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.


Bernanke: This is Nirvana

Bernanke: Mortgage Woes Not Spreading
Bernanke: Economic Expansion Not Running Out of Steam
Wednesday March 28, 11:32 am ET
By Jeannine Aversa, AP Economics Writer

Bernanke Says Risky Mortgage Problems Aren't Spreading to Broader Economy
WASHINGTON (AP) -- Federal Reserve Chairman Ben Bernanke told Congress on Wednesday that growing troubles in the market for risky mortgages thus far doesn't appear to be spreading to the overall economy but the situation bears close watching.

Bernanke doesn't believe the nation will slip into a recession, rejecting the notion raised by predecessor Alan Greenspan that the economy's expansion could be in danger of fizzling out.

"At this juncture ... the impact on the broader economy and financial markets of the problems in the subprime markets seems likely to be contained," Bernanke said in testimony to Congress' Joint Economic Committee.

It marked Bernanke's most extensive discussion yet of the mounting problems in the risky mortgage market. Those troubles raise "some additional questions about the housing sector," which has been mired in a deep slump for more than a year, Bernanke said.

Fallout in the risky mortgage market is clobbering some lenders and homeowners and has stoked concerns on Wall Street, Capitol Hill and elsewhere.

So-called "subprime" lenders who make home loans to people with blemished credit histories or low incomes have been battered. Weak home prices and rising interest rates have made it increasingly difficult for borrowers to keep up with their payments. Delinquencies and foreclosures in the subprime mortgage market are soaring.

"Although the turmoil in the subprime mortgage market has created financial problems for many individuals and families, the implications of these developments for the housing market as a whole are less clear," Bernanke said.

The crumbling housing market has been a major factor behind the slowdown in the U.S. economy. Bernanke said the "near-term prospects for the housing market remain uncertain."

Even so, Bernanke stuck with the Federal Reserve's assessment that the economy is likely to grow at a moderate pace over the coming quarters. He also repeated the Fed's belief that inflation also should ease in the months ahead.

To be sure, Bernanke was careful to hedge the Fed's economic bets. The housing slump could turn out to be worse than expected, perhaps exacerbated by problems in the market for risky mortgages, he said. Recent weakness in business investment also could persist, he added. Those forces could further dampen economic growth.

On the other hand, consumers which proved "quite resilient" despite the housing slump and increases in energy prices, could continue to keep spending at a pace that would make the economy grow faster than currently expected, he said. And, there are other forces, including a still-good jobs market that is producing fatter paychecks, that could push up inflation.

The Fed chief's testimony comes amid fresh questions about the country's economic health, given problems with subprime mortgages, stock market turbulence and worries about the severity of the housing slump.

Against this backdrop, Sen. Charles Schumer, D-N.Y., chairman of the Joint Economic Committee, and some other lawmakers said the Fed should be open to cutting interest rates.

"Another reason to be open to an easing of monetary policy is the concern that the housing market adjustment is far from over," Schumer said. "Recent housing data has offered little encouragement that the market might be stabilizing. So it is still too early to tell if the worst is over for the housing market," he added.

There are some fears that consumers -- whose confidence is sagging -- and businesses could clamp down on spending and investing, thus short-circuiting overall economic growth. Rising prices for gasoline and other items also are raising concerns about inflation. These economic crosscurrents can complicate the Fed's job of trying to keep the economy and inflation on an even keel.

Just hours before Bernanke testified, the government reported that new orders for costly manufactured goods staged a modest rebound in February after a sharp slide the month before that jarred investors.

Last week Bernanke and his Fed colleagues decided to once again hold a key interest rate steady at 5.25 percent, which hasn't budged since August. They also gave themselves more leeway about future rate moves, raising the possibility that rates could go down. Previous policy statements had spoken only of the possibility of rate increases. The direction of rates, the Fed said, hinges on what incoming barometers say about the economy and inflation. Bernanke repeated that point on Wednesday.

Wall Street investors and some economists believe the Fed could start to cut rates this year to guard against any undue economic weakness. Other economists, however, believe rates probably will stay where they are throughout this year.

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