So 2008 is upon us. But it does not seem a particularly happy new year. Or not, at least, for the markets.

Never mind the soaring oil and gold prices, or the wobble in equity prices. For my money, one of the more alarming trends is in leveraged finance, the corner of the banking world that provides funds for sub-investment grade companies, such as debt-laden buy-out deals.

In the past three years, the leveraged finance world – the business of arranging funding for sub-investment grade companies – has witnessed an explosion in activity. It has become ludicrously cheap and easy for buy-out groups to raise funds.

What has been even more remarkable than the scale of deals is that until now there have been few defaults.

Under some metrics, leveraged corporate defaults were near record lows in 2007, a pattern that has puzzled many rating agencies, bankers and investors given an almost universal assumption in recent years that default rates would soon rise, based on historical models.

With so many analysts having been so wrong-footed, most have gone rather quiet on the subject.

However, the credit research team at Citigroup have stuck their necks out and declared that US leveraged corporate defaults are set to soar from 1.3 per cent last year to 5.5 per cent at the start of 2009, meaning, in effect, that out of 100 leveraged companies, five are expected to default.

This forecast* is much gloomier than the consensus. But it is worth noting. For this Citi team has made some prescient calls in the past. If they are now correct again, it has big implications.

One remarkable detail about the credit crunch is that defaults have hitherto only really affected one part of the debt world – mortgage borrowing.

If the trend now spreads into the corporate world, this could produce a second wave of losses on a scale that potentially rivals subprime losses.

What makes Citi so gloomy? Surprisingly, it is not the economy. Its 5.5 per cent default forecast is based on an assumption that there is no US recession, and it warns that if a recession does occur, the default rate will be much higher.

Instead, what worries Citi is the attitude of big US banks.

Citi analysts point to a structural change in the loan world. In particular, liquidity has been so abundant this decade that lenders have offered loans with very weak legal covenants known as “cov-lite”. That has allowed ailing companies, which would have defaulted in other credit cycles, to stagger on.

The issue at stake has not just been the quantitative price of money but the qualitative factors that are hard to measure in models.

However, as Federal Reserve surveys show, US banks now plan to tighten corporate lending at a pace not seen for a decade.

The crucial point about cov-lite structures, Citi argues, is that they are not watertight for borrowers. On the contrary, Citi thinks lenders can usually find a way to use the fine print to punish weak companies if they really want. That implies that the hitherto low default rate could now surge if banks get tough.

Will they? Frankly, it is hard to know exactly what is happening on a micro level now, since there is a paucity of timely data about the leveraged finance world. In that sense, the pattern has echoes of the subprime world.

But given that Citi has been a keen dancer in the global leveraged finance party – as Chuck Prince, the former chief executive indicated – it is a fair bet that its analysts can read the mood music.

The moral? If 2007 was the year we all learnt to watch obscure mortgage derivatives indices, 2008 looks set to turn us all into experts on the finer details of the corporate default rate.



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