A passing storm? Is the worst over?

Next month the city of Birmingham, Alabama, will host its annual pet parade and May Crawfish Boil. But this year's festivities risk being overshadowed by more dramatic events.

Jefferson County, in which Birmingham is located, is one of the most indebted municipal governments in the US, owing an estimated $7,000 (£3,550, €4,500) for every adult and child. In recent years it took advantage of easy lending conditions in the municipal bond market, mainly to fix its ailing sewerage system. But since the credit crunch started last summer, funding costs have soared and investors have been less willing to lend. The county is now struggling to meet its interest payments.

If it cannot reach some kind of agreement with its lenders in the coming weeks, Jefferson could become the site of the largest municipal bankruptcy seen in the US – overshadowing even California's Orange County fiasco from the 1990s.

Some 860 miles away on Wall Street, the mood is quite different. A belief is growing that the turmoil in credit markets that began last August could finally be abating. "The first quarter was the roughest I have ever seen in nearly 20 years of being in the business," says Bruce Thomson, co-head of capital markets at Bank of America. "But there are now signs that we are working our way through the issues that have caused such widespread problems."

This improved sentiment can be seen in many corners of the credit world, leaving some observers hoping that the green shoots of recovery are about to spread through the financial system as a whole. Even the municipal market is showing signs of improved heath – though perhaps too late for Jefferson County.

The optimists have plenty of reason for spring cheer. Last year's upheaval in the credit markets was essentially brought on by high levels of foreclosures on risky US mortgages amid a sharp fall in house prices. As these problems spread through the system, the price of many securities fell sharply – and some markets stopped functioning altogether as investors refused to trade.

In recent weeks, however, activity in a number of these markets has started to resume. In leveraged loans, for example, some banks have concluded deals, helping to clear their backlogs of unsold assets. This has been accompanied by a partial recovery in the price at which these loans are traded in secondary markets.

Some banks are also starting to rid themselves of troubled mortgage-linked assets. Senior officials at UBS, for example, say the Swiss bank recently sold a large chunk of its mortgage-linked securities to outside investors "at our writedown prices". While UBS took large losses on these sales, the fact that deals are starting to occur means that mortgage-linked prices have found bottom in recent weeks, judging from related derivatives indices such as the ABX index (see chart).

This switch in sentiment is pulling more investors back into these markets. "Both our sales desks and client visits report a significant switch by real, long-only investors – such as pension funds and insurance companies – towards investment-grade debt securities," says Jan Loeys, of JPMorgan Chase. "These are largely investors who have been out of credit [market purchases] for some time." They are using what he calls a "turnround in momentum" to pick up bonds and other instruments.

Stocks have rallied too – cheered by a perception that a feared collapse of the financial sector has been averted by aggressive central bank intervention and banks' own willingness to confess to their losses, take writedowns and raise fresh equity to bolster their balance sheets. "With banks now shoring up their balance sheets, equity markets have rallied as the perceived threat of protracted financial market distress has eased," say analysts at ING Barings.

Moreover, companies are starting to borrow money again: in the US and Europe, for example, bond issuance by non-financial companies in the investment-grade sector was at its heaviest in recent years in April. While many of these groups are paying higher premiums relative to government debt, recent falls in official interest rates are in many cases reducing the interest payments they are having to make relative to, for example, a year ago.

Yet not even the optimists would deny that these signs of recovery remain, at best, tentative and patchy. There is still little demand for high-yield debt, or bonds that carry ratings below investment grade, and even some highly rated companies still struggle to raise short-term funds.

Banks are finding it very hard to relaunch their securitisation businesses – the process whereby loans are repackaged into bonds. "Most people I talk to say it could be 2009 or even 2010 before the market really restarts," Rick Watson, head of the European Securitisation Forum, told a conference in London this week.

The markets are still plagued by some startling pricing anomalies, which reveal the continued sense of dislocation and fear. While hedge funds and other investors used to rush to take advantage of such quirks, and thus trade them away, most remain too nervous to jump back in yet.

One such quirk is that securitised debt, which is in theory safer than ordinary bonds because it is backed by tangible assets, still trades at wider interest rate spreads than unsecured bonds. Another is that loans made in the European market are trading at a premium to dollar loans – partly because in Europe a much larger proportion of loans than in the US has been sold in recent years to hedge funds, which are under stress.

