By Karen Brettell
NEW YORK, Aug 19 (Reuters) - Banks are significantly tightening their purse strings when it comes to lending to U.S. companies and, as credit dries up, defaults are also likely to accelerate at a faster rate than now reflected in the debt markets.
Bonds of the riskiest companies, which are at the lower end of the rating spectrum, are also trading at tighter levels than in previous downturns and are most likely to underperform as defaults rise.
The July survey of senior loan officers, released by the Federal Reserve last week, found that 60 percent of domestic banks reported tightening credit standards on commercial and industrial loans.
Eighty percent of banks also said they had increased the spreads of loan rates over their cost of funds on loans to large- and middle-market firms. For details, see [ID:nN11383165].
"The pace of bank credit tightening has become draconian in scope and now stands at the recessionary levels last seen in 1991 and 2002," credit analyst Christopher Garman said in a report. "This promises a rapid increase in default rates over the next few quarters."
Tighter lending standards have historically had a strong relationship with default rates, he said.
"The relationship is rock-solid in statistical terms," Garman said. "Tighter policy leads Last Twelve Months (LTM) default rates by nine months, with 84 percent reliability. The relationship points us toward 11.4 percent default rates by June 2009."
This is larger than rating agency or market estimates.
Standard & Poor's said on Tuesday that market expectations of defaults have risen in the past three months to around 9 percent over the coming year, from 7 percent previously.
"Our forecast is for the 12-month trailing speculative-grade default rate in the U.S. to increase to 4.9 percent 12 months forward," S&P analyst Diane Vazza said in a report. "Our pessimistic scenario, based on a larger-than-expected deterioration in economic fundamentals, has the default rate rising to 8.5 percent within 12 months."
Moody's Investors Service said last week that the default rate for U.S. speculative-grade issuers could increase to 5.7 percent by the end of the year and to 7.2 percent a year from now.
In the United States, the default rate rose to 3 percent in July from June's revised level of 2.5 percent and 1.5 percent a year ago. The last time the default count hit double-digit levels was in July 2003 when 11 companies defaulted, according to Moody's data.
And while reduced demand for high-yield debt has led spreads weaker in previous months, the riskiest "CCC"-rated credits may still not be pricing in their default risks, said Garman, publisher of Leverage World.
Average "CCC"-rated company spreads are trading at 1,280 basis points over Treasuries, Garman said.
But, "at this level of commercial bank unwillingness to lend, CCCs should show spreads of 1950 basis points, or a rise of near-7 percent in yield," he said. "This level would be comparable to CCC spreads in 1990 or 2001-2002."
Bonds of companies rated in the "BB" and "B" junk rating buckets are trading at levels that are in line with tighter lending standards, he added. (Editing by Jonathan Oatis)