Subprime fallout
Global Markets Face Protracted Adjustment
September 24, 2007
Synopsis:
- Markets face difficult period ahead
- Credit difficulties likely to have broader economic effects
- Market framework needs strengthening
Markets are likely to go through a protracted adjustment period following recent financial turbulence triggered by the collapse of the U.S. subprime mortgage market, according to the IMF's latest Global Financial Stability Report (GFSR).
The report, released on September 24, said the turbulence represents the first significant test of innovative financial instruments and markets used to distribute credit risks through the global financial system, with markets recognizing the extent that credit discipline has deteriorated in recent years. This has caused a repricing of credit risk and a retrenchment from risky assets that, combined with increased complexity and illiquidity, has led to disruptions in core funding markets and increased market turbulence in August.
Central banks in several countries have stepped in to help stabilize markets and mitigate the impact on the broader economy. But the GFSR said the period ahead may still be difficult as bouts of turbulence are likely to recur and the adjustment process will take time. "Credit conditions may not normalize soon, and some of the practices that have developed in the structured credit markets will have to change," it stated.
Slowing global growth
The report, prepared by the IMF's Monetary and Capital Markets Department twice a year, said the turbulence could impact global economic growth. "Although the dislocations, especially to short-term funding markets, have been large, and in some cases unexpected, the event hit during a period of above-average global growth. Our assessment is that credit losses and the liquidity constriction experienced to date will [nevertheless] likely slow the global expansion," it stated. The IMF will give its next forecast for world growth on October 17.
The GFSR noted that systemically important financial institutions began this episode with adequate capital to absorb the likely level of credit losses. "Corporations, have, for the most part, been able to secure the financing they need to maintain their operations. However, the adjustment period is continuing and if the intermediation process stalls and financial conditions deteriorate further, the global financial sector and real economy could experience more serious negative repercussions," the report added.
Risks to macroeconomy
The report said that tighter monetary and credit conditions could reduce economic activity through a number of channels. A tightening of the supply of credit to weaker household borrowers could exacerbate the downturn in the U.S. housing market, while falling equity prices could reduce spending through the wealth effect and a weakening of consumer sentiment. Capital spending could also be curtailed owing to a higher cost of capital for the corporate sector. In addition, the dislocations in credit and funding markets could slow the overall provision and channeling of credit.
So far, emerging markets have weathered the turbulence relatively well in part because global growth has been strong and domestic macroeconomic policymaking has improved, though vigilance is still needed. Lower sovereign risks and their improving balance sheets supported by strong fundamentals are balanced against rising risks in some economies experiencing rapid credit growth, particularly where banks are using capital markets to finance credit growth. Furthermore, some private sector borrowers in certain emerging markets are adopting relatively risky strategies to raise financing.
Building a stronger system
Jaime Caruana, the IMF's Financial Counsellor and Director of the Monetary and Capital Markets Department, told reporters in Washington that the task for policymakers and market participants now was to learn lessons from the turbulence and use them to help make the global financial system stronger. "This does not require, as some have suggested, a new regulatory paradigm, but we must be ready to reexamine some elements of the framework we have, and to enhance it where necessary," he stated.
Key components of that framework include:
• Greater transparency. Accurate and timely information about underlying risks is critical for the market's ability to properly differentiate and price risk. Importantly, financial institutions need to make sure that they have robust funding strategies appropriately suited for their business model and that such funding strategies can accommodate stressful conditions. Greater transparency is needed on links between systemically important financial institutions and some of their off-balance sheet vehicles.
• Better risk monitoring. While securitization—and financial innovation more generally—has made markets more efficient, enhanced risk distribution, and facilitated the ongoing globalization of markets, there is a need to understand how securitization contributed to the current situation. In particular, the incentive structure may have weakened credit discipline, including incentives for originating lenders to monitor risk. Generally, the "originate and distribute" business model may need to be re-evaluated to ensure that adequate incentives are present.
• Improvements by rating agencies. Ratings and rating agencies will continue to be a fundamental component in the functioning of financial markets. Differentiated ratings scales for structured products could alert investors to the scope for more rapid ratings deterioration in such instruments, compared to, for instance, traditional corporate or sovereign bonds. Similarly, investors should ensure their portfolio allocation decisions are not overly reliant on letter ratings, and that such ratings should not be used as a substitute for appropriate due diligence.
• Better valuation. The valuation of complex products in a market where liquidity is insufficient to provide reliable market prices requires more consideration, in particular when assessing the appropriate allowance for liquidity risk premiums and financial institutions holding such securities as collateral. More work on best practices in liquidity management is necessary.
• A wider risk perimeter. The relevant perimeter of risk consolidation for banks has proved to be larger than the usual accounting or legal perimeters. The result is that risks that appear to have been distributed may yet return in various forms to the banks that distributed them. Reputational risk may force banks to internalize losses of legally independent entities, and new instruments or structures may mask off-balance sheet or contingent liabilities.
Policymakers face a delicate balancing act, the report stated. They must refine their prudential frameworks to encourage investors and institutions to maintain high credit standards and strengthen risk management systems in good times as well as bad, while preserving the enormous benefits from financial innovation seen in recent years.
Showing posts with label credit risk. Show all posts
Showing posts with label credit risk. Show all posts
Thursday, September 27, 2007
Friday, August 17, 2007
Retrospection - Fed's decision to keep rates at 5.25%
Fed Gives Weak Nod to Growth and Credit Risks: Caroline Baum
By Caroline Baum
Aug. 8 (Bloomberg) -- Fed to market: You made your bed, you lie in it.
That was the essence of the Federal Reserve's message yesterday when it left its benchmark lending rate unchanged at 5.25 percent and said inflation remains the ``predominant policy concern.''
Ever since the stock market started to get wobbly in late July, with losses in the Dow Jones Industrial Average exceeding 200 points some days, interest-rate futures markets got it in their head that Fed Chairman Ben Bernanke was going to bail them out.
The message yesterday was: Not so fast. Policy makers gave the weakest possible nod to the volatility in the markets and ``tighter credit conditions for some households and businesses'' without tipping their hand, or their risk assessment, away from inflation.
In the Fed's view, the ``downside risks to growth have increased somewhat'' as the housing correction continues. Inflation in goods-and-services prices is still more troubling than deflation in asset prices (specifically housing). The decline in nationwide home prices has been mild to date, but it is certain to accelerate as the bloated supply of unsold homes comes face to face with reduced demand, with credit-tightening shutting some borrowers out of the market.
The first reaction to the Fed's statement at 2:15 p.m. New York time was to sell. The prices of stocks, bonds, gold and interest-rate futures all went down initially as the Fed failed to corroborate the view that the economic environment was deteriorating rapidly.
Antidote
Until now, ``the Fed has been pretty good at describing the theme people were sensing,'' said Jim Glassman, senior U.S. economist at JPMorgan Chase & Co. in New York. Yesterday's statement ``is out of character with the reality as we know it.''
That doesn't mean the Fed is living in a parallel universe. Policy makers have to differentiate between a financial-market event and a macroeconomic one. For the moment, they have determined that the weakness in residential real estate, the widening of credit spreads and tighter lending standards aren't a threat to economic growth.
The ``cure'' for a period of excess credit is credit restraint: from the Fed; from mortgage lenders, who are faced with rising delinquencies and increased foreclosures on the part of subprime, and now prime, borrowers; and from investors, who are suffering losses on opaque collateralized mortgage and debt obligations that were supposed to diffuse the risk of the underlying loans.
Tainted Inheritance
Bernanke inherited the housing bubble from predecessor Alan Greenspan, who seemed to be rewriting history and offloading some of the blame in yesterday's Wall Street Journal. (Greenspan's greatest problem right now is that his soon-to-be-published memoir, ``The Age of Turbulence,'' may arrive just as the foundation is collapsing.)
He also inherited an institutional burden from his predecessor. Greenspan has been accused of creating a moral hazard, or encouraging risky behavior by putting a floor under the stock market (the ``Greenspan put'').
It may well be that the current Fed chief needs to expiate the sins of the father. Bernanke earned himself the moniker ``Helicopter Ben,'' early on -- unjustly, in my view -- when he compared the Fed's money-creation process to a chopper dropping dollars from the sky.
That's right out of the Milton Friedman teaching toolkit. When was the last time anyone accused the University of Chicago economist and Nobel laureate of fanning inflation?
Base Case
For what it's worth, the Fed's provision of credit, or high- powered money, has slowed to a crawl. The monetary base, which includes currency and bank reserves, grew 2.1 percent in July from the same month a year earlier, according to the St. Louis Fed's database. That's less than the inflation rate. As recently as last year, base money was still growing in excess of 5 percent annually.
There has been some suggestion -- accusation, really -- that the current Fed board is populated with academics (Bernanke along with Fed Governors Frederic Mishkin and Randall Kroszner), and that academics lack Greenspan's innate instincts about the market.
Maybe. Not all of his gut reactions were good ones, however. Greenspan lowered the federal funds rate three times in the fall of 1998 to counter the ``seizing up'' of financial markets in response to the near-collapse of hedge fund Long-Term Capital Management.
The economy didn't miss a beat. Greenspan waited until May 1999 to remove that stimulus. In the meantime, the Nasdaq Composite Index was well on its way to an 86 percent gain for the year.
Gut Check
Greenspan was slow to cut rates when capital spending was imploding in 2000, then did so with a vengeance in 2001. The overnight rate was still at 1 percent when the economy was taking off. Real gross domestic product grew at a 7.5 percent annualized rate in the third quarter of 2003, the start of a three-year trend of strong growth. Yet Greenspan took his time moving the funds rate back to a neutral level.
The Bernanke Fed, with its model-driven forecast, may turn out to be wrong in its laissez-faire attitude toward tightening credit conditions. It will come to that decision in its own way in its own time.
The inverted yield curve, with long-term rates below the Fed's policy rate, has been signaling for almost a year that the Fed is holding the funds rate too high. That disequilibrium is always resolved in favor of lower short-term rates.
I doubt this time will be different. It never is.
By Caroline Baum
Aug. 8 (Bloomberg) -- Fed to market: You made your bed, you lie in it.
That was the essence of the Federal Reserve's message yesterday when it left its benchmark lending rate unchanged at 5.25 percent and said inflation remains the ``predominant policy concern.''
Ever since the stock market started to get wobbly in late July, with losses in the Dow Jones Industrial Average exceeding 200 points some days, interest-rate futures markets got it in their head that Fed Chairman Ben Bernanke was going to bail them out.
The message yesterday was: Not so fast. Policy makers gave the weakest possible nod to the volatility in the markets and ``tighter credit conditions for some households and businesses'' without tipping their hand, or their risk assessment, away from inflation.
In the Fed's view, the ``downside risks to growth have increased somewhat'' as the housing correction continues. Inflation in goods-and-services prices is still more troubling than deflation in asset prices (specifically housing). The decline in nationwide home prices has been mild to date, but it is certain to accelerate as the bloated supply of unsold homes comes face to face with reduced demand, with credit-tightening shutting some borrowers out of the market.
The first reaction to the Fed's statement at 2:15 p.m. New York time was to sell. The prices of stocks, bonds, gold and interest-rate futures all went down initially as the Fed failed to corroborate the view that the economic environment was deteriorating rapidly.
Antidote
Until now, ``the Fed has been pretty good at describing the theme people were sensing,'' said Jim Glassman, senior U.S. economist at JPMorgan Chase & Co. in New York. Yesterday's statement ``is out of character with the reality as we know it.''
That doesn't mean the Fed is living in a parallel universe. Policy makers have to differentiate between a financial-market event and a macroeconomic one. For the moment, they have determined that the weakness in residential real estate, the widening of credit spreads and tighter lending standards aren't a threat to economic growth.
The ``cure'' for a period of excess credit is credit restraint: from the Fed; from mortgage lenders, who are faced with rising delinquencies and increased foreclosures on the part of subprime, and now prime, borrowers; and from investors, who are suffering losses on opaque collateralized mortgage and debt obligations that were supposed to diffuse the risk of the underlying loans.
Tainted Inheritance
Bernanke inherited the housing bubble from predecessor Alan Greenspan, who seemed to be rewriting history and offloading some of the blame in yesterday's Wall Street Journal. (Greenspan's greatest problem right now is that his soon-to-be-published memoir, ``The Age of Turbulence,'' may arrive just as the foundation is collapsing.)
He also inherited an institutional burden from his predecessor. Greenspan has been accused of creating a moral hazard, or encouraging risky behavior by putting a floor under the stock market (the ``Greenspan put'').
It may well be that the current Fed chief needs to expiate the sins of the father. Bernanke earned himself the moniker ``Helicopter Ben,'' early on -- unjustly, in my view -- when he compared the Fed's money-creation process to a chopper dropping dollars from the sky.
That's right out of the Milton Friedman teaching toolkit. When was the last time anyone accused the University of Chicago economist and Nobel laureate of fanning inflation?
Base Case
For what it's worth, the Fed's provision of credit, or high- powered money, has slowed to a crawl. The monetary base, which includes currency and bank reserves, grew 2.1 percent in July from the same month a year earlier, according to the St. Louis Fed's database. That's less than the inflation rate. As recently as last year, base money was still growing in excess of 5 percent annually.
There has been some suggestion -- accusation, really -- that the current Fed board is populated with academics (Bernanke along with Fed Governors Frederic Mishkin and Randall Kroszner), and that academics lack Greenspan's innate instincts about the market.
Maybe. Not all of his gut reactions were good ones, however. Greenspan lowered the federal funds rate three times in the fall of 1998 to counter the ``seizing up'' of financial markets in response to the near-collapse of hedge fund Long-Term Capital Management.
The economy didn't miss a beat. Greenspan waited until May 1999 to remove that stimulus. In the meantime, the Nasdaq Composite Index was well on its way to an 86 percent gain for the year.
Gut Check
Greenspan was slow to cut rates when capital spending was imploding in 2000, then did so with a vengeance in 2001. The overnight rate was still at 1 percent when the economy was taking off. Real gross domestic product grew at a 7.5 percent annualized rate in the third quarter of 2003, the start of a three-year trend of strong growth. Yet Greenspan took his time moving the funds rate back to a neutral level.