"There are still substantive disconnects between different markets across regions and asset classes," says Therese Esperdy, global head of debt capital markets at JPMorgan. "Valuations and investor demand in the US unsecured market have seen positive momentum. Activity and pricing in other markets, such as the securitisation market, remain less than optimal. We will need to see a return of true capacity there to be able to declare that markets are again normal."

Another problem is that while central banks have injected funding into the system, banks are not passing this benefit on. "The cost of funds for banks, corporates or individuals is not falling despite the recent cut in base rates. The process of credit creation is now impaired and there is a risk that it may become further impaired," says Robin Savage, of KBC Peel Hunt, part of the Belgian financial group.

The level of trading in the secondary markets is also low, since banks do not want to commit their balance sheets to providing liquidity. According to one banker involved in recent sales of investment-grade bonds, some investors will not buy new debt because they are worried they will not be able to sell even the newest bonds. In the municipal bond market, one investor says a recent offering of $100m of triple-A rated bonds was taking two or three days to complete. "A year ago it would have taken one phone call," he adds.

Or as Jon Schotz, the chief investment officer at Saybrook Capital, which specialises in municipal bonds, says: "There is much less liquidity and a big change in the investor profile . . . The leveraged buyer is gone and there are few signs that void will get filled."

Indeed, the sense of unease is continuing to affect even areas with little or no connection to the subprime woes. Take shipping finance. In normal circumstances, this is a staid corner of syndicated finance, since investors are overwhelmingly banks, the assets are linked to tangible goods and the cost of funds are based on Libor, the interbank benchmark.

But these days, some bankers question whether Libor is an accurate barometer for setting deals, partly because many banks are facing liquidity constraints and some find their funding costs are higher than those experienced by shipowners. That makes it "much more difficult to get deals done", says Rory Hussey, a senior syndicate banker at ING.

This pattern is repeated on a much wider scale across the corporate world. "If you have a world where it costs banks more to raise funds than many of their clients, then . . .?it will be hard to have any return to normality," says one senior banker.

Adding to the uncertainty is a lingering fear that the economic downturn could create a new wave of losses and bad loans in the coming months.

People point to the loans market, for one. In 2001, after being hit by the collapse of the technology bubble, the sector rallied sharply – only to retreat in 2002 after the implosion of Worldcom and defaults by other large companies in US broadcasting and telecommunications, such as Adelphia.

"The 2002 experience is one of the many examples of bear market rallies that end in tears," says Steve Miller, analyst at Standard & Poor's Leveraged Commentary & Data. "Certainly, the current run of good feelings could easily be disrupted by a countless number of shocks, including worse-than-expected economic numbers, ever higher oil prices or, perhaps most important, a large default that comes completely out of left field."

"Much as writedowns seized the stage in previous quarters, credit quality is now taking the spotlight," says Meredith Whitney, bank sector analyst at Oppenheimer. "As declining housing prices continue to weigh on all aspects of the economy, deteriorating credit quality is reverberating through bank earnings as provisions and charge-offs rise." Bank of America last week made provisions of $6bn against potential loan losses, causing its share price to fall.

Defaults on debt are already expected to rise. S&P predicts that the default rate on US high-yield bonds will "escalate substantially in the next 12 months", to 4.7 per cent from the 25-year low of less than 1 per cent seen at the end of last year.

"The increase in defaults reflects the unfolding recessionary conditions, weaker earnings prospects, and continued financial pressures that will increase lending constraints," says Diane Vazza, an analyst at S&P.

Further shocks could come from the revelations of mortgage-related losses at financial institutions other than banks. The International Monetary Fund has warned that total credit losses could reach almost $1,000bn; of this, only one-fifth or so would directly hit banks, with the remainder appearing at insurance companies and investment institutions.

Last week illustrated this risk: Ambac, a bond insurer that struggled earlier this year to hang on to its triple-A credit ratings, shocked its investors by revealing that its losses on subprime mortgages could reach more than $3bn. Ambac guarantees almost $30bn of complex bonds backed by mortgages, many of which are owned by banks. That means that if the rating agencies downgrade Ambac or MBIA, its bigger rival, banks and other investors could be hit. As one analyst observes: "Counterparty risk is back in the spotlight."

