What went wrong in 2007: DBRS

There are plenty of ways to sum up 2007 — volatile, uncertain, sub-prime — but DBRS, the Toronto-based rating service, likes to think about the year in terms of good, bad and ugly.

The firm released its 2007 year in review on Wednesday, and in it the company outlines what it felt were the highlights and lowlights in the fixed income universe over the past 12 months.

One positive was emerging-market growth, says the company. The sector was mostly driven by the BRIC countries. “Those corporate issuers with exposure to emerging markets benefited considerably in 2007,” says the report.

DBRS also felt that the falling greenback was good news for Canada. “The collapse of the U.S. dollar gave a clear signal of the growth opportunities in the global economy and the free flow of capital into foreign markets.”

Other positive developments last year involved the “central bank bailout,” which saw various central banks provide liquidity during the credit crisis, and high commodity prices, which are “typically associated with a strong global economy.”

DBRS’s “bad” list starts off with the inverted yield curve. The company says that the “prolonged inversion of the yield curve has invariably led to a contraction in the economy.”

Global capital markets were also on the list’s bad side. The rating service notes that the credit crunch highlighted just how connected the world’s various economies are. “Few could have foreseen that such a small component of the U.S. housing sector would essentially shut down North American and European fixed income markets,” DRBS says.

Leveraged buyouts were another sore spot. Bondholders who faced LBO takeovers “scrambled to better understand the trust indentures with respect to ‘change of control clauses,'” says DBRS. Without protection, the report explains, investors of high-grade paper could find themselves holding junk bonds overnight.

The ugly news of the year, according to DBRS, included the usual suspects, such as the U.S housing market bubble exploding, sub-prime issues, short-term commercial paper liquidity issues and bank write-downs.

The report says bank write-downs in 2007 were on a “massive scale, affecting virtually every major global bank.” The housing market was the main reason for the problems, but to blunt the impact on the balance sheet from the write-downs, some of the biggest banks were forced to inject considerable equity into their operations.

All of these things forced DBRS to downgrade ratings in 55 cases this year, the most since 2002. (There were also 36 upgrades.)

But DBRS isn’t just living in the past; its report also includes a 2008 forecast. The company thinks “concentration of credit through higher lending standards” will be a big issue in the coming months.

“A concentration of credit is expected to continue through 2008 as banks take on great on-balance-sheet exposure and write-downs have a negative impact on their capital base,” says the report.

Credit concentration will lead to higher lending standards and, as a result, greater difficulty for issuers and consumers to secure financing. “Look for more stringent covenant tests for borrowers in 2008,” says DBRS.

U.S. stagflation is also something people need to worry about next year. With an economic slowdown likely, consumer spending could pull back. Inflationary pressure on food, energy and borrowing costs could be affected because of this.

Other key themes for next year include pressure in the financial services sector and the Beijing Olympics. The former is important because earnings in the sector will continue to be affected by ongoing write-downs and continued sub-prime problems. “This, combined with tighter lending standards, a weaker U.S. economy and lower volume of business in early 2008, will likely pressure credit quality.”

While the Olympics itself isn’t an issue, the fact that they’re being held in China could “represent the catalyst to a long overdue stock market correction in the Shanghai Stock Market,” says the report. DBRS admits that the Chinese market has been “impressive,” but characteristics similar to what the industry saw before the tech-bust are developing.

These issues, combined with a weak U.S. economy, mean that DBRS expects more downgrades than upgrades in 2008. The year-end report says downgrades will likely occur in the financial services sector, but auto and auto parts, retail and forest products could also see their ratings drop. Mining, oil and gas and oilfield services could see upgrades, though, as commodity prices are expected to remain strong.

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

(01/16/08)