The Bernanke Fed, with its model-driven forecast, may turn out to be wrong in its laissez-faire attitude toward tightening credit conditions. It will come to that decision in its own way in its own time.
The inverted yield curve, with long-term rates below the Fed's policy rate, has been signaling for almost a year that the Fed is holding the funds rate too high. That disequilibrium is always resolved in favor of lower short-term rates.
I doubt this time will be different. It never is.
Tuesday, August 14, 2007
KKR says financing costs increased significantly
KKR Says Financing Costs `Increased Significantly' (Update3)
By Elizabeth Hester and Jason Kelly
Aug. 13 (Bloomberg) -- Kohlberg Kravis Roberts & Co., the private-equity firm that plans to raise $1.25 billion in an initial public offering, said the recent jump in borrowing costs for leveraged buyouts may hurt its funds' performance.
The cost to issue high-risk, high-yield debt has ``recently increased significantly'' and the New York-based firm may need to rely on investment banks to fund transactions, KKR said in a filing with the U.S. Securities and Exchange Commission today. Blackstone Group LP, manager of the world's largest private-equity fund, also cited ``more challenging financing'' when it announced earnings today.
``More costly and restrictive financing may adversely impact the returns of our leveraged-buyout transactions and, therefore, adversely affect our results of operations and financial condition,'' KKR said in its filing.
Investors, wary of risk after the collapse of the subprime-mortgage market, are shunning bonds and loans used to pay for buyouts including KKR's planned takeover of U.K. pharmacy chain Alliance Boots Plc. The extra yield investors demand to own non-investment-grade corporate bonds rather than Treasuries has climbed to 412 basis points from a record-low 241 on June 5, Merrill Lynch & Co. data show. A basis point is one one-hundredth of one percent.
About $330 billion in bonds and loans for announced deals remain unsold, according to an Aug. 8 estimate from Citigroup Inc. analyst Prashant Bhatia.
`Way Too Optimistic'
Private-equity executives and investment bankers are debating how long it will take lenders to sell that debt. Blackstone President Tony James said today that it's unlikely to happen in the near term.
``The sense that people will come back right after Labor Day is way too optimistic,'' James said on a conference call with investors. ``It will take a while to work through these issues.''
Blackstone, based in New York, said today that second- quarter profit more than tripled from a year ago to $774 million and revenue increased to $975 million from $325 million. The earnings report was Blackstone's first since its initial public offering in June.
While the early part of the period was ``fundamentally positive,'' concern over the U.S. housing market and the volume of debt waiting to be financed for LBOs created ``more challenging financing conditions'' that persist, Blackstone said in the statement.
Blackstone's Stock
Blackstone shares gained 1.7 percent to $25.71 in New York Stock Exchange composite trading. Earlier today, they rose as much as 7.8 percent, the most since the company's IPO.
KKR, founded by Henry Kravis and George Roberts, filed July 3 to sell shares of their management company to the public for the first time. Kravis and Roberts won't sell shares, and will use the money raised in the IPO to expand the firm and finance buyouts, the company said. The number of shares and the price weren't disclosed.
Net income for the quarter ended March 31 rose 46 percent to $380.9 million from $260.6 million in the year-earlier period, according to the filing. The company estimated that its buyout funds had $20 billion of investments as of March 31.
KKR paid current owners $318.8 million for the quarter ended March 31 and $1.06 billion in 2006. Before the IPO, the firm plans to make at least one cash distribution to owners of ``substantially all of the cash-on-hand,'' the filing said.
Antitrust Inquiry
KKR also disclosed in the filing that the U.S. Justice Department requested ``certain documents'' from KKR as part of an investigation into whether private-equity firms violated U.S. antitrust laws.
The Justice Department began an informal antitrust inquiry last year into the collaboration among buyout firms in some deals, a person familiar with the matter said last October.
Prosecutors haven't filed charges related to the probe.
Morgan Stanley and Citigroup are managing the KKR offering.
By Elizabeth Hester and Jason Kelly
Aug. 13 (Bloomberg) -- Kohlberg Kravis Roberts & Co., the private-equity firm that plans to raise $1.25 billion in an initial public offering, said the recent jump in borrowing costs for leveraged buyouts may hurt its funds' performance.
The cost to issue high-risk, high-yield debt has ``recently increased significantly'' and the New York-based firm may need to rely on investment banks to fund transactions, KKR said in a filing with the U.S. Securities and Exchange Commission today. Blackstone Group LP, manager of the world's largest private-equity fund, also cited ``more challenging financing'' when it announced earnings today.
``More costly and restrictive financing may adversely impact the returns of our leveraged-buyout transactions and, therefore, adversely affect our results of operations and financial condition,'' KKR said in its filing.
Investors, wary of risk after the collapse of the subprime-mortgage market, are shunning bonds and loans used to pay for buyouts including KKR's planned takeover of U.K. pharmacy chain Alliance Boots Plc. The extra yield investors demand to own non-investment-grade corporate bonds rather than Treasuries has climbed to 412 basis points from a record-low 241 on June 5, Merrill Lynch & Co. data show. A basis point is one one-hundredth of one percent.
About $330 billion in bonds and loans for announced deals remain unsold, according to an Aug. 8 estimate from Citigroup Inc. analyst Prashant Bhatia.
`Way Too Optimistic'
Private-equity executives and investment bankers are debating how long it will take lenders to sell that debt. Blackstone President Tony James said today that it's unlikely to happen in the near term.
``The sense that people will come back right after Labor Day is way too optimistic,'' James said on a conference call with investors. ``It will take a while to work through these issues.''
Blackstone, based in New York, said today that second- quarter profit more than tripled from a year ago to $774 million and revenue increased to $975 million from $325 million. The earnings report was Blackstone's first since its initial public offering in June.
While the early part of the period was ``fundamentally positive,'' concern over the U.S. housing market and the volume of debt waiting to be financed for LBOs created ``more challenging financing conditions'' that persist, Blackstone said in the statement.
Blackstone's Stock
Blackstone shares gained 1.7 percent to $25.71 in New York Stock Exchange composite trading. Earlier today, they rose as much as 7.8 percent, the most since the company's IPO.
KKR, founded by Henry Kravis and George Roberts, filed July 3 to sell shares of their management company to the public for the first time. Kravis and Roberts won't sell shares, and will use the money raised in the IPO to expand the firm and finance buyouts, the company said. The number of shares and the price weren't disclosed.
Net income for the quarter ended March 31 rose 46 percent to $380.9 million from $260.6 million in the year-earlier period, according to the filing. The company estimated that its buyout funds had $20 billion of investments as of March 31.
KKR paid current owners $318.8 million for the quarter ended March 31 and $1.06 billion in 2006. Before the IPO, the firm plans to make at least one cash distribution to owners of ``substantially all of the cash-on-hand,'' the filing said.
Antitrust Inquiry
KKR also disclosed in the filing that the U.S. Justice Department requested ``certain documents'' from KKR as part of an investigation into whether private-equity firms violated U.S. antitrust laws.
The Justice Department began an informal antitrust inquiry last year into the collaboration among buyout firms in some deals, a person familiar with the matter said last October.
Prosecutors haven't filed charges related to the probe.
Morgan Stanley and Citigroup are managing the KKR offering.
Monday, August 6, 2007
Hot money abandons credit markets, Loans find few buyers
LBO `Freeze' Shuts Wall Street Pipeline; $1.3 Billion Dries Up
By Edward Evans and Jason Kelly
Aug. 6 (Bloomberg) -- While investment bankers feasted on an unprecedented $8.4 billion of fees for arranging leveraged buyouts in the first half, the rest of the year may prove to be a famine.
``It's impossible to conclude that it's not going to be a tougher time for Wall Street,'' said Steven Rattner, co-founder of New York-based buyout firm Quadrangle Group and former vice chairman of Lazard Freres & Co. ``There's going to be an impact on revenues and profits.''
While no one's predicting a Biblical seven-year drought, the pace of buyouts has slowed more than 33 percent since June, data compiled by Bloomberg show. Investors are cutting back on riskier assets such as the loans and bonds that fund LBOs after being burned by losses from U.S. subprime mortgages. At that rate, banks would miss out on at least $1.3 billion of fees in the second half.
JPMorgan Chase & Co., the third-biggest U.S. bank, has the most at stake after earning more than anyone else from arranging leveraged loans in the first half. Together with Credit Suisse Group and Deutsche Bank AG, it made a combined $919 million from loans in period, data compiled by New York-based Freeman & Co. and Thomson Financial show. The three also got $426 million for advising LBO firms on takeovers and $190 million from bond sales.
Mortgage defaults by Americans with poor credit histories prompted the collapse in June of two hedge funds managed by Bear Stearns Cos. and triggered a worldwide rout in the debt markets. Companies such as London-based Cadbury Schweppes Plc, the world's biggest candy maker, have delayed asset sales, and banks including New York-based JPMorgan and Frankfurt-based Deutsche Bank have been left on the hook for as much as $300 billion of debt they've agreed to provide for LBOs.
`Grinding Halt'
``There's indigestion, as investors aren't buying the paper to the extent that they were buying it before, and banks will be nervous about committing to any new significant underwritings of any size,'' said Daniel Stillit, a London-based analyst at UBS AG. ``There's a significant risk of the LBO driver coming to a grinding halt.''
A 50 percent drop in income from arranging buyouts and other ``higher-risk credit,'' together with a 10 percent decline in other investment-banking revenue would slash earnings at Zurich- based Credit Suisse by 19 percent, London-based Deutsche Bank analyst Matt Spick said in a July 26 note to investors. Credit Suisse spokeswoman Rebecca O'Neill declined to comment.
Private-equity firms announced a record $616 billion of buyouts in the first half, capping four lucrative years of deals, according to Bloomberg data. New York-based Morgan Stanley, the second-biggest U.S. securities firm, is set to earn $45 million from New York-based Kohlberg Kravis Roberts & Co. for the $25.6 billion buyout of First Data Corp., the world's largest processor of credit-card payments.
Chrysler Sale
The takeovers have depended on the banks finding investors to buy debt. LBO firms use borrowed money to fund about two thirds of the cost of the deals. Bankers typically earn fees of 2 percent for underwriting loan sales for buyouts.
``Private equity has been an engine of growth for us and the industry in general,'' said Gary Crittenden, chief financial officer of Citigroup Inc., the biggest U.S. bank, on a July 27 conference call with investors. ``I would be stretching the truth if I said that our business plans anticipated what just happened in the past four to six weeks in the leveraged loans business and the potential impact that it could have on the private-equity market.''
Until last month, demand from investors was so strong that buyout firms were able to borrow with fewer restrictions, using so-called covenant lite securities and pay-in-kind bonds that allow companies to pay off debt by issuing new debt.
Yield Spreads
Investors have put the brakes on the LBO market, rejecting sales to fund buyouts of Auburn Hills, Michigan-based automaker Chrysler Corp. and Nottingham, England-based Alliance Boots Plc, the U.K.'s largest pharmacy chain. The companies failed to sell enough debt, leaving the banks stuck holding the loans while the buyout firms completed their takeovers.
Chrysler's German parent DaimlerChrysler AG last week said it would inject an additional $1.5 billion of debt to support the buyout.
``The high-yield market did a hop, skip and a jump and said, `We're not taking that stuff on those terms,''' said Frederick Joseph, managing director of New York-based Morgan Joseph & Co. and the former chief executive officer of Drexel Burnham Lambert Inc. ``The brokerage firms are getting stuck with some paper and it's going to take a while for it to get digested.''
Momentary `Blip'
The extra premium investors demand to own investment-grade corporate bonds over U.S. Treasuries widened 20 basis points to 128 basis points last week, according to data compiled by New York-based Merrill Lynch & Co. Spreads on high-yield bonds rose 91 basis points to 428 basis points, the highest since May 2005. A basis point is 0.01 percentage point.
``We're clearly going into a time of a very, very limited ability to access the lending market,'' said the 55-year-old Rattner of Quadrangle.
Cadbury had to delay the sale of its U.S. drinks unit because two groups of buyout firms weren't willing to meet the $15 billion asking price. The groups included Stephen Schwarzman's Blackstone Group LP in New York and Thomas H. Lee Partners LP of Boston.
``Some transactions came to market that pushed beyond what the debt markets were willing to do,'' said Scott Sperling, co- president of Thomas H. Lee, in a July 27 interview.
Scrapped Deals
While the pace of leveraged loans is slowing, the market will probably be ``back in business'' by October, Johnny Cameron, head of corporate and investment banking at Edinburgh-based Royal Bank of Scotland Group Plc, told reporters on a conference call on Aug. 3. Royal Bank earned almost $270 million from arranging leveraged loans in the first half, according to Freeman.
``Everybody's thinking about when the music's going to stop and I don't think we've hit that yet,'' said Ilan Nissan, a partner in the New York office of O'Melveny & Myers who works on buyouts. ``We're at a blip at this moment. Many people are saying `Let's take a breather and see what happened.'''
JPMorgan CEO Jamie Dimon, speaking on July 18, told investors that the drop in demand is ``a little freeze.''
That's sending a chill over the investment banks' shares. JPMorgan's stock slipped 11.5 percent in the past month, Deutsche Bank shares dropped 9.4 percent, and Credit Suisse fell 9 percent. Shares of New York-based Goldman Sachs Group Inc. declined 20 percent and Lehman Brothers Holdings Inc. fell 25 percent.
Lost Revenue
Investment banks in the U.S. and Europe are grappling with the loans they've underwritten for buyouts. They're carrying $400 billion of high-risk, high-yield loans they can't get other investors to take, according to Baring Asset Management in London. Companies have scrapped 46 debt deals worth $60 billion since June 22, Baring data show.
``Leveraged deals for private-equity will probably dry up until banks can clear up part of the backlog which will take at least until the end of September,'' said Toby Nangle, who helps manage $37 billion in assets at Baring Asset Management. ``As long as the conveyor belt is jammed, new fee revenues won't be forthcoming.''
Deutsche Bank is one of a group of banks on the line for the funding for KKR's takeover of Alliance Boots. The banks cancelled last week the sale of $2 billion of debt after failing to find investors, increasing the amount of debt the underwriters have been left holding to about $16.8 billion.