Optimists hope that even if these potential new shocks do materialise, markets should be able to swallow them without reverting to full-scale panic, given that investors have become inured to such blows.

However, as the pessimists point out, and nobody expects the risk of such shocks to vanish soon. After all, the credit bubble that emerged this decade was so large in scale, and created so many dislocations, that it will inevitably take time to deflate.

"During the next few months we may witness a new phase of dislocations, led this time by the real economy," Mohamed El-Erian (left), co-chief executive at Pimco, the fixed-income manager owned by Germany's Allianz, wrote in the Financial Times last week.

"The blame game will intensify; political pressure will continue to mount; momentum will build for greater and broader regulation of financial activity within the banking system and beyond."

If Mr El-Erian is right, those on Wall Street – like the residents of Jefferson County – are likely to remain stuck in a state of nervous tension for some time yet.

BANKS START TO CLEAR THE BACKLOG

Citigroup and Deutsche Bank have grabbed attention recently with their planned sales of large pools of loans. But these deals, if they are completed, would not be the first chapters in the story of the US leveraged finance market's rehabilitation, writes Paul J. Davies.

Banks with exposure to these loans, which were mainly used to fund highly indebted, private-equity-backed takeovers, have been aggressively selling down their US positions in smaller deals that have mostly passed under the radar. Credit Suisse, for instance, recently reported that it had cut its US loan exposure by 41 per cent to SFr21.6bn ($20.9bn, £10.6bn, €13.4bn) in the past three months.

The European leveraged loan market has lacked a similar process and opinions are divided about when or if such sales will begin.

The differences between the two markets can be seen as illustrating the character of the financial industries' reactions to the credit crisis. Banks in the US are driven to take their hits and move on in a cathartic process akin to confession, penance and (they hope) redemption. Their European counterparts have until recently been more inclined to keep quiet, in the hope that the markets' severe judgments would turn out to be temporary.

So the US overhang of highly leveraged loans granted to buy-out deals at the height of the credit bubble in the first half of 2007 has been cut from almost $250bn to about $90bn – if the mooted $12bn sale by Citigroup and $5bn offloading by Deutsche Bank are included, according to data from Standard & Poor's Leveraged Commentary and Data. In Europe the overhang was only ever about €60bn but that has barely changed. It now stands at just over €55bn, says S&P LCD.

Getting rid of these exposures is important to the banks, both to reduce the strain on their balance sheets and to allow them to make new loans. No new loans means no new revenues from fees.

"In Europe, banks are becoming more willing to sell now, but there is still a stigma," says one London-based investor. "They don't want to sell as aggressively as those in the US, because they often have not marked down their exposures yet."

UK banks, in particular, are expected to start selling on more loans because many observers think there was a quid pro quo in the recent Bank of England moves to ease liquidity problems: banks should confess their ills in exchange for liquidity. The Royal Bank of Scotland, for instance, the first in the UK to pursue a capital raising, is said by investors already to be hawking its loans far more aggressively.

"I think the process may speed up in Europe, but it depends on the balance sheet pressures at the individual banks," says Hamish Buckland at JPMorgan Chase. "It becomes easier once banks have made the psychological leap to start marking prices down."

The potential for pain is decreasing, as average loan prices have started to recover from their lows of mid-February.

The US market has dealt with its loan hangover more quickly, in part because of the depth and maturity of its investor base – there is almost always a buyer at the right price. The younger European market, by contrast, was driven by an influx of new structured investment funds called collateralised loan obligations (CLOs), whose economics struggle to stand up.

A second big boon is that US banks have apparently been able to create new CLOs out of the loans on their balance sheets and swap them for funding with the Federal Reserve.

The European Central Bank, meanwhile, has been happy to swap mortgage-backed bonds for government bonds in its funding operations, but does not appear to have done the same for CLOs.

However, the biggest worry about the US leveraged lending market is the possibility that involuntary balance sheet growth may be forcing US banks to sell on their loans more rapidly than European rivals. The problem here lies in corporate overdrafts known as revolvers – billions of dollars' worth of promises to lend at favourable rates that were also granted to risky companies before the credit crisis hit.

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