It'll be a cold day before debt markets reopen:James Saft
Tue Jul 31, 2007 9:44AM EDT
By James Saft
LONDON (Reuters) - Hopes that debt markets will reopen for leveraged borrowers after a pleasant summer holiday will be dashed, leaving mergers and buyouts and the stocks which depend upon them very exposed.
The riskier parts of the debt markets, especially leveraged loans, have all but shut up shop. Hedge funds generally can't get credit from their bank lenders and structured finance isn't buying either.
And it's not just that investors could have a long wait before the debt-powered private equity pipeline starts flowing again, it's also possible that a liquidity crisis prompts defaults and wider economic fallout.
Many deals have been shelved or underwriters forced to actually hold paper they hoped to sell on. Cadbury Schweppes (CBRY.L: Quote, Profile, Research) delayed the sale of its U.S. drink business last week, while sale of loans to Alliance Boots (AB.UL: Quote, Profile, Research) and Chrysler totaling more than $22 billion were postponed.
While the catalyst has been a reassessment of the very loose terms credit markets were offering, caused in turn by losses in the subprime debacle, what we are seeing in debt markets is a classic liquidity crisis.
With both collateralized loan obligations, structured vehicles which bundle debt together, and hedge funds sidelined, and with a huge forward calendar of deals needing to be sold, it is hard to see how debt markets can revive quickly.
"It's going to take longer than September for the market to fully reopen," said Meredith Coffey, an analyst with Reuters Loan Pricing Corporation in New York.
"There is massive oversupply, and demand has dwindled to nearly zero in the short term."
Reuters LPC estimates that there are $317 billion of leveraged loans, many supporting buyouts, to be sold in coming months in Europe and the U.S., as well as another $128 billion of U.S. institutional deals.
A particularly worrying development is that banks have cut back massively on providing Total Return Swaps (TSRs) to their hedge fund clients in the loan markets. TSRs allow hedge funds to borrow from banks relatively cheaply and buy into leveraged debt, pocketing the difference in yield between the cheap loan from the bank and the more expensive one to a corporate or private equity borrower.
If buyers of risky debt don't reappear in numbers, stock markets will be dependent on corporate buyers, presumably ones who don't need much debt financing, or on improving earnings.
SELF-FULFILLING CRISIS?
The issue now is can the liquidity crisis prompt a wider one, perhaps causing more defaults and hitting economic activity.
Marco Annunziata at Unicredit in London thinks that markets now fear that liquidity may be quickly and finally draining out of the system, which in turn could derail investment and consumer spending.
"The risk however, is that the current market movement might eventually infect fundamentals, creating a self-fulfilling crisis," he wrote in a Monday note to clients.
Companies could cut back on investment, and households in the United States, already hit by falling home prices, could tighten their belts even more if stock falls accelerate.
To be sure, loan markets have snapped back quickly from dislocations in the past, though never with this amount of loans yet to be sold in the offing.
And while defaults among riskier borrowers are at multi-year lows, should markets be closed for an extended period or general conditions worsen, that rate might rise.
Coffey of Reuters LPC thinks that one mitigating factor is that many of the loans made in recent years only oblige the borrowers to pay back quite small amounts at first, with a large "balloon" payment later. This lessens the chances of defaults, she says.
This "easy" repayment schedule, along with fewer covenants, which allow lenders to call a default if borrowers don't behave, is one of the most remarkable things about the loan markets in recent years.
Come to think of it, if loans to risky borrowers don't have covenants allowing lenders to throw them into default if they do foolish things, and if those same loans don't require lenders to pay much back soon, perhaps the very low levels of corporate default are not telling us that everything is fine and dandy anyway.
We shall see, but it will take longer than until September to find out.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. James Saft is a Reuters columnist. The opinions expressed are his own. You can reach him at saft@reuters.com)
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