``Investors are taking a more cautious approach with respect to leveraged finance,'' Chief Financial Officer Anthony di Iorio told analysts on an Aug. 1 conference call. The bank took a ``not insignificant'' charge in the second quarter to mark down the value of some outstanding leveraged loans, he said.
Business Mix
Leveraged loans made up less than 4 percent of Deutsche Bank's total revenue during the past six quarters. That's less than JPMorgan, which netted more than 7 percent in 2006, and Credit Suisse, which received 7.5 percent of its total revenue from leveraged finance, according to estimates from Standard & Poor's.
As the pace of buyouts slows, not only will banks forgo revenue from underwriting loans, they may miss out on fees from advising on buyouts, according to Richard Barnes, a London-based analyst at S&P. For every dollar a bank earns in fees, it earns a further 50 cents in sales of other products, he said.
``A softening of investment banking performance was inevitable at some point,'' Barnes said. ``We're likely to see that in the third-quarter numbers.''
By Edward Evans and Jason Kelly
Aug. 6 (Bloomberg) -- While investment bankers feasted on an unprecedented $8.4 billion of fees for arranging leveraged buyouts in the first half, the rest of the year may prove to be a famine.
``It's impossible to conclude that it's not going to be a tougher time for Wall Street,'' said Steven Rattner, co-founder of New York-based buyout firm Quadrangle Group and former vice chairman of Lazard Freres & Co. ``There's going to be an impact on revenues and profits.''
While no one's predicting a Biblical seven-year drought, the pace of buyouts has slowed more than 33 percent since June, data compiled by Bloomberg show. Investors are cutting back on riskier assets such as the loans and bonds that fund LBOs after being burned by losses from U.S. subprime mortgages. At that rate, banks would miss out on at least $1.3 billion of fees in the second half.
JPMorgan Chase & Co., the third-biggest U.S. bank, has the most at stake after earning more than anyone else from arranging leveraged loans in the first half. Together with Credit Suisse Group and Deutsche Bank AG, it made a combined $919 million from loans in period, data compiled by New York-based Freeman & Co. and Thomson Financial show. The three also got $426 million for advising LBO firms on takeovers and $190 million from bond sales.
Mortgage defaults by Americans with poor credit histories prompted the collapse in June of two hedge funds managed by Bear Stearns Cos. and triggered a worldwide rout in the debt markets. Companies such as London-based Cadbury Schweppes Plc, the world's biggest candy maker, have delayed asset sales, and banks including New York-based JPMorgan and Frankfurt-based Deutsche Bank have been left on the hook for as much as $300 billion of debt they've agreed to provide for LBOs.
`Grinding Halt'
``There's indigestion, as investors aren't buying the paper to the extent that they were buying it before, and banks will be nervous about committing to any new significant underwritings of any size,'' said Daniel Stillit, a London-based analyst at UBS AG. ``There's a significant risk of the LBO driver coming to a grinding halt.''
A 50 percent drop in income from arranging buyouts and other ``higher-risk credit,'' together with a 10 percent decline in other investment-banking revenue would slash earnings at Zurich- based Credit Suisse by 19 percent, London-based Deutsche Bank analyst Matt Spick said in a July 26 note to investors. Credit Suisse spokeswoman Rebecca O'Neill declined to comment.
Private-equity firms announced a record $616 billion of buyouts in the first half, capping four lucrative years of deals, according to Bloomberg data. New York-based Morgan Stanley, the second-biggest U.S. securities firm, is set to earn $45 million from New York-based Kohlberg Kravis Roberts & Co. for the $25.6 billion buyout of First Data Corp., the world's largest processor of credit-card payments.
Chrysler Sale
The takeovers have depended on the banks finding investors to buy debt. LBO firms use borrowed money to fund about two thirds of the cost of the deals. Bankers typically earn fees of 2 percent for underwriting loan sales for buyouts.
``Private equity has been an engine of growth for us and the industry in general,'' said Gary Crittenden, chief financial officer of Citigroup Inc., the biggest U.S. bank, on a July 27 conference call with investors. ``I would be stretching the truth if I said that our business plans anticipated what just happened in the past four to six weeks in the leveraged loans business and the potential impact that it could have on the private-equity market.''
Until last month, demand from investors was so strong that buyout firms were able to borrow with fewer restrictions, using so-called covenant lite securities and pay-in-kind bonds that allow companies to pay off debt by issuing new debt.
Yield Spreads
Investors have put the brakes on the LBO market, rejecting sales to fund buyouts of Auburn Hills, Michigan-based automaker Chrysler Corp. and Nottingham, England-based Alliance Boots Plc, the U.K.'s largest pharmacy chain. The companies failed to sell enough debt, leaving the banks stuck holding the loans while the buyout firms completed their takeovers.
Chrysler's German parent DaimlerChrysler AG last week said it would inject an additional $1.5 billion of debt to support the buyout.
``The high-yield market did a hop, skip and a jump and said, `We're not taking that stuff on those terms,''' said Frederick Joseph, managing director of New York-based Morgan Joseph & Co. and the former chief executive officer of Drexel Burnham Lambert Inc. ``The brokerage firms are getting stuck with some paper and it's going to take a while for it to get digested.''
Momentary `Blip'
The extra premium investors demand to own investment-grade corporate bonds over U.S. Treasuries widened 20 basis points to 128 basis points last week, according to data compiled by New York-based Merrill Lynch & Co. Spreads on high-yield bonds rose 91 basis points to 428 basis points, the highest since May 2005. A basis point is 0.01 percentage point.
``We're clearly going into a time of a very, very limited ability to access the lending market,'' said the 55-year-old Rattner of Quadrangle.
Cadbury had to delay the sale of its U.S. drinks unit because two groups of buyout firms weren't willing to meet the $15 billion asking price. The groups included Stephen Schwarzman's Blackstone Group LP in New York and Thomas H. Lee Partners LP of Boston.
``Some transactions came to market that pushed beyond what the debt markets were willing to do,'' said Scott Sperling, co- president of Thomas H. Lee, in a July 27 interview.
Scrapped Deals
While the pace of leveraged loans is slowing, the market will probably be ``back in business'' by October, Johnny Cameron, head of corporate and investment banking at Edinburgh-based Royal Bank of Scotland Group Plc, told reporters on a conference call on Aug. 3. Royal Bank earned almost $270 million from arranging leveraged loans in the first half, according to Freeman.
``Everybody's thinking about when the music's going to stop and I don't think we've hit that yet,'' said Ilan Nissan, a partner in the New York office of O'Melveny & Myers who works on buyouts. ``We're at a blip at this moment. Many people are saying `Let's take a breather and see what happened.'''
JPMorgan CEO Jamie Dimon, speaking on July 18, told investors that the drop in demand is ``a little freeze.''
That's sending a chill over the investment banks' shares. JPMorgan's stock slipped 11.5 percent in the past month, Deutsche Bank shares dropped 9.4 percent, and Credit Suisse fell 9 percent. Shares of New York-based Goldman Sachs Group Inc. declined 20 percent and Lehman Brothers Holdings Inc. fell 25 percent.
Lost Revenue
Investment banks in the U.S. and Europe are grappling with the loans they've underwritten for buyouts. They're carrying $400 billion of high-risk, high-yield loans they can't get other investors to take, according to Baring Asset Management in London. Companies have scrapped 46 debt deals worth $60 billion since June 22, Baring data show.
``Leveraged deals for private-equity will probably dry up until banks can clear up part of the backlog which will take at least until the end of September,'' said Toby Nangle, who helps manage $37 billion in assets at Baring Asset Management. ``As long as the conveyor belt is jammed, new fee revenues won't be forthcoming.''
Deutsche Bank is one of a group of banks on the line for the funding for KKR's takeover of Alliance Boots. The banks cancelled last week the sale of $2 billion of debt after failing to find investors, increasing the amount of debt the underwriters have been left holding to about $16.8 billion.
``Investors are taking a more cautious approach with respect to leveraged finance,'' Chief Financial Officer Anthony di Iorio told analysts on an Aug. 1 conference call. The bank took a ``not insignificant'' charge in the second quarter to mark down the value of some outstanding leveraged loans, he said.
Business Mix
Leveraged loans made up less than 4 percent of Deutsche Bank's total revenue during the past six quarters. That's less than JPMorgan, which netted more than 7 percent in 2006, and Credit Suisse, which received 7.5 percent of its total revenue from leveraged finance, according to estimates from Standard & Poor's.
As the pace of buyouts slows, not only will banks forgo revenue from underwriting loans, they may miss out on fees from advising on buyouts, according to Richard Barnes, a London-based analyst at S&P. For every dollar a bank earns in fees, it earns a further 50 cents in sales of other products, he said.
``A softening of investment banking performance was inevitable at some point,'' Barnes said. ``We're likely to see that in the third-quarter numbers.''
Friday, July 27, 2007
LBO Financing faces increasing challenge
Chrysler, Boots Financing Woes Dim `Golden Era' for Buyouts
By Edward Evans and Jason Kelly
July 26 (Bloomberg) -- The ``golden era'' for leveraged buyouts proclaimed by Henry Kravis two months ago is losing its luster.
Kravis, co-founder of New York-based Kohlberg Kravis Roberts & Co., said on May 29 that there was ``plenty of capital'' to finance acquisitions. Yesterday, Chrysler and Alliance Boots Plc failed to find buyers for $20 billion of loans to pay for their buyouts. Ten banks, including Deutsche Bank AG and JPMorgan Chase & Co., were stuck holding the debt.
LBO firms, which announced an unprecedented $690.4 billion of takeovers this year, need to raise $300 billion of debt to fund purchases, according to data compiled by Bear Stearns Cos. That's going to get harder because investors, hit by losses on subprime mortgages, are shunning riskier bonds and loans.
``You're going to see more broken deals,'' billionaire investor Wilbur Ross said in an interview yesterday in New York. ``If the investment banks continue to get hung up, their appetite for risk is going to go down. That'll be a big change.''
Sales still in negotiations are being affected. Cadbury Schweppes Plc, the London-based maker of Dairy Milk chocolate, may get less than the $15 billion sought for its U.S. beverage unit as two buyout groups bidding for the division struggle to arrange funding, people with knowledge of the talks said yesterday.
It may also mean lower fees for Wall Street firms. Deutsche Bank, Germany's biggest bank, JPMorgan, the third-largest in the U.S., Credit Suisse Group, Switzerland's second-biggest bank, and New York-based Goldman Sachs Group Inc., the world's most profitable investment bank, took the biggest share of the $8.4 billion in fees paid by LBO firms in the first half, according to data compiled by Freeman & Co. and Thomson Financial in New York.
`Ugly' Scenario
``You've got an ugly short-term scenario,'' said Marek Gumienny, managing director at London-based buyout firm Candover Investments Plc, in a telephone interview yesterday. ``There will be pressure from credit committees at banks to reprice, restructure and offload this stuff.''
KKR has announced $136 billion of leveraged buyouts this year. Buyers typically fund LBOs with debt backed by the target's assets. They pay off the borrowing using cash flow and profit by selling the company three to five years later.
Kravis, who helped create the LBO business in 1976 with his cousin George Roberts, needs to raise money to pay for credit- card-payment processor First Data Corp. of Greenwood Village, Colorado, and Harman International Industries Inc., the Washington-based maker of Harman Kardon speakers.
Gross, Dimon
Since Kravis, 63, made his ``golden era'' comment in a speech to Canada's Venture Capital & Private Equity Association, almost 40 bond and loan sales have been canceled or restructured. Record defaults on U.S. subprime mortgages triggered the flight from below-investment-grade debt.
Bill Gross, chief investment officer at Pacific Investment Management Co. in Newport Beach, California, said on July 24 that lenders are ``frozen'' and ``absolutely nothing is moving.'' Jamie Dimon, chief executive officer of New York-based JPMorgan, described the drop in demand last week as ``a little freeze.''
Frankfurt-based Deutsche Bank, which is leading the financing for KKR's takeover of Nottingham, England-based pharmacy chain Alliance Boots, failed to sell 5 billion pounds ($10 billion) of senior loans to fund Europe's biggest LBO, two people with direct knowledge of the negotiations said yesterday. Chrysler, the U.S. unit of Stuttgart, Germany-based DaimlerChrysler AG, postponed the $10 billion sale of loans for its buyout by New York-based Cerberus Capital Management LLC, according to investors briefed on the decision.
Banks' Expense
``LBO financing has got much more expensive,'' said Willem Sels, a credit strategist at Dresdner Kleinwort Ltd. in London.
While terms of the Chrysler and Alliance Boots takeovers may have to change, both will still be completed. The banks funding the sales, rather than the buyout firms, have committed to covering most of the extra cost.
``Too many people have forgotten that underwriting is underwriting: you're on risk,'' Candover's Gumienny said. ``Some banks may not be in a position to do deals at the moment until they've reduced their credit or feel they can syndicate very easily. They're not going to be rushing out, throwing money at things.''
The private-equity firms aren't low on cash themselves. Pension funds, university endowments and wealthy individuals poured a record $210 billion into buyout funds last year, according to data compiled by London-based research firm Private Equity Intelligence Ltd.
`Huge Pipeline'
While mergers and acquisitions may slow, private-equity firms and their banks won't abandon LBOs unless the broader economy stumbles, said Warren Hellman, co-founder of San Francisco-based buyout firm Hellman & Friedman LLC.
``If there's a turn in the economy, a lot of stuff, the mega-stuff that's been done is going to start to look troubled,'' Hellman, a former president of New York-based Lehman Brothers Holdings Inc., said in an interview in San Francisco. ``That's the most concerning thing.''
The slide will be gradual, rather than an implosion that kills almost every LBO, said Mitchell Cohen, a managing director at Hellman & Friedman.
``It will be a little bit awkward for the next couple of months when this huge pipeline of stuff works its way through,'' Cohen said in an interview.
By Edward Evans and Jason Kelly
July 26 (Bloomberg) -- The ``golden era'' for leveraged buyouts proclaimed by Henry Kravis two months ago is losing its luster.
