pre 2008 deals priced significantly lower than current transactions. Additionally, 2008 deals are characterized by higher ratings, tighter financial covenants, lower leverage and smaller deal size. As the market begins to stabilize, look for these credits to trade closer to or above original issuance levels. Once investors can again point to higher post-close trading levels, they will likely begin to invest new capital in the primary debt markets.

By contrast, the 15 largest single B rated loans (per S&P/LCD Q1-Q3 2008) are currently trading at a price of 62.93 (vs. an issue price at or near par) for an implied yield of LIBOR plus 1,960 basis points. This spread compares to LIBOR + 540 basis points as of May 31, 2007 (implied price of 91.01) and LIBOR + 446 basis points at yearend 2007 (implied price of 93.72). Perhaps even more meaningful are the secondary trading levels observed for the 30-35 deals completed in 2008.

2. Improved balance sheets at large commercial and investment banks. The $700 billion U.S. Treasury Department’s Troubled Asset Relief Plan (“TARP”) should help stabilize the debt capital markets. Treasury’s decision to invest up to $250 billion directly into the 9 largest commercial and investment banks is expected to gradually free up liquidity in short-term debt markets and with nearly 50% of total TARP funds still available, additional capital remains available for future initiatives. The ability for banks to borrow at lower rates should eventually lead to more lending to corporate debt issuers.

3. Relative stability in the $55 trillion credit default swap market. The cost of default insurance has risen dramatically, driven largely by the lack of transparency and clarity around which counterparties are deemed to be credit worthy by investors. As the cost of these “insurance” policies begin to decline, this will likely be a leading indicator for improved investor confidence.

4. A strengthening commercial paper (CP) market. CP is a critical source of short term financing for companies across all industries. Government actions to stabilize the CP markets should lower short-term borrowing costs while removing illiquidity risk for the thousands of companies who access the CP market for their daily cash flow needs.

5. Reduced LIBOR. Overnight LIBOR rates between banks have been volatile with 2008 rates as high as 6% in late September vs. levels seen as recently as July of 2%. At yearend 2008, three month LIBOR rates have decreased to 1.9%, approximately 100 basis points below levels observed prior to the collapse of Bear Stearns in March 2008. Governments from around the world have been pumping seemingly limitless amounts of cash into the financial system to improve liquidity. The markets are cautiously awaiting signs that the large commercial and investment banks have resumed their normal lending practices. This should help normalize 3-month LIBOR rates, which historically trade within 10-20 basis points vs. the Fed funds target rate.

Restructuring opportunities arising over the next several months will likely remain challenging, especially for relatively weaker credits. Investors are largely expected to remain risk averse until clear data points emerge from the government’s unprecedented efforts to restore normalized market conditions. Let the market thaw begin…

Thomas Miele (thomas.miele@ge.com) is senior vice president, GE Capital Markets, Inc. and focuses on syndicated finance for General Electric Capital Corporation—one of the largest secured lenders in North America. gelending.com