Subprime woes spread to loans; stocks next:James Saft
LONDON (Reuters) - It may not be dramatic, it almost certainly will not be quick, and it definitely will not be pretty. A fundamental factor supporting the astonishing recent performance of global markets -- the super easy availability of credit -- is in the process of reversing.
The credit pullback has spread from the mortgage market for subprime, or less creditworthy, borrowers to the most aggressive sectors of corporate and buyout lending -- in part because the hedge funds and complex financing vehicles that extend credit to both have taken a hit in housing finance.
And because the corporate credit market now facing difficulties is the bulwark of private equity, share market valuations may soon come under pressure.
"The deals which were being done in private equity are going slightly astray," said Albert Edwards, global head of asset allocation at Dresdner Kleinwort in London.
"A lot of the stock market has a bid premium, apart from the mega caps. If companies have problems getting debt paper away, the big marginal bidder goes away."
The MSCI World equity index hit a lifetime high on Monday, with much of the excitement based on the idea of more bids from private equity buyers yet to come.
But the richness of those bids depends in turn on readily available cheap financing, often dispensing with the traditional strictures on what borrowers can do with the money and with their businesses.
A number of high yield bond and leveraged loan offerings supporting such bids have been scrapped, postponed or restructured due to market resistance.
Ratings agency Fitch said in a Friday report that of six deals that have been pulled or postponed since late June -- U.S. Foodservice (UFS.N), ServiceMaster (SVM.N), Magnum Coal, Catalyst Paper Corp., Swift & Co. and Quebecor Media -- it is estimated that a total of nearly $13 billion of debt could be bridged by the underwriters.
On Monday, a 1.075 billion euro loan backing the buyout of Dutch retailer Maxeda DIY was pulled after its structure, which gave lenders little say over how the borrower managed its balance sheet in future, failed to attract sufficient commitments.
While that may be small in proportion to the overall amount of debt being extended and buyouts offered, the leveraged markets are not based on underwriters actually holding large amounts of the debt: indeed, it is quite the opposite of how they see their role, raising the possibility that they will not be so quick to underwrite future deals.
Other measures of the willingness to lend are showing signs of strain. The iTraxx Crossover index ITCRS5EA=GFI, which measures the cost of insuring a group of European below investment grade names against default, widened sharply after the Maxeda news.
The index has now moved more than 95 basis points wider, or about 50 percent, since mid June.
If credit markets demand more payment to take on the same risk, or simply won't do some deals at any price, the flow of private equity and leveraged buyouts, much less debt-financed share repurchases, must be in doubt.
THE SUBPRIME CONNECTION
But what has all this got to do with U.S. subprime mortgages?
Both types of finance are at the aggressive end of their markets, with less borrower equity, and both are now largely made by people hoping to sell the loans on quickly to a third party.
Tellingly, lending safeguards that would have been standard only two or three years ago have been eroded in both leveraged finance and subprime lending.
Subprime lending had its "liar loans," in which borrowers simply state their income without documentation. Leveraged lending has spawned "covenant-lite" lending, which lacks tests, or covenants, that allow lenders to throw borrowers into default if they don't meet pre-agreed financial hurdles. The Maxeda deal was among the first in Europe to attempt the covenant-lite structure.
But the most important connection, and one that bodes poorly for corporate credit, is that both assets are sold on to the same kind of investors; sometimes through structured finance vehicles such as collateralized debt obligations or collateralized loan obligations, which bundle debt together, and sometimes directly to hedge funds.
That means the ugly losses suffered by investors in subprime structured vehicles are having a knock-on effect on appetite for corporate credit.
DOWNGRADES, FORCED SELLERS AND LOANS STILL TO SELL
As such, the extreme volatility in corporate credit last week, coinciding with a huge wave of subprime downgrades and warnings from ratings agencies, was no surprise. All three main debt rating houses, Fitch, Moody's and Standard & Poor's, announced last week that they were downgrading subprime loans and related assets, with signs of more to follow.
A large risk is that the downgrades turn investors such as pension funds or insurance companies, which may be allowed to hold only highly rated debt, into forced sellers of subprime assets.
If that happens -- and some believe it already is -- the fall in subprime debt prices would accelerate and further reduce the risk appetite of investors and structured financiers buying corporate loans and bonds.
Eric Tutterow, managing director of leveraged finance at Fitch Ratings in Chicago, says this is all happening just as a huge group of loans is set to be marketed to finance deals already announced. Fitch says investors are about to be offered more than $300 billion of this high-yield and leveraged debt.
"There will be some good tests of the market coming up with some large numbers," Tutterow said. Arrangers "don't want to be left holding the bag, they want to get this stuff syndicated out."
If more of those tests go bad, look to the stock market to pay the price.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication, James Saft did not own securities in any company mentioned in this article. He may be an owner, albeit indirectly, as an investor in a fund. Send questions or comments to saft@reuters.com.)