Kravis, co-founder of New York-based Kohlberg Kravis Roberts & Co., said on May 29 that there was ``plenty of capital'' to finance acquisitions. Yesterday, Chrysler and Alliance Boots Plc failed to find buyers for $20 billion of loans to pay for their buyouts. Ten banks, including Deutsche Bank AG and JPMorgan Chase & Co., were stuck holding the debt.
LBO firms, which announced an unprecedented $690.4 billion of takeovers this year, need to raise $300 billion of debt to fund purchases, according to data compiled by Bear Stearns Cos. That's going to get harder because investors, hit by losses on subprime mortgages, are shunning riskier bonds and loans.
``You're going to see more broken deals,'' billionaire investor Wilbur Ross said in an interview yesterday in New York. ``If the investment banks continue to get hung up, their appetite for risk is going to go down. That'll be a big change.''
Sales still in negotiations are being affected. Cadbury Schweppes Plc, the London-based maker of Dairy Milk chocolate, may get less than the $15 billion sought for its U.S. beverage unit as two buyout groups bidding for the division struggle to arrange funding, people with knowledge of the talks said yesterday.
It may also mean lower fees for Wall Street firms. Deutsche Bank, Germany's biggest bank, JPMorgan, the third-largest in the U.S., Credit Suisse Group, Switzerland's second-biggest bank, and New York-based Goldman Sachs Group Inc., the world's most profitable investment bank, took the biggest share of the $8.4 billion in fees paid by LBO firms in the first half, according to data compiled by Freeman & Co. and Thomson Financial in New York.
`Ugly' Scenario
``You've got an ugly short-term scenario,'' said Marek Gumienny, managing director at London-based buyout firm Candover Investments Plc, in a telephone interview yesterday. ``There will be pressure from credit committees at banks to reprice, restructure and offload this stuff.''
KKR has announced $136 billion of leveraged buyouts this year. Buyers typically fund LBOs with debt backed by the target's assets. They pay off the borrowing using cash flow and profit by selling the company three to five years later.
Kravis, who helped create the LBO business in 1976 with his cousin George Roberts, needs to raise money to pay for credit- card-payment processor First Data Corp. of Greenwood Village, Colorado, and Harman International Industries Inc., the Washington-based maker of Harman Kardon speakers.
Gross, Dimon
Since Kravis, 63, made his ``golden era'' comment in a speech to Canada's Venture Capital & Private Equity Association, almost 40 bond and loan sales have been canceled or restructured. Record defaults on U.S. subprime mortgages triggered the flight from below-investment-grade debt.
Bill Gross, chief investment officer at Pacific Investment Management Co. in Newport Beach, California, said on July 24 that lenders are ``frozen'' and ``absolutely nothing is moving.'' Jamie Dimon, chief executive officer of New York-based JPMorgan, described the drop in demand last week as ``a little freeze.''
Frankfurt-based Deutsche Bank, which is leading the financing for KKR's takeover of Nottingham, England-based pharmacy chain Alliance Boots, failed to sell 5 billion pounds ($10 billion) of senior loans to fund Europe's biggest LBO, two people with direct knowledge of the negotiations said yesterday. Chrysler, the U.S. unit of Stuttgart, Germany-based DaimlerChrysler AG, postponed the $10 billion sale of loans for its buyout by New York-based Cerberus Capital Management LLC, according to investors briefed on the decision.
Banks' Expense
``LBO financing has got much more expensive,'' said Willem Sels, a credit strategist at Dresdner Kleinwort Ltd. in London.
While terms of the Chrysler and Alliance Boots takeovers may have to change, both will still be completed. The banks funding the sales, rather than the buyout firms, have committed to covering most of the extra cost.
``Too many people have forgotten that underwriting is underwriting: you're on risk,'' Candover's Gumienny said. ``Some banks may not be in a position to do deals at the moment until they've reduced their credit or feel they can syndicate very easily. They're not going to be rushing out, throwing money at things.''
The private-equity firms aren't low on cash themselves. Pension funds, university endowments and wealthy individuals poured a record $210 billion into buyout funds last year, according to data compiled by London-based research firm Private Equity Intelligence Ltd.
`Huge Pipeline'
While mergers and acquisitions may slow, private-equity firms and their banks won't abandon LBOs unless the broader economy stumbles, said Warren Hellman, co-founder of San Francisco-based buyout firm Hellman & Friedman LLC.
``If there's a turn in the economy, a lot of stuff, the mega-stuff that's been done is going to start to look troubled,'' Hellman, a former president of New York-based Lehman Brothers Holdings Inc., said in an interview in San Francisco. ``That's the most concerning thing.''
The slide will be gradual, rather than an implosion that kills almost every LBO, said Mitchell Cohen, a managing director at Hellman & Friedman.
``It will be a little bit awkward for the next couple of months when this huge pipeline of stuff works its way through,'' Cohen said in an interview.
Tuesday, July 17, 2007
Another bearish article on the credit cycle
Goldman, JPMorgan Stuck With Debt They Can't Sell to Investors
By Caroline Salas and Miles Weiss
July 17 (Bloomberg) -- Goldman Sachs Group Inc., JPMorgan Chase & Co. and the rest of Wall Street are stuck with at least $11 billion of loans and bonds they can't readily sell.
The banks have had to dig into their own pockets to finance parts of at least five leveraged buyouts over the past month because of the worst bear market in high-yield debt in more than two years, data compiled by Bloomberg show.
Bankers, who just a few months ago boasted that demand for high-yield assets was so great that they would have no problem raising debt for a $100 billion LBO, are now paying for their overconfidence. The cost of tying up their own capital may curb earnings and stem the flood of LBOs, which generated a record $8.4 billion in fees during the first half of 2007, according to Brad Hintz, the former chief financial officer at New York-based Lehman Brothers Holdings Inc.
``The private equity firms, being very tough negotiators, are unlikely to let the banks off the hook,'' said Martin Fridson, chief executive officer of high-yield research firm FridsonVision LLC in New York. ``They'll say that's your problem and that's why we're paying you: To take risk.''
As the market began to turn sour last month, Goldman Sachs, Citigroup Inc., Lehman and Wachovia Corp. had to buy $725 million of bonds that Goodlettsville, Tennessee-based Dollar General Corp. was selling to finance Kohlberg Kravis Roberts & Co. purchase of the company for $6.9 billion. All of the securities firms are based in New York, except Wachovia, which is located in Charlotte, North Carolina.
Bonds Tumble
Those bonds are probably worth 94 cents on the dollar, or $43.5 million less than when they were sold on June 28, according to Justin Monteith, an analyst at high-yield research firm KDP Investment Advisors in Montpelier, Vermont. KKR completed the acquisition of Dollar General on July 9.
Bear Stearns Cos. strategists estimate that about $290 billion of deals still need to get funded, including those of Greenwood Village, Colorado-based credit-card processor First Data Corp. and energy company TXU Corp. of Dallas.
The question is ``how much yield are the brokerage firms going to have to eat,'' said Hintz, who is now an analyst at Sanford C. Bernstein & Co. in New York. ``What they've committed to is not current trading rates in the market. If I have a problem it doesn't mean I can't place the problem, but it's going to cause a mark-to-market loss.''
Record Sales
Acquisitions by private equity firms such as New York's KKR and Blackstone Group LP helped push sales of high-yield bonds and loans worldwide up more than 70 percent during the first half of the year to a record $708 billion, according to data compiled by Bloomberg. High-yield, or junk, bonds are those rated below Baa3 by Moody's Investors Service and BBB- by Standard & Poor's.
The investment banking fees generated by LBOs in the first half amounted to almost two-thirds of the $12.8 billion paid by LBO firms to Wall Street in 2006, data compiled by Freeman & Co. and Thomson Financial show. In the race to win deals, the five largest U.S. investment banks more than tripled their lending commitments to non-investment grade borrowers during the past year to $174 billion, according to their regulatory filings.
KKR co-founder Henry Kravis in May called it the ``golden era'' of buyouts at a conference in Halifax, Nova Scotia. The extra yield investors demanded to own junk bonds rather than Treasuries shrank to a record low of 2.41 percentage points in June from the peak of more than 10 percentage points in 2002, according to index data from New York-based Merrill Lynch & Co.
No Escape
For loans rated four or five levels below investment grade, the spread over the London interbank offered rate shrank to 2.12 percentage points in February from more than 4 percentage points in 2003. It has since widened to 2.72 percentage points.
Some bankers even speculated that $100 billion LBO was possible, a scenario that is now ``definitely'' off the table, said Stephen Antczak, high-yield strategist at UBS AG in Stamford, Connecticut. Wall Street's confidence in its ability to finance just about any deal led buyout firms to remove clauses in their purchase agreements that would allow them to back out if their banks couldn't come up with the financing.
Just three of the 40 biggest pending LBOs have an escape clause that lets the buyer back out if funding can't be arranged, said Mike Belin, U.S. head of equity derivatives strategy at Deutsche Bank AG in New York. A couple of years ago, a majority of deals included a financing contingency, Belin said, based on his research.
``If you were a credit officer or a risk manager who said `No' to virtually anything over the last few years you were wrong,'' Hintz said. ``So did they take it too far? Well, yeah. But that's part of any cycle. The issue is did they take it too far and is it going to hurt their earnings.''
Market Cracks
The market for high-yield bonds and junk-rated, or leveraged loans began to crack in June as concerns that LBOs were becoming too risky coincided with a slump in the market for subprime mortgages that caused the near-collapse of two Bear Stearns hedge funds.
Junk bonds lost 1.61 percent last month, the most since March 2005 when General Motors Corp. forecast its biggest quarterly loss since 1992 and the debt lost 2.73 percent, according to Merrill Lynch.
Investors refused to buy bonds to finance purchases of companies including Dollar General and ServiceMaster Co., forcing bankers to either buy the bonds themselves or extend a loan to make up for the securities that weren't sold.
In most deals, investment banks promise to provide loans to the buyer. They then seek other lenders to take pieces of the loans and find buyers for bonds. When buyers vanish, the banks must either buy the bonds themselves or provide a bridge loan to the borrower, tying up capital that would otherwise be used to finance more deals. The banks typically parcel out portions of bridge loans to reduce their risk.
Lending Commitments
Citigroup, the biggest U.S. bank, reported that its securities and banking division recorded an expense of $286 million in the first quarter to increase loan-loss reserves to account for higher commitments to leveraged transactions and an increase in the average length of loans.
Lehman reported on July 10 that its commitments for ``contingent acquisition facilities'' more than doubled in the quarter ended May 31 to $43.9 billion, exceeding its stock market capitalization of $39.1 billion. Lehman said its commitments contain ``flexible pricing features'' that allow it to charge more if market conditions deteriorate.
Goldman Sachs more than doubled its lending commitments to non-investment grade borrowers to $71.5 billion in the year ended May 31.
Citigroup spokeswoman Danielle Romero-Apsilos, Lehman spokeswoman Tasha Pelio and Goldman Sachs spokesman Michael Duvally, either declined to comment or didn't return phone calls.
ServiceMaster Bonds
JPMorgan failed to sell $1.15 billion of bonds for Memphis, Tennessee-based ServiceMaster on July 3. The banks provided ServiceMaster, the maker of TruGreen and Terminix lawn-care products, with a bridge loan to make up for the failed bond sale. ServiceMaster is being bought by private equity firm Clayton Dubilier & Rice Inc. for $4.7 billion.
KKR and New York-based Clayton Dubilier this month completed their $7.1 billion purchase of Columbia, Maryland- based US Foodservice, a unit of Dutch supermarket company Royal Ahold NV, even though junk bond investors refused to buy $1.55 billion of bonds and $3.37 billion of loans to finance the deal, according to estimates from New York-based Bear Stearns.
Deutsche Bank led the bond offering, which included $1 billion of ``toggle'' bonds that would have allowed US Foodservice to pay interest in either cash or additional debt. KKR and Clayton Dubilier relied on loans to complete the deal, according to S&P's Leveraged Commentary and Data unit.
`Beyond Our Risk'
``Many of these things are beyond our risk desires,'' said Bruce Monrad, who manages $1.5 billion of high-yield bonds at Northeast Investment Management Inc. in Boston.
JPMorgan spokesman Adam Castellani, Deutsche bank spokesman Scott Helfman and Morgan Stanley spokeswoman Jennifer Sala either declined to comment or didn't return calls. All the banks are based in New York, except Deutsche Bank, which is in Frankfurt.
Banks can always sell the debt if demand increases. Meanwhile, they may have to report a loss from the decline in value of their holdings, a process known as marking to market.
Banks could also lose money should they have to offer discounts on loans in order to syndicate the deals, said Tanya Azarchs, a banking industry analyst at New York-based S&P.
``I don't think it's going to cause banks to fail or even lead to downgrades,'' Azarchs said. ``But I do think there will be a little indigestion and lower earnings.''
The biggest concern is ``hung deals,'' where a lender is left holding a large loan to a single borrower, said Azarchs. ``Those traditionally in all the prior credit cycles have caused the greatest amount of grief for the large syndicating banks,'' Azarchs said.
`Burning Bed'
In 1989, First Boston Corp., now part of Credit Suisse, made a bridge loan for a buyout of Ohio Mattress Co., the predecessor to Sealy Corp. The junk bond market collapsed before First Boston could refinance the loan, and the securities firm ended up owning a big stake in the bedding manufacturer.
The deal became known as ``Burning Bed.''
``The thing about this business is memories are two seconds long,'' said James Schell, a private equity attorney in the New York office of Skadden, Arps, Slate, Meagher & Flom LLP.
Banks led by Citigroup committed to extend $37.2 billion in credit to fund the purchase of TXU by a group that included KKR, Fort Worth, Texas-based TPG Inc. and Goldman Sachs's private equity group. The financing will comprise $25.9 billion of term loans and $11.3 billion in an unsecured bridge loan.
First Data
Credit Suisse, based in Zurich, is leading banks in the U.S. that have agreed to provide KKR with $16 billion of loans for its $26.1 billion takeover of First Data. The plans include an $8 billion bond sale, which is scheduled for August or September, according to Bank of America Corp.
