What strange beast

There's no dressing it up. This is the worst period for leveraged lending since perhaps 1991.

The sell side -- what's left of it -- had little to sell, while the buy side raised precious little new money to invest. Volume, therefore, was down 59% in the third quarter, to $34 billion. During the first three quarters of 2008, volume plunged 71%, to $133 billion, from $457 billion during the first nine months of 2007.

As weak as supply was, demand was even softer. Indeed, the once-proud market for institutional loan investors has shriveled in 2008. By our count, the number of loan accounts has shrunk to 245 as of Sept. 30, from 307 at year's end.

With the structured finance market dead -- or at least playing possum -- and retail flows running cold, the traditional sources are dry. Hedge funds, hit with the double whammy of redemptions and banks unwilling to provide much in the way of prime broker lines, have also been selling more than buying, traders say. While there is a trickle of money coming in from pension funds and other institutional investors that sense value in today's market, the numbers involved are meager in the scheme of things, collateral managers say.

With so little demand in the system, accounts can now call the tune in the new-issue market. Thus, the ratings profile of 2008-crafted loans is among the best on record. Even so, most participants continue to hold their powder.

Most market participants offer a bleak view for the fourth quarter. Arrangers, certainly, are concerned about unveiling new transactions in the face of so much uncertainty. What little money is sitting on the sidelines is being held tightly by accounts betting that buying opportunities will improve in the months ahead.

With this in mind, volume is expected to continue to run at low ebb, focused on modestly sized deals in three basic flavors: (1) corporate BB loans priced at LIBOR+450-500, (2) opportunistic middle-market business that can be clubbed among regional banks and finance companies and (3) asset-based lending. But, in the best case, arrangers describe the market today as a single-file line where accounts are capable of focusing on just one or two deals at a time, making decisions with extreme care. To paraphrase Yeats, the bulls lack all conviction while the bears are filled with passionate intensity. The question for market players: Can the center hold? Likely it will, though a full revival may take a while. From what we gather from the market, players sense there are three possible outcomes: bad, worse and catastrophic.

In the bad case -- otherwise known as the best case -- default rates peak in mid-2009 at, say, 6% to 8%, and start falling as the economy recovers. A more stable environment ensues, allowing liquidity to spill back into the market. A virtuous cycle emerges, with inflows pushing prices higher. Returns improve, begetting new inflows, and things start to feel like 1993 or 2003, with the new-issue market reopened to more meaningful dealflow, albeit at still-conservative pricing and terms. David Wyss, Standard & Poor's chief economist, puts the likelihood of such an outcome at 60%.

In scenario two the economic carnage is bloodier. Recession stretches into the second half of next year, pushing default rates into the low double digits and delaying any sort of recovery until 2010. Wyss sees this as a more remote possibility.The common denominator in both of these scenarios is that the government is able to quarantine the ongoing strife in the financial system and mortgage market. Players are not yet dismissing a darker outcome, however.

How this might play out is anyone's guess, but the most popular theory among doomsday proponents: All the commitments the U.S. is taking on -- now at $1 trillion and counting -- become an unbearable burden, sparking a run on the dollar. From here, potentially, a Japan-circa-1990s malaise ensues for years to come.

What such failure would mean for the loan market is too grim to contemplate or, frankly, grasp. Still, it's possible, even if the chances are slight. How slight? Wyss puts the odds of the nightmare scenario at not more than 5% to 10%.

Steven Miller is managing director at Standard & Poor's Leveraged Commentary and Data.