Wednesday, March 28, 2007



Sketchy Loans Abound

With Capital Plentiful, Debt Buyers Take Subprime-Type Risks
March 27, 2007

In a frank moment several weeks ago, Bill Conway, co-founder of private-equity heavyweight Carlyle Group, issued a directive to employees warning of a corporate debt market bubble. Wall Street bankers bluntly describe it as a house of cards, too.

So here's a question. If borrowers and lenders alike agree the corporate debt boom can't last, why isn't anyone stopping it?

Lenders have been doling out increasingly large sums of money and accepting increasingly crummy conditions and meager returns on their loans. Remember those "low-doc" loans that got subprime home buyers in trouble -- the ones that required minimal proof of ability to repay? These are their corporate cousins.

Waves of money are coming at the markets from investors around the world. Bond and loan buyers have to put this money to work, even if the deals are shoddy. In the last year alone, they bought up $148 billion in new junk bonds from U.S. issuers, the largest sum in history by more than half for such high-risk debt.

The fuller answer tunnels into the Street's cynical heart, and why it has always been so profitable to work there: Hedge-fund managers, buyout artists, and bankers get paid for short-term performance. The long-term consequences of their actions are, conveniently, someone else's problem.

People inside the big banks are eerily candid about the credit cycle creeping to an end. They also candidly admit they don't want to get caught missing the next big deal. Their banks, and their own bonuses, might suffer. So they ply ahead.

The incentives are just as clear for hedge-fund and other money managers: The more money they put to work, the more 2% management fees they collect. And if they can outpace the market, there's 20% of the profits in performance fees for the taking, too.

"The fabulous profits we have been able to generate," Carlyle's Mr. Conway said in a letter to his employees, resulted in large part from the availability of cheap debt. The bankers, he added, "are making very risky credit decisions."

As they say in "The Lion King," Hakuna Matata. No worries.

Consider the idea of "covenant lite," the term the Street has attached to a new kind of debt, which sounds like a new flavor of ice cream. These are bank loans that subject borrowers to few of the usual performance requirements that have been standard in the past. A borrower's earnings might falter or receivables balloon, and a lender's only recourse is a ponderous shrug.

Debt buyers have taken on $41 billion of such 'lite' loans during 2007, a figure greater than the last 10 years combined, says Standard & Poor's. Covenant lite represents 37% of institutional loans written this year, compared with just 1% in 2005.

"Stupendous" is how S&P put the supply and demand. Another record is being set for Payment-in-Kind notes, which typically substitute interest payments with company shares or more money later. The term reputedly dates back to when debtors would replace "kyn" -- Old English for "cattle" -- for coin.

"Bad loans are made in good times," says Markus K. Brunnermeier, a Princeton economist who studies financial bubbles.

I recall a bracing winter morning meeting with executives of a midsize private-equity firm. They were chuckling like frat boys after a caper, marveling over the loans they had just secured from a group of banks. I asked what happens if the business implodes for a quarter. Doesn't matter, they said. The company can take a "covenant holiday" that treats the quarter as if it never existed. What if it happens again? We'll take another holiday, they said.

The debt markets "have reached a point where we can't go any further," says S&P analyst Steven Miller. "Some of the deals introduced into the market [this year] felt like they were at the edge of a cliff, leaning over. With someone holding their belt loops."

Turmoil in the bond and stock markets the past couple of months could be a signal that this will soon come to an end. The problem is that those words have been uttered for the past two years. Since then, corporate defaults have dipped to their lowest levels in more than 10 years.

Low defaults and high profits suggest companies could bear much more debt, which could sustain still more issuance. "If you tried to call the end, you'd be really poor waiting for it," Mr. Miller says.

Structural changes in the way people buy and sell debt adds to the appetite. The Street's soothsayers say this has fundamentally changed markets, by spreading risk far and wide, like a rake shaping a deep sand trap into a large, shallow one.

Banks themselves have generally ceased their role as gatekeepers. They're now in the shipping business, not the storage business. They parcel out to other investors the big loan packages they cut, typically as much as 95% of the loans they originally underwrite. These are sliced and packaged into products and gobbled up by hedge funds, insurance companies and institutional investors hungry for anything with a sizable yield.

The slicing is supposed to disperse risk in a way that minimizes exposure to any one large default. The changes give comfort to a market that has shown precious little sign of cracking. In such conditions, chasing bad deals might be entirely rational, says Dr. Brunnermeier.

"You can sell off loans very easily in the market," he says. "If others continue to go on, then you can stay on. You try to forecast when the others are getting out. You don't focus on the fundamentals. You focus on the other players."

This is why no one person has an interest in withdrawing from the market, he explains. Nobody wants to fold his cards first.

"We haven't had a hard shock to the credit markets since 2001," says Moody's Senior Credit Officer Matthew Noll. "It's yet to be seen how the new shock absorber actually takes the shock."
In other words, don't worry about how these times will end. Just know that everyone will be getting paid until the day arrives. And no one will have to give it back.

No worries, indeed.

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