For firms such as KKR or Blackstone, both based in New York, the tighter credit environment may make their acquisitions less profitable and even change the way they go after future targets. Mark Semer, a spokesman for KKR, declined to comment.
``The underwriters are going to be forced to provide bridge loans and it's getting pretty ugly, but Wall Street deserves to get smacked around a little,'' said William Featherston, managing director in high-yield at J. Giordano Securities LLC in Stamford, Connecticut. ``It's been easy for so long.''
By Caroline Salas and Miles Weiss
July 17 (Bloomberg) -- Goldman Sachs Group Inc., JPMorgan Chase & Co. and the rest of Wall Street are stuck with at least $11 billion of loans and bonds they can't readily sell.
The banks have had to dig into their own pockets to finance parts of at least five leveraged buyouts over the past month because of the worst bear market in high-yield debt in more than two years, data compiled by Bloomberg show.
Bankers, who just a few months ago boasted that demand for high-yield assets was so great that they would have no problem raising debt for a $100 billion LBO, are now paying for their overconfidence. The cost of tying up their own capital may curb earnings and stem the flood of LBOs, which generated a record $8.4 billion in fees during the first half of 2007, according to Brad Hintz, the former chief financial officer at New York-based Lehman Brothers Holdings Inc.
``The private equity firms, being very tough negotiators, are unlikely to let the banks off the hook,'' said Martin Fridson, chief executive officer of high-yield research firm FridsonVision LLC in New York. ``They'll say that's your problem and that's why we're paying you: To take risk.''
As the market began to turn sour last month, Goldman Sachs, Citigroup Inc., Lehman and Wachovia Corp. had to buy $725 million of bonds that Goodlettsville, Tennessee-based Dollar General Corp. was selling to finance Kohlberg Kravis Roberts & Co. purchase of the company for $6.9 billion. All of the securities firms are based in New York, except Wachovia, which is located in Charlotte, North Carolina.
Bonds Tumble
Those bonds are probably worth 94 cents on the dollar, or $43.5 million less than when they were sold on June 28, according to Justin Monteith, an analyst at high-yield research firm KDP Investment Advisors in Montpelier, Vermont. KKR completed the acquisition of Dollar General on July 9.
Bear Stearns Cos. strategists estimate that about $290 billion of deals still need to get funded, including those of Greenwood Village, Colorado-based credit-card processor First Data Corp. and energy company TXU Corp. of Dallas.
The question is ``how much yield are the brokerage firms going to have to eat,'' said Hintz, who is now an analyst at Sanford C. Bernstein & Co. in New York. ``What they've committed to is not current trading rates in the market. If I have a problem it doesn't mean I can't place the problem, but it's going to cause a mark-to-market loss.''
Record Sales
Acquisitions by private equity firms such as New York's KKR and Blackstone Group LP helped push sales of high-yield bonds and loans worldwide up more than 70 percent during the first half of the year to a record $708 billion, according to data compiled by Bloomberg. High-yield, or junk, bonds are those rated below Baa3 by Moody's Investors Service and BBB- by Standard & Poor's.
The investment banking fees generated by LBOs in the first half amounted to almost two-thirds of the $12.8 billion paid by LBO firms to Wall Street in 2006, data compiled by Freeman & Co. and Thomson Financial show. In the race to win deals, the five largest U.S. investment banks more than tripled their lending commitments to non-investment grade borrowers during the past year to $174 billion, according to their regulatory filings.
KKR co-founder Henry Kravis in May called it the ``golden era'' of buyouts at a conference in Halifax, Nova Scotia. The extra yield investors demanded to own junk bonds rather than Treasuries shrank to a record low of 2.41 percentage points in June from the peak of more than 10 percentage points in 2002, according to index data from New York-based Merrill Lynch & Co.
No Escape
For loans rated four or five levels below investment grade, the spread over the London interbank offered rate shrank to 2.12 percentage points in February from more than 4 percentage points in 2003. It has since widened to 2.72 percentage points.
Some bankers even speculated that $100 billion LBO was possible, a scenario that is now ``definitely'' off the table, said Stephen Antczak, high-yield strategist at UBS AG in Stamford, Connecticut. Wall Street's confidence in its ability to finance just about any deal led buyout firms to remove clauses in their purchase agreements that would allow them to back out if their banks couldn't come up with the financing.
Just three of the 40 biggest pending LBOs have an escape clause that lets the buyer back out if funding can't be arranged, said Mike Belin, U.S. head of equity derivatives strategy at Deutsche Bank AG in New York. A couple of years ago, a majority of deals included a financing contingency, Belin said, based on his research.
``If you were a credit officer or a risk manager who said `No' to virtually anything over the last few years you were wrong,'' Hintz said. ``So did they take it too far? Well, yeah. But that's part of any cycle. The issue is did they take it too far and is it going to hurt their earnings.''
Market Cracks
The market for high-yield bonds and junk-rated, or leveraged loans began to crack in June as concerns that LBOs were becoming too risky coincided with a slump in the market for subprime mortgages that caused the near-collapse of two Bear Stearns hedge funds.
Junk bonds lost 1.61 percent last month, the most since March 2005 when General Motors Corp. forecast its biggest quarterly loss since 1992 and the debt lost 2.73 percent, according to Merrill Lynch.
Investors refused to buy bonds to finance purchases of companies including Dollar General and ServiceMaster Co., forcing bankers to either buy the bonds themselves or extend a loan to make up for the securities that weren't sold.
In most deals, investment banks promise to provide loans to the buyer. They then seek other lenders to take pieces of the loans and find buyers for bonds. When buyers vanish, the banks must either buy the bonds themselves or provide a bridge loan to the borrower, tying up capital that would otherwise be used to finance more deals. The banks typically parcel out portions of bridge loans to reduce their risk.
Lending Commitments
Citigroup, the biggest U.S. bank, reported that its securities and banking division recorded an expense of $286 million in the first quarter to increase loan-loss reserves to account for higher commitments to leveraged transactions and an increase in the average length of loans.
Lehman reported on July 10 that its commitments for ``contingent acquisition facilities'' more than doubled in the quarter ended May 31 to $43.9 billion, exceeding its stock market capitalization of $39.1 billion. Lehman said its commitments contain ``flexible pricing features'' that allow it to charge more if market conditions deteriorate.
Goldman Sachs more than doubled its lending commitments to non-investment grade borrowers to $71.5 billion in the year ended May 31.
Citigroup spokeswoman Danielle Romero-Apsilos, Lehman spokeswoman Tasha Pelio and Goldman Sachs spokesman Michael Duvally, either declined to comment or didn't return phone calls.
ServiceMaster Bonds
JPMorgan failed to sell $1.15 billion of bonds for Memphis, Tennessee-based ServiceMaster on July 3. The banks provided ServiceMaster, the maker of TruGreen and Terminix lawn-care products, with a bridge loan to make up for the failed bond sale. ServiceMaster is being bought by private equity firm Clayton Dubilier & Rice Inc. for $4.7 billion.
KKR and New York-based Clayton Dubilier this month completed their $7.1 billion purchase of Columbia, Maryland- based US Foodservice, a unit of Dutch supermarket company Royal Ahold NV, even though junk bond investors refused to buy $1.55 billion of bonds and $3.37 billion of loans to finance the deal, according to estimates from New York-based Bear Stearns.
Deutsche Bank led the bond offering, which included $1 billion of ``toggle'' bonds that would have allowed US Foodservice to pay interest in either cash or additional debt. KKR and Clayton Dubilier relied on loans to complete the deal, according to S&P's Leveraged Commentary and Data unit.
`Beyond Our Risk'
``Many of these things are beyond our risk desires,'' said Bruce Monrad, who manages $1.5 billion of high-yield bonds at Northeast Investment Management Inc. in Boston.
JPMorgan spokesman Adam Castellani, Deutsche bank spokesman Scott Helfman and Morgan Stanley spokeswoman Jennifer Sala either declined to comment or didn't return calls. All the banks are based in New York, except Deutsche Bank, which is in Frankfurt.
Banks can always sell the debt if demand increases. Meanwhile, they may have to report a loss from the decline in value of their holdings, a process known as marking to market.
Banks could also lose money should they have to offer discounts on loans in order to syndicate the deals, said Tanya Azarchs, a banking industry analyst at New York-based S&P.
``I don't think it's going to cause banks to fail or even lead to downgrades,'' Azarchs said. ``But I do think there will be a little indigestion and lower earnings.''
The biggest concern is ``hung deals,'' where a lender is left holding a large loan to a single borrower, said Azarchs. ``Those traditionally in all the prior credit cycles have caused the greatest amount of grief for the large syndicating banks,'' Azarchs said.
`Burning Bed'
In 1989, First Boston Corp., now part of Credit Suisse, made a bridge loan for a buyout of Ohio Mattress Co., the predecessor to Sealy Corp. The junk bond market collapsed before First Boston could refinance the loan, and the securities firm ended up owning a big stake in the bedding manufacturer.
The deal became known as ``Burning Bed.''
``The thing about this business is memories are two seconds long,'' said James Schell, a private equity attorney in the New York office of Skadden, Arps, Slate, Meagher & Flom LLP.
Banks led by Citigroup committed to extend $37.2 billion in credit to fund the purchase of TXU by a group that included KKR, Fort Worth, Texas-based TPG Inc. and Goldman Sachs's private equity group. The financing will comprise $25.9 billion of term loans and $11.3 billion in an unsecured bridge loan.
First Data
Credit Suisse, based in Zurich, is leading banks in the U.S. that have agreed to provide KKR with $16 billion of loans for its $26.1 billion takeover of First Data. The plans include an $8 billion bond sale, which is scheduled for August or September, according to Bank of America Corp.
For firms such as KKR or Blackstone, both based in New York, the tighter credit environment may make their acquisitions less profitable and even change the way they go after future targets. Mark Semer, a spokesman for KKR, declined to comment.
``The underwriters are going to be forced to provide bridge loans and it's getting pretty ugly, but Wall Street deserves to get smacked around a little,'' said William Featherston, managing director in high-yield at J. Giordano Securities LLC in Stamford, Connecticut. ``It's been easy for so long.''
A hint that credit spreads are widening?
Derivatives Banks Concerned by Hedge Fund Leverage, Fitch Says
By Hamish Risk
July 17 (Bloomberg) -- Hedge funds are borrowing too much to finance investments in credit derivatives, contracts based on debt, which may magnify volatility in a market downturn, according to a Fitch Ratings survey of 65 banks, insurers and money managers.
Hedge funds' influence on credit derivatives and debt markets has continued to grow at a ``dramatic pace,'' Fitch said in today's report. The funds are responsible for 60 percent of all trading in credit-default swaps and about 33 percent of collateralized debt obligations, securities that package debt, the ratings company said, citing data from Greenwich Associates.
U.S. corporate bond risk premiums reached the highest in almost two years last week as hedge funds bought credit-default swaps to offset potential losses from the subprime mortgage rout. Bear Stearns in New York earlier this month was forced to provide $1.6 billion for one of two hedge funds that made wrong-way bets on subprime debt. The firm declined to bail out lenders to the other fund, which borrowed more money against its investors' capital to take bigger risks.
In a market slump, large transactions financed with borrowed money may ``result in a number of hedge funds and banks attempting to close out positions with no potential takers of credit risk on the other side,'' Fitch analysts led by Ian Linnell in London wrote in the report for the 2006 survey.
Banks and money managers bought and sold about $50 trillion of credit derivatives in 2006, more than twice the total in the previous year, Fitch said. The market has grown 15-fold since Fitch started conducting the survey in 2003, the ratings company said.
Counterparty Concentration
Morgan Stanley was cited as the most frequent trader of the contracts, followed by Deutsche Bank AG, Goldman Sachs Group Inc. and JPMorgan Chase & Co., Fitch said. The top 10 firms accounted for 89 percent of credit derivatives bought and sold in 2006, from 86 percent in the previous year, Fitch said.
``For better or worse, counterparty concentration appears to remain a feature of this market,'' Fitch analysts wrote.
Contracts based on the debt of General Motors Corp., the largest U.S. automaker, were the most frequently traded single- name credit-default swaps last year, Fitch said, followed by DaimlerChrysler AG, the world's second-largest maker of luxury cars.
After GM, contracts based on Brazilian government debt were the second-busiest in terms of the amount traded.
Banks and hedge funds say it's cheaper and easier to use credit-default swaps to speculate on the ability of companies to repay debt than trading the underlying securities.
In a credit-default swap, the buyer pays an annual premium to guard against a borrower's failing to pay its debts. In the event of default, the buyer gets paid the full amount insured, and hands over defaulted loans or bonds to the swap seller. Swap prices typically decline when creditworthiness improves, and rise when it worsens.
A derivative is a financial obligation whose value is derived from such underlying assets as debt and equity, commodities and currencies.
By Hamish Risk
July 17 (Bloomberg) -- Hedge funds are borrowing too much to finance investments in credit derivatives, contracts based on debt, which may magnify volatility in a market downturn, according to a Fitch Ratings survey of 65 banks, insurers and money managers.
Hedge funds' influence on credit derivatives and debt markets has continued to grow at a ``dramatic pace,'' Fitch said in today's report. The funds are responsible for 60 percent of all trading in credit-default swaps and about 33 percent of collateralized debt obligations, securities that package debt, the ratings company said, citing data from Greenwich Associates.
U.S. corporate bond risk premiums reached the highest in almost two years last week as hedge funds bought credit-default swaps to offset potential losses from the subprime mortgage rout. Bear Stearns in New York earlier this month was forced to provide $1.6 billion for one of two hedge funds that made wrong-way bets on subprime debt. The firm declined to bail out lenders to the other fund, which borrowed more money against its investors' capital to take bigger risks.
In a market slump, large transactions financed with borrowed money may ``result in a number of hedge funds and banks attempting to close out positions with no potential takers of credit risk on the other side,'' Fitch analysts led by Ian Linnell in London wrote in the report for the 2006 survey.
Banks and money managers bought and sold about $50 trillion of credit derivatives in 2006, more than twice the total in the previous year, Fitch said. The market has grown 15-fold since Fitch started conducting the survey in 2003, the ratings company said.
