Credit risk rising thanks to sub-prime woes

Canada’s financial sector has enjoyed smooth sailing for the past four years, with a relatively low credit default rate, so it’s easy to forget how quickly the good times can turn sour. A stark reminder could be just on the horizon.

In a speech to the Toronto CFA Society, Suzanne Labarge, former chief risk officer with RBC, said investors should not be complacent when it comes to credit risk — it’s only a matter of time until something goes wrong.

“We’ve had one of the longest positive economic cycles in a very long time,” Labarge said. “It’s going to end, but does it end with a bang or a whimper?”

Until recently, the lack of credit risk issues resulted in euphoria among those in the financial community, she said. The current crop of bankers were not in the industry during the last credit crunch in the late ’80s and have yet to experience a major downturn in the credit risk market.

“People forget that cycles come to an end because they haven’t lived through it,” she says. “Most people who are now running organizations weren’t part of the last downturn we had. And when things are good for a long time … people get sloppier about their credit standards.”

While Labarge says it’s not yet time to panic, the markets have been shaken by the initial round of collapses in the sub-prime mortgage market, dampening the euphoria. “Everybody’s going through a reassessment right now, looking at their books and asking ‘did we get carried away or didn’t we?'”

What’s happened is that the sub-prime problem has driven investors away from bonds, drying up liquidity, especially in the high-yield market. “All of a sudden, the deals that used to get done in the high-yield market weren’t getting done,” explains Labarge. “Banks were stuck with things they thought they were going to put out into the market. Then people say, ‘well, if that’s it, I’m not going to fund this.'”

The slumping market has also affected mergers and acquisitions activity. Labarge says concern about the high levels of debt in the marketplace will “certainly stop M&A activity or slow it dramatically.”

It is still too early to tell how the sub-prime woes will turn out and if they will affect credit risk further. Labarge says the worst-case scenario would see the sub-prime issues carry over into other parts of the economy. That prospect is really keeping people on their toes.

“Everybody’s stepped back and said ‘I don’t know what’s going to happen; therefore, I’m not going to buy the same risk I did a month ago,'” says Labarge. “That’s not a bad thing if that’s all that it is, but if things deteriorate, and you get into a serious crunch, things can start to implode.

“If it spreads to the broader housing market in the U.S. and consumers stop buying, then you’re into a downturn and you could end up in a recession. That’s what everybody’s waiting to see.”

Filed by Bryan Borzykowski, Advisor.ca, bryan.borzykowski@advisor.rogers.com