Counterparty Concentration
Morgan Stanley was cited as the most frequent trader of the contracts, followed by Deutsche Bank AG, Goldman Sachs Group Inc. and JPMorgan Chase & Co., Fitch said. The top 10 firms accounted for 89 percent of credit derivatives bought and sold in 2006, from 86 percent in the previous year, Fitch said.
``For better or worse, counterparty concentration appears to remain a feature of this market,'' Fitch analysts wrote.
Contracts based on the debt of General Motors Corp., the largest U.S. automaker, were the most frequently traded single- name credit-default swaps last year, Fitch said, followed by DaimlerChrysler AG, the world's second-largest maker of luxury cars.
After GM, contracts based on Brazilian government debt were the second-busiest in terms of the amount traded.
Banks and hedge funds say it's cheaper and easier to use credit-default swaps to speculate on the ability of companies to repay debt than trading the underlying securities.
In a credit-default swap, the buyer pays an annual premium to guard against a borrower's failing to pay its debts. In the event of default, the buyer gets paid the full amount insured, and hands over defaulted loans or bonds to the swap seller. Swap prices typically decline when creditworthiness improves, and rise when it worsens.
A derivative is a financial obligation whose value is derived from such underlying assets as debt and equity, commodities and currencies.
Sunday, July 15, 2007
Can Wall Street be trusted to value risky CDOs?
Can Wall Street be trusted to value risky CDOs?
Sat Jul 14, 2007 9:33AM EDT
By Neil Shah - Analysis
NEW YORK (Reuters) - The complex models that Wall Street uses to analyze risky investments in subprime mortgages may be as suspect as some of the securities themselves.
With a surge in defaults on subprime home loans jolting credit rating agencies and two Bear Stearns hedge funds in recent weeks, some fear that these models may overlook swift market downturns or corrupt loan data. That could spell further turmoil for credit markets.
The worry is that well-heeled hedge funds, Wall Street proprietary trading desks and ratings agencies may be too optimistic when analyzing or valuing exotic mortgage investments. As a consequence, future drops in market prices may be more severe and possibly trigger panic selling by sophisticated investors.
"These models end up breaking down rather dramatically during abnormal times," said Andrew Lo, a finance professor at Massachusetts Institute of Technology. "And, of course, those are exactly the times that we should and need to worry about."
Ratings companies like Moody's Investors Service use computer models to help predict losses on thinly traded debt investments called collateralized debt obligations, or CDOs, that are often tied to pools of high-risk home loans. The models help the agencies determine what rating a security merits.
Because securities in the $1 trillion CDO market trade infrequently, it is difficult for hedge funds and other investors to mark their values to recent sale prices, called "marking to market."
Hedge funds instead use mathematical models of their own to estimate and report the value of their CDO holdings to investors -- a practice known as "marking to model."
Recent troubles at hedge funds run by Bear Stearns (BSC.N: Quote, Profile, Research), Braddock Financial Corp. and United Capital Markets have highlighted the problems inherent in that approach. Even so, fund managers are resisting market views on the value of subprime assets and continuing to "mark to model," claiming declines represent short-term volatility.
"'Mark to model' is a joke," said Janet Tavakoli, president of Tavakoli Structured Finance, a Chicago consulting firm. "What you need to do now is vet the underlying collateral" in CDOs instead of just modeling, which wasn't done earlier, she said. "It's grubby, roll-up-your-sleeves kind of work."
Some hedge funds may now have to report losses on CDOs, while pension funds and insurance companies may dump other securities if these are dropped by raters to "junk" status.
UNREALISTIC ASSUMPTIONS
While models may be necessary to analyze investments of such complexity and have worked well under normal conditions, they may break down quickly in times of crisis, MIT's Lo said.
Many popular hedge fund models ignore the possibility of a sudden withdrawal of liquidity, while ratings agencies may make overly abstract or unrealistic modeling assumptions and rely on the quality of the data assembled by Wall Street banks.
This week, Moody's and its rivals Standard & Poor's and Fitch Ratings slashed ratings on billions of subprime-related bonds, including CDOs, rattling global financial markets.
Josh Rosner, managing director at investment research firm Graham Fisher & Co., points to a recent S&P statement that the loan performance data it uses has called into question the accuracy of some of the data initially provided to them.
"I find it troubling that the rating agencies are only now publicly recognizing this," Rosner said.
The potential for self-serving pricing by hedge funds is a "serious concern," MIT's Lo said. "There needs to be more independence in pricing and valuation."
Bear Stearns on May 15 said that the riskier of its two hedge funds was down 6.5 percent for April, but then revised that figure to down almost 19 percent a few weeks later.
A logical choice for independent CDO pricing might be rating agencies, but this may be difficult in practice, Lo said.
"If the ratings agency ends up coming up with a really, really good pricing model, the individual responsible for developing those models will very quickly be hired by the hedge funds," Lo said.
The ratings agencies are themselves facing mounting complaints that they have been too slow and opaque in their tackling of the subprime crisis. Some say the agencies ignore key credit risks and cash in by doling out top-notch ratings to subprime-related CDOs.
In the wake of troubles at Bear's hedge funds, the chairman of the House Financial Services Committee said on Wednesday that he would hold a hearing on the role of credit-rating agencies in the fall.
S&P spokesman Adam Tempkin said the agency is very transparent. "We make all of our technical papers completely available to anybody that wants them. They explain every aspect of the models we use."
Noel Kirnon, senior managing director at Moody's, said, "The performance of our ratings overall suggest we're doing a pretty good job."
"The ratings aren't the output of a model," said Fitch managing director Kevin Kendra. "Ratings are the output of a credit committee."
BLAME IT ON THE INVESTORS
But many say investors in lightly regulated hedge funds or risky CDO securities knew what they were doing.
"Nobody made anybody else put their money into a hedge fund," said Mark Adelson, head of structured finance research at Nomura Securities International in New York.
Fear of a broad-based selloff in CDOs may also be overblown since some bondholders would be loathe to sell at fire-sale prices and also because any sudden sales would bring in other hedge funds hungry for bargains.
"Not all hedge funds are crying today," said Arturo Cifuentes, managing director at R.W. Pressprich and former global head of CDO research at Wachovia. "For some hedge funds, this is a great opportunity."
Sat Jul 14, 2007 9:33AM EDT
By Neil Shah - Analysis
NEW YORK (Reuters) - The complex models that Wall Street uses to analyze risky investments in subprime mortgages may be as suspect as some of the securities themselves.
With a surge in defaults on subprime home loans jolting credit rating agencies and two Bear Stearns hedge funds in recent weeks, some fear that these models may overlook swift market downturns or corrupt loan data. That could spell further turmoil for credit markets.
The worry is that well-heeled hedge funds, Wall Street proprietary trading desks and ratings agencies may be too optimistic when analyzing or valuing exotic mortgage investments. As a consequence, future drops in market prices may be more severe and possibly trigger panic selling by sophisticated investors.
"These models end up breaking down rather dramatically during abnormal times," said Andrew Lo, a finance professor at Massachusetts Institute of Technology. "And, of course, those are exactly the times that we should and need to worry about."
Ratings companies like Moody's Investors Service use computer models to help predict losses on thinly traded debt investments called collateralized debt obligations, or CDOs, that are often tied to pools of high-risk home loans. The models help the agencies determine what rating a security merits.
Because securities in the $1 trillion CDO market trade infrequently, it is difficult for hedge funds and other investors to mark their values to recent sale prices, called "marking to market."
Hedge funds instead use mathematical models of their own to estimate and report the value of their CDO holdings to investors -- a practice known as "marking to model."
Recent troubles at hedge funds run by Bear Stearns (BSC.N: Quote, Profile, Research), Braddock Financial Corp. and United Capital Markets have highlighted the problems inherent in that approach. Even so, fund managers are resisting market views on the value of subprime assets and continuing to "mark to model," claiming declines represent short-term volatility.
"'Mark to model' is a joke," said Janet Tavakoli, president of Tavakoli Structured Finance, a Chicago consulting firm. "What you need to do now is vet the underlying collateral" in CDOs instead of just modeling, which wasn't done earlier, she said. "It's grubby, roll-up-your-sleeves kind of work."
Some hedge funds may now have to report losses on CDOs, while pension funds and insurance companies may dump other securities if these are dropped by raters to "junk" status.
UNREALISTIC ASSUMPTIONS
While models may be necessary to analyze investments of such complexity and have worked well under normal conditions, they may break down quickly in times of crisis, MIT's Lo said.
Many popular hedge fund models ignore the possibility of a sudden withdrawal of liquidity, while ratings agencies may make overly abstract or unrealistic modeling assumptions and rely on the quality of the data assembled by Wall Street banks.
This week, Moody's and its rivals Standard & Poor's and Fitch Ratings slashed ratings on billions of subprime-related bonds, including CDOs, rattling global financial markets.
Josh Rosner, managing director at investment research firm Graham Fisher & Co., points to a recent S&P statement that the loan performance data it uses has called into question the accuracy of some of the data initially provided to them.
"I find it troubling that the rating agencies are only now publicly recognizing this," Rosner said.
The potential for self-serving pricing by hedge funds is a "serious concern," MIT's Lo said. "There needs to be more independence in pricing and valuation."
Bear Stearns on May 15 said that the riskier of its two hedge funds was down 6.5 percent for April, but then revised that figure to down almost 19 percent a few weeks later.
A logical choice for independent CDO pricing might be rating agencies, but this may be difficult in practice, Lo said.
"If the ratings agency ends up coming up with a really, really good pricing model, the individual responsible for developing those models will very quickly be hired by the hedge funds," Lo said.
The ratings agencies are themselves facing mounting complaints that they have been too slow and opaque in their tackling of the subprime crisis. Some say the agencies ignore key credit risks and cash in by doling out top-notch ratings to subprime-related CDOs.
In the wake of troubles at Bear's hedge funds, the chairman of the House Financial Services Committee said on Wednesday that he would hold a hearing on the role of credit-rating agencies in the fall.
S&P spokesman Adam Tempkin said the agency is very transparent. "We make all of our technical papers completely available to anybody that wants them. They explain every aspect of the models we use."
Noel Kirnon, senior managing director at Moody's, said, "The performance of our ratings overall suggest we're doing a pretty good job."
"The ratings aren't the output of a model," said Fitch managing director Kevin Kendra. "Ratings are the output of a credit committee."
BLAME IT ON THE INVESTORS
But many say investors in lightly regulated hedge funds or risky CDO securities knew what they were doing.
"Nobody made anybody else put their money into a hedge fund," said Mark Adelson, head of structured finance research at Nomura Securities International in New York.
Fear of a broad-based selloff in CDOs may also be overblown since some bondholders would be loathe to sell at fire-sale prices and also because any sudden sales would bring in other hedge funds hungry for bargains.
"Not all hedge funds are crying today," said Arturo Cifuentes, managing director at R.W. Pressprich and former global head of CDO research at Wachovia. "For some hedge funds, this is a great opportunity."
Tougher lenders in Asia (ex-Japan perhaps)
Private equity ambitions curbed by lenders in Asia
Fri Jul 13, 2007 7:35AM EDT
By Alison Tudor - Analysis
TOKYO (Reuters) - Private equity firms eyeing jumbo acquisitions in Asia are facing more demanding terms from their lenders, but fierce competition among banks for new business means the region's buyout boom is unlikely to be derailed.
A tougher stance from lenders could make takeovers -- particularly massive ones -- more expensive and more difficult for buyout funds, which prefer to pay for companies using a little of their own equity and a lot of debt.
Deal-hungry private equity firms that have had their way with banks during the buyout boom may now be forced to pay higher interest rates on the debt, or use less debt in bigger, riskier deals, making mega deals harder to structure and potentially reducing their returns.
"This is the first sign that the pendulum may be swinging back the other way - investors have linked arms and pushed back," said Tim Donahue, head of leveraged finance Asia Pacific at JP Morgan, where he helps private equity funds raise debt for deals.
Debt providers have become more risk averse following a global spike in credit costs caused by rising defaults in U.S. mortgage-related bonds, another highly-leveraged product.
Bankers estimate credit spreads for Asian buyouts have widened by about 20-30 basis points in the last few weeks, equivalent to a couple of million dollars of extra cost on a billion-dollar deal. If credit spreads continue to widen, clinching bigger deals will get even tougher.
"Until recently we'd push as hard as we could to get more debt, but now credit committees at banks will play more of a watchdog role, which is healthy for the market," said one manager of a private equity firm in Australia, the biggest buyout market in Asia so far in 2007.
U.S. private equity firm TPG cited credit market volatility as a reason for recently pulling out of bidding for Australian retailer Coles. Financial sources said higher credit costs may have been the final straw after a protracted bidding war with another retailer, Wesfarmers
Private equity firms announced $22 billion worth of deals in Asia-Pacific excluding Japan in the first half of this year, another record for the industry, according to data provider Thomson Financial.
Loan volume for LBOs across the Asia Pacific hit $15.8 billion in the first half of 2007, already above the 2006 total of $13.4 billion and up from $3 billion in 2004, according to Reuters unit Basis Point, which tracks acquisition finance.
Defaults are near record lows in Asia Pacific, but ratings agency Moody's said the benign environment has turned mildly negative, with debt-laden buyouts a major factor.
A STEP TOO FAR?
Asia's loan market is dominated by banks hungry for new business and with a sea of capital to lend, which ensures there will be plenty of appetite to fund most buyouts -- even if terms are tougher.
But the loose lending terms that buyout firms have been able to demand on massive deals, including so-called "covenant lite" structures that lack traditional protection offered to buyers of the debt, are expected to be harder to come by.
A barometer of funds' ability to raise debt in the region will be TPG's $1.4 billion acquisition of Singapore's United Test and Assembly Center (UTAC). Banks that funded the deal with the less-stringent terms may have a harder time syndicating the loan to other buyers.
Lenders have begun asking for a few covenants to be put back on loans and for higher spreads on the biggest deals, which could make buyouts more expensive and less profitable.
"While inconvenient, that's not a deal-breaker," said another private equity fund manager based in Australia.
Buyouts in Asia are smaller than in the West, where the push-back from debt lenders is greatest, and leverage in the region is lower, which means any backlash should be less severe.
Debt multiples on Asian deals average about 5-6 times earnings before interest, tax, depreciation and amortization (EBITDA), far below the 9-11 times on some recent U.S. deals.
And with fewer assets for sale, Asia lacks the glut of deals seen in the west, although deal sizes in the region are creeping higher. Last year private equity firms announced 15 buyouts over $1 billion across the Asia Pacific, up from three in 2003, Thomson Financial said.
A small but growing band of institutions that buy the more risky parts of Asian buyout debt, such as hedge funds and managers of pools of loans such as collateralized loan obligations, are stepping up the pressure on private equity.
But for now, deals continue to flow.
"There is push back on deals that are structured 'lite', but if a deal is reasonably structured, well protected and at an appropriate leverage multiple then it will get done," said Farhan Faruqui, head of global loans Asia Pacific for Citigroup.
Fri Jul 13, 2007 7:35AM EDT
By Alison Tudor - Analysis
TOKYO (Reuters) - Private equity firms eyeing jumbo acquisitions in Asia are facing more demanding terms from their lenders, but fierce competition among banks for new business means the region's buyout boom is unlikely to be derailed.
A tougher stance from lenders could make takeovers -- particularly massive ones -- more expensive and more difficult for buyout funds, which prefer to pay for companies using a little of their own equity and a lot of debt.
Deal-hungry private equity firms that have had their way with banks during the buyout boom may now be forced to pay higher interest rates on the debt, or use less debt in bigger, riskier deals, making mega deals harder to structure and potentially reducing their returns.
"This is the first sign that the pendulum may be swinging back the other way - investors have linked arms and pushed back," said Tim Donahue, head of leveraged finance Asia Pacific at JP Morgan, where he helps private equity funds raise debt for deals.
Debt providers have become more risk averse following a global spike in credit costs caused by rising defaults in U.S. mortgage-related bonds, another highly-leveraged product.
Bankers estimate credit spreads for Asian buyouts have widened by about 20-30 basis points in the last few weeks, equivalent to a couple of million dollars of extra cost on a billion-dollar deal. If credit spreads continue to widen, clinching bigger deals will get even tougher.
"Until recently we'd push as hard as we could to get more debt, but now credit committees at banks will play more of a watchdog role, which is healthy for the market," said one manager of a private equity firm in Australia, the biggest buyout market in Asia so far in 2007.
U.S. private equity firm TPG cited credit market volatility as a reason for recently pulling out of bidding for Australian retailer Coles. Financial sources said higher credit costs may have been the final straw after a protracted bidding war with another retailer, Wesfarmers
Private equity firms announced $22 billion worth of deals in Asia-Pacific excluding Japan in the first half of this year, another record for the industry, according to data provider Thomson Financial.
Loan volume for LBOs across the Asia Pacific hit $15.8 billion in the first half of 2007, already above the 2006 total of $13.4 billion and up from $3 billion in 2004, according to Reuters unit Basis Point, which tracks acquisition finance.
Defaults are near record lows in Asia Pacific, but ratings agency Moody's said the benign environment has turned mildly negative, with debt-laden buyouts a major factor.
A STEP TOO FAR?
Asia's loan market is dominated by banks hungry for new business and with a sea of capital to lend, which ensures there will be plenty of appetite to fund most buyouts -- even if terms are tougher.
But the loose lending terms that buyout firms have been able to demand on massive deals, including so-called "covenant lite" structures that lack traditional protection offered to buyers of the debt, are expected to be harder to come by.
A barometer of funds' ability to raise debt in the region will be TPG's $1.4 billion acquisition of Singapore's United Test and Assembly Center (UTAC). Banks that funded the deal with the less-stringent terms may have a harder time syndicating the loan to other buyers.
Lenders have begun asking for a few covenants to be put back on loans and for higher spreads on the biggest deals, which could make buyouts more expensive and less profitable.
"While inconvenient, that's not a deal-breaker," said another private equity fund manager based in Australia.
Buyouts in Asia are smaller than in the West, where the push-back from debt lenders is greatest, and leverage in the region is lower, which means any backlash should be less severe.
Debt multiples on Asian deals average about 5-6 times earnings before interest, tax, depreciation and amortization (EBITDA), far below the 9-11 times on some recent U.S. deals.
And with fewer assets for sale, Asia lacks the glut of deals seen in the west, although deal sizes in the region are creeping higher. Last year private equity firms announced 15 buyouts over $1 billion across the Asia Pacific, up from three in 2003, Thomson Financial said.
A small but growing band of institutions that buy the more risky parts of Asian buyout debt, such as hedge funds and managers of pools of loans such as collateralized loan obligations, are stepping up the pressure on private equity.
But for now, deals continue to flow.
"There is push back on deals that are structured 'lite', but if a deal is reasonably structured, well protected and at an appropriate leverage multiple then it will get done," said Farhan Faruqui, head of global loans Asia Pacific for Citigroup.
Friday, July 13, 2007
Another doomsday report on credit "bubble"
Another pounding
Jul 12th 2007
From The Economist print edition
Problems in America's housing market begin to undermine confidence in the global credit bubble
WHEN the man approaching you is wearing boxing gloves, it makes sense to duck. The crisis in the American subprime-mortgage market was clearly visible months ago. Too many homebuyers with a poor or non-existent payment record were lent too much money. But when the rating agencies on July 10th finally got round to acknowledging the problem, investors were clobbered. Shares briefly wobbled and the dollar sank. Swap spreads, a measure of risk aversion, reached their highest point since 2003. Credit derivatives, where much of the financial innovation in recent years has taken place, recoiled (see chart). Investors flocked to the haven of Treasury bonds.
Why were investors so slow to react? It seems they have been consistently blindsided by how widespread the subprime problems have become—as well as complacent about the potential spillover into other areas of the debt markets.
At first, investors thought the subprime issue was confined to a few lenders, but the forthright website www.lenderimplode.com suggests that 97 of them have now been hit. Then they thought that defaults would be confined to a few states in the Midwest but the crisis has spread to heavily populated California and Florida.
The second delay was caused by the way that mortgages had been repackaged and sold. Initially they were bundled into residential mortgage-backed securities or RMBSs; Moody's, a rating agency, downgraded 399 of these bonds, while Standard & Poor's, a rival, indicated it was preparing to downgrade some 612 bonds, worth $12 billion. These bonds are only a small portion of the mortgage-related market. But according to Josh Rosner of the investment firm Graham Fisher, the agencies suggested further downgrades were to come.
The RMBSs are in turn divided up and placed in instruments called collateralised debt obligations or CDOs. These were sold to a wide range of investors, depending on their tolerance for risk. One set of securities, known as an equity tranche, pays the highest returns but is the first to suffer if the underlying bonds default; other securities offer a much lower yield but a triple-A credit rating, because a lot of defaults would be needed to trigger losses.
The result of this process has, in theory, helped the market. Bank failures have been at the heart of most financial crises. But instead of the banks taking the first hit from mortgage defaults, the pain will be spread round the financial system.
However, nobody knows where the risk now lies. Many of these securities are illiquid, so regular prices are not available. Indeed, highly rated CDO tranches may still be owned by banks that do not have to put a value on these securities. They may not recognise the problem until they are forced to by auditors or by ratings downgrades. On July 11th Moody's said it may cut its ratings on tranches of 91 CDOs worth about $5 billion. “My initial analysis suggests we could see massive cumulative losses into the double-A tranches of many RMBS-backed CDOs,” says Mr Rosner. (Double-A tranches, as their name suggests, are just below triple-A.)
Those required to ascribe a market value to these securities are faced with what ING, an investment bank, describes as a version of the prisoner's dilemma. Everybody would be better off if nobody traded, so that there would be no need to recognise lower prices. But if everybody is planning to sell, those who trade first will have an advantage.
This problem cropped up when two hedge funds run by Bear Stearns, an investment bank, got into trouble in June. The Bear funds had borrowed to enhance returns, and in doing so had to post collateral with lenders, known as prime brokers. When things went wrong, one of the brokers, Merrill Lynch, tried to sell its collateral but soon stopped when it transpired it was only succeeding in driving prices sharply lower. Eventually, Bear Stearns pledged some of its own money to fill the gap.
But prime brokers may also be shrinking the investor pool by increasing the margin that funds must put up when buying CDO assets; according to Matt King of Citigroup, the margin requirement on paper rated at the lowest level of investment grade has risen from 10-20% to 50%. That is bound to discourage some hedge funds.
All this may reduce the pool of potential mortgage investors. This effect may be reinforced by other developments. In recent years, there has been a concerted effort to increase the share of homeowners in America from the post-war average of around 63% to 70%. Lending standards were relaxed and deposits were no longer required. The extreme was reached with so-called NINJA loans (borrowers needed no income, job or assets). The influx of new buyers pushed up house prices, which made lenders even more eager.
But as the rating agencies have now discovered, fraud played a part too. Everybody had an incentive to do a deal, almost regardless of the homebuyers' ability to repay; the buyer hoping for a quick profit, the real-estate agent and mortgage broker hoping for a fee. And the banks did not need to be as concerned about creditworthiness as they used to be, given they would be quickly selling the loan.
Now that defaults have shot up, particularly on loans taken out last year, lending standards are being tightened. That will reduce the number of potential buyers and put downward pressure on prices.
Many homeowners are already in trouble. Figures from MacroMavens, an economic consultancy, suggest that 23% of adjustable-rate mortgages, covering loans with a value of $693 billion, are already in negative equity, where the loan is worth more than the property. But the full impact of defaults may not be felt until the low “teaser” rates on mortgages expire and push up borrowing costs. These teaser loans were done on a “two and 28” basis (with low rates applying for the first two years, and higher rates for the next 28). So the worst news from the 2006 vintage may not be felt until 2008.
Nor does default necessarily mean the end of the road. Few lenders want to foreclose, a process that takes ages, incurs massive costs and often causes the departing residents to trash the house. It is better to agree on a quick sale. But too much selling will force prices lower, weakening the rest of the portfolio.
So it may take a while for the property of struggling borrowers to trickle onto the market. Jeffrey Kirsch of American Residential Equities, a company specialising in buying delinquent loans, says foreclosing a property can take more than three years. He doubts the housing market will bottom out until the first quarter of 2009.
The current fear is not so much that the housing market could drive America into recession, although that could still happen. The worry is more that credit conditions may get tighter. The spread paid by higher-risk European firms has increased by almost a percentage point since mid-June. Investors are shying away from some loans being offered to finance leveraged buy-outs. A slowdown in such private equity-driven bids would hit the stockmarket.
Richard Bernstein, a Merrill Lynch strategist, says excessive lending has been fuelling the growth in financial markets in recent years. But he fears that now liquidity is drying up. That means no cushion when the punch lands.
Jul 12th 2007
From The Economist print edition
Problems in America's housing market begin to undermine confidence in the global credit bubble
WHEN the man approaching you is wearing boxing gloves, it makes sense to duck. The crisis in the American subprime-mortgage market was clearly visible months ago. Too many homebuyers with a poor or non-existent payment record were lent too much money. But when the rating agencies on July 10th finally got round to acknowledging the problem, investors were clobbered. Shares briefly wobbled and the dollar sank. Swap spreads, a measure of risk aversion, reached their highest point since 2003. Credit derivatives, where much of the financial innovation in recent years has taken place, recoiled (see chart). Investors flocked to the haven of Treasury bonds.
Why were investors so slow to react? It seems they have been consistently blindsided by how widespread the subprime problems have become—as well as complacent about the potential spillover into other areas of the debt markets.
At first, investors thought the subprime issue was confined to a few lenders, but the forthright website www.lenderimplode.com suggests that 97 of them have now been hit. Then they thought that defaults would be confined to a few states in the Midwest but the crisis has spread to heavily populated California and Florida.
The second delay was caused by the way that mortgages had been repackaged and sold. Initially they were bundled into residential mortgage-backed securities or RMBSs; Moody's, a rating agency, downgraded 399 of these bonds, while Standard & Poor's, a rival, indicated it was preparing to downgrade some 612 bonds, worth $12 billion. These bonds are only a small portion of the mortgage-related market. But according to Josh Rosner of the investment firm Graham Fisher, the agencies suggested further downgrades were to come.
The RMBSs are in turn divided up and placed in instruments called collateralised debt obligations or CDOs. These were sold to a wide range of investors, depending on their tolerance for risk. One set of securities, known as an equity tranche, pays the highest returns but is the first to suffer if the underlying bonds default; other securities offer a much lower yield but a triple-A credit rating, because a lot of defaults would be needed to trigger losses.
The result of this process has, in theory, helped the market. Bank failures have been at the heart of most financial crises. But instead of the banks taking the first hit from mortgage defaults, the pain will be spread round the financial system.
However, nobody knows where the risk now lies. Many of these securities are illiquid, so regular prices are not available. Indeed, highly rated CDO tranches may still be owned by banks that do not have to put a value on these securities. They may not recognise the problem until they are forced to by auditors or by ratings downgrades. On July 11th Moody's said it may cut its ratings on tranches of 91 CDOs worth about $5 billion. “My initial analysis suggests we could see massive cumulative losses into the double-A tranches of many RMBS-backed CDOs,” says Mr Rosner. (Double-A tranches, as their name suggests, are just below triple-A.)
Those required to ascribe a market value to these securities are faced with what ING, an investment bank, describes as a version of the prisoner's dilemma. Everybody would be better off if nobody traded, so that there would be no need to recognise lower prices. But if everybody is planning to sell, those who trade first will have an advantage.
This problem cropped up when two hedge funds run by Bear Stearns, an investment bank, got into trouble in June. The Bear funds had borrowed to enhance returns, and in doing so had to post collateral with lenders, known as prime brokers. When things went wrong, one of the brokers, Merrill Lynch, tried to sell its collateral but soon stopped when it transpired it was only succeeding in driving prices sharply lower. Eventually, Bear Stearns pledged some of its own money to fill the gap.
But prime brokers may also be shrinking the investor pool by increasing the margin that funds must put up when buying CDO assets; according to Matt King of Citigroup, the margin requirement on paper rated at the lowest level of investment grade has risen from 10-20% to 50%. That is bound to discourage some hedge funds.
All this may reduce the pool of potential mortgage investors. This effect may be reinforced by other developments. In recent years, there has been a concerted effort to increase the share of homeowners in America from the post-war average of around 63% to 70%. Lending standards were relaxed and deposits were no longer required. The extreme was reached with so-called NINJA loans (borrowers needed no income, job or assets). The influx of new buyers pushed up house prices, which made lenders even more eager.
But as the rating agencies have now discovered, fraud played a part too. Everybody had an incentive to do a deal, almost regardless of the homebuyers' ability to repay; the buyer hoping for a quick profit, the real-estate agent and mortgage broker hoping for a fee. And the banks did not need to be as concerned about creditworthiness as they used to be, given they would be quickly selling the loan.
Now that defaults have shot up, particularly on loans taken out last year, lending standards are being tightened. That will reduce the number of potential buyers and put downward pressure on prices.
Many homeowners are already in trouble. Figures from MacroMavens, an economic consultancy, suggest that 23% of adjustable-rate mortgages, covering loans with a value of $693 billion, are already in negative equity, where the loan is worth more than the property. But the full impact of defaults may not be felt until the low “teaser” rates on mortgages expire and push up borrowing costs. These teaser loans were done on a “two and 28” basis (with low rates applying for the first two years, and higher rates for the next 28). So the worst news from the 2006 vintage may not be felt until 2008.
Nor does default necessarily mean the end of the road. Few lenders want to foreclose, a process that takes ages, incurs massive costs and often causes the departing residents to trash the house. It is better to agree on a quick sale. But too much selling will force prices lower, weakening the rest of the portfolio.
So it may take a while for the property of struggling borrowers to trickle onto the market. Jeffrey Kirsch of American Residential Equities, a company specialising in buying delinquent loans, says foreclosing a property can take more than three years. He doubts the housing market will bottom out until the first quarter of 2009.
The current fear is not so much that the housing market could drive America into recession, although that could still happen. The worry is more that credit conditions may get tighter. The spread paid by higher-risk European firms has increased by almost a percentage point since mid-June. Investors are shying away from some loans being offered to finance leveraged buy-outs. A slowdown in such private equity-driven bids would hit the stockmarket.
Richard Bernstein, a Merrill Lynch strategist, says excessive lending has been fuelling the growth in financial markets in recent years. But he fears that now liquidity is drying up. That means no cushion when the punch lands.
Wednesday, June 20, 2007
CDS may be the financial innovation that will reduce credit spreads permanently
Credit default swaps are fast becoming a cost-effective means of transferring credit risk as well as leveraged financing hedging strategy.
Loan Credit-Default Swaps May Exceed Loan Trades (Update2)
By Patricia Kuo and Junko Fujita
June 20 (Bloomberg) -- Credit-default swaps linked to loans will be more actively traded in the U.S. than the loans themselves within a year, according to analysts at Citigroup Inc., the largest U.S. bank.
Trading of loan credit-default swaps now accounts for 50 percent of the volume of loan trades handled by Citigroup, New York-based Jonathan Calder, head of the U.S. bank's loan sales and trading, told a conference yesterday in Tokyo.
``It's an easy bet that over next year, loan credit-default swaps will exceed cash loan trades volume by at least two times,'' Calder said at the conference organized by New York- based Loan Syndications and Trading Association.
Credit-default swaps on loans, used to speculate on the ability of companies to repay the debt, are luring investors such as hedge funds and fund managers as a lower-cost alternative to investing in loans. They also provide arbitragers with opportunities to profit from the gap in risk premium between loans, derivatives and bonds.
The amount of loan credit-default swaps outstanding has ballooned to more than $85 billion from $31.6 billion last year and $6.3 billion in 2005, according to estimates from Goldman Sachs Group Inc. and Markit Group Ltd., administrator of the LCDX index, the first tradeable index contract tied to the loan market.
The amount traded on the LCDX index, based on the loans of 100 companies, reached $25 billion in its first two weeks, according to Markit. Goldman estimates that about $60 billion in credit swaps tied to individual companies were outstanding before the index started trading.
First Data
Arrangers of the non-investment grade loans that Kohlberg Kravis Roberts & Co. is seeking for its takeover of First Data Corp., the world's largest card payment processor, may start selling the debt in the next few weeks. Credit-default swaps on the loans, which haven't yet been sold, are already actively traded, Calder said.
Greenwood Village, Colorado-based First Data said in a regulatory filing in May that New York-based KKR will seek $16 billion of loans to fund the acquisition.
``This is not just an evolution. This is something that will significantly change the way we do business,'' Calder said.
$40 Billion Trade
Traders have bought an estimated $40 billion of loan credit- default swaps as part of what is called a negative basis trade, Calder said. In such a trade, investors can profit from holding both a loan and its protection against default when the cost of the derivative contract is less than the interest income they get from the loan.
The loan's yield premium over the cost of protection -- which ranged between 30 basis points and 120 basis points in the U.S. this year -- will probably disappear once the commercial lending departments of banks start purchasing credit-default swaps based on loans they've made, he said. A basis point is 0.01 percentage point.
The funds might leave the U.S. loan market should investors reverse these trades, Calder said.
``At the moment, cash is flowing into loans to do the negative basis trade,'' Calder said. ``At some point in the future, cash may flow out of loans.''
`Move the Market'
Even loan investors who don't use credit derivatives should learn about this trade because it is big enough to affect the loan market, Calder said.
``The size associated with that potential flow is enough to move the market,'' he said.
Credit-default swaps tied to corporate bonds, which were conceived about a decade ago, more than doubled in 2006 to cover $34.5 trillion in securities, according to the International Swaps and Derivatives Association. That's almost 10 times the amount of senior unsecured bonds outstanding. Credit swaps were conceived to protect bondholders against default and pay the buyer face value in exchange for the underlying securities.
Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates.
The record amount of money sought to finance buyouts may cause borrowers in the U.S. to pay more for non-investment grade loans by the end of the year, Calder said. Standard & Poor's Leveraged Commentary & Data unit estimates that companies will seek about $197 billion of junk-rated loans in the next 12 months.
That concern is reflected in the LCDX index. The index fell for a seventh day, declining 0.30 to 99.74 at 4:03 p.m. in New York. The index is below 100 for the first time since May 22, according to Markit Group. A decline in the index signals deteriorating perceptions of creditworthiness.
Leveraged Loans
Leveraged loans in the U.S. grew 85 percent to $550 billion this year compared with the same period of 2006, Bloomberg data show.
``With the large size of individual deals and large aggregate calendar, we expect there will be some backup in the rates in the U.S. leveraged loan market as we go through the summer,'' Calder said. ``We're going to have the busiest summer and I will be very surprised if we don't see coupons expand a little bit.''
Loan Credit-Default Swaps May Exceed Loan Trades (Update2)
By Patricia Kuo and Junko Fujita
June 20 (Bloomberg) -- Credit-default swaps linked to loans will be more actively traded in the U.S. than the loans themselves within a year, according to analysts at Citigroup Inc., the largest U.S. bank.
Trading of loan credit-default swaps now accounts for 50 percent of the volume of loan trades handled by Citigroup, New York-based Jonathan Calder, head of the U.S. bank's loan sales and trading, told a conference yesterday in Tokyo.
``It's an easy bet that over next year, loan credit-default swaps will exceed cash loan trades volume by at least two times,'' Calder said at the conference organized by New York- based Loan Syndications and Trading Association.
Credit-default swaps on loans, used to speculate on the ability of companies to repay the debt, are luring investors such as hedge funds and fund managers as a lower-cost alternative to investing in loans. They also provide arbitragers with opportunities to profit from the gap in risk premium between loans, derivatives and bonds.
The amount of loan credit-default swaps outstanding has ballooned to more than $85 billion from $31.6 billion last year and $6.3 billion in 2005, according to estimates from Goldman Sachs Group Inc. and Markit Group Ltd., administrator of the LCDX index, the first tradeable index contract tied to the loan market.
The amount traded on the LCDX index, based on the loans of 100 companies, reached $25 billion in its first two weeks, according to Markit. Goldman estimates that about $60 billion in credit swaps tied to individual companies were outstanding before the index started trading.
First Data
Arrangers of the non-investment grade loans that Kohlberg Kravis Roberts & Co. is seeking for its takeover of First Data Corp., the world's largest card payment processor, may start selling the debt in the next few weeks. Credit-default swaps on the loans, which haven't yet been sold, are already actively traded, Calder said.
Greenwood Village, Colorado-based First Data said in a regulatory filing in May that New York-based KKR will seek $16 billion of loans to fund the acquisition.
``This is not just an evolution. This is something that will significantly change the way we do business,'' Calder said.
$40 Billion Trade
Traders have bought an estimated $40 billion of loan credit- default swaps as part of what is called a negative basis trade, Calder said. In such a trade, investors can profit from holding both a loan and its protection against default when the cost of the derivative contract is less than the interest income they get from the loan.
The loan's yield premium over the cost of protection -- which ranged between 30 basis points and 120 basis points in the U.S. this year -- will probably disappear once the commercial lending departments of banks start purchasing credit-default swaps based on loans they've made, he said. A basis point is 0.01 percentage point.
The funds might leave the U.S. loan market should investors reverse these trades, Calder said.
``At the moment, cash is flowing into loans to do the negative basis trade,'' Calder said. ``At some point in the future, cash may flow out of loans.''
`Move the Market'
Even loan investors who don't use credit derivatives should learn about this trade because it is big enough to affect the loan market, Calder said.
``The size associated with that potential flow is enough to move the market,'' he said.
Credit-default swaps tied to corporate bonds, which were conceived about a decade ago, more than doubled in 2006 to cover $34.5 trillion in securities, according to the International Swaps and Derivatives Association. That's almost 10 times the amount of senior unsecured bonds outstanding. Credit swaps were conceived to protect bondholders against default and pay the buyer face value in exchange for the underlying securities.
Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates.
The record amount of money sought to finance buyouts may cause borrowers in the U.S. to pay more for non-investment grade loans by the end of the year, Calder said. Standard & Poor's Leveraged Commentary & Data unit estimates that companies will seek about $197 billion of junk-rated loans in the next 12 months.
That concern is reflected in the LCDX index. The index fell for a seventh day, declining 0.30 to 99.74 at 4:03 p.m. in New York. The index is below 100 for the first time since May 22, according to Markit Group. A decline in the index signals deteriorating perceptions of creditworthiness.
Leveraged Loans
Leveraged loans in the U.S. grew 85 percent to $550 billion this year compared with the same period of 2006, Bloomberg data show.
``With the large size of individual deals and large aggregate calendar, we expect there will be some backup in the rates in the U.S. leveraged loan market as we go through the summer,'' Calder said. ``We're going to have the busiest summer and I will be very surprised if we don't see coupons expand a little bit.''
Call for greater transparency in leveraged loans
Call for greater openness in leveraged loans
By Stacy-Marie Ishmael
(FT June 13) Investors should demand more transparency and accountability from managers of collateralised loan obligations, according to a new report from Standard & Poor’s.
The rating agency said the the rising popularity of so-called covenant-lite loans imposed significant risks on investors in the opaque CLO market.
Demand for CLOs, complex financial instruments which repackage portfolios of loans, has surged recently. The products can offer investors better returns for a given rating than traditional fixed-income assets.
In the first quarter of 2007, global covenant-lite loan volume reached $48bn, compared with $24bn recorded for the whole of last year. The use of these loans to fund buy-outs is already well-established in the US and becoming more accepted in Europe.
But S&P said the absence of the traditional covenants that give creditors early warnings of financial problems diminished recovery prospects for such loans.
“Cumulative credit risk to lenders and players in the risk transfer chain is building as covenant strength is evaporating,” S&P said in its report. The agency said it was adjusting its CLO rating criteria to reflect the increased risk.
Abundant liquidity and the disproportionate power of borrowers, arrangers, and financial sponsors have allowed a growing segment of high-risk companies to issue covenant-lite loans, S&P said. Many of the loans are held in CLOs.
“We suggest that investors ask managers to disclose their cov-lite holdings in their investor letters or reports, and demand more traditional ‘cov-strong’ rather than ‘cov-weak’ protection,” S&P said.
Managers must also be held accountable if they extend credit to borrowers demanding weaker covenants. “We encourage investors to focus in now more than ever on a CLO manager’s ability to differentiate among debt structures, covenant protections, and asset coverage in their asset selection process,” S&P said.
“We feel we should raise awareness before the next cycle turn,” S&P said
By Stacy-Marie Ishmael
(FT June 13) Investors should demand more transparency and accountability from managers of collateralised loan obligations, according to a new report from Standard & Poor’s.
The rating agency said the the rising popularity of so-called covenant-lite loans imposed significant risks on investors in the opaque CLO market.
Demand for CLOs, complex financial instruments which repackage portfolios of loans, has surged recently. The products can offer investors better returns for a given rating than traditional fixed-income assets.
In the first quarter of 2007, global covenant-lite loan volume reached $48bn, compared with $24bn recorded for the whole of last year. The use of these loans to fund buy-outs is already well-established in the US and becoming more accepted in Europe.
But S&P said the absence of the traditional covenants that give creditors early warnings of financial problems diminished recovery prospects for such loans.
“Cumulative credit risk to lenders and players in the risk transfer chain is building as covenant strength is evaporating,” S&P said in its report. The agency said it was adjusting its CLO rating criteria to reflect the increased risk.
Abundant liquidity and the disproportionate power of borrowers, arrangers, and financial sponsors have allowed a growing segment of high-risk companies to issue covenant-lite loans, S&P said. Many of the loans are held in CLOs.
“We suggest that investors ask managers to disclose their cov-lite holdings in their investor letters or reports, and demand more traditional ‘cov-strong’ rather than ‘cov-weak’ protection,” S&P said.
Managers must also be held accountable if they extend credit to borrowers demanding weaker covenants. “We encourage investors to focus in now more than ever on a CLO manager’s ability to differentiate among debt structures, covenant protections, and asset coverage in their asset selection process,” S&P said.
“We feel we should raise awareness before the next cycle turn,” S&P said
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