LONDON, July 30 (Reuters) - A severe downturn in the leveraged finance market would be painful for banks that originate deals or invest in them, but ratings are likely to remain intact unless problems spread to investment-grade credit, Standard & Poor’s said in a report.
Turmoil in the global credit markets has left banks unable to syndicate funding for a string of high-profile leveraged buyouts, including those of British health and beauty chain Alliance Boots [AB.UL] and U.S. carmaker Chrysler.
The funding, often with aggressive terms, was committed to when the credit-market sky was clear and investors seemed to have an unquenchable thirst for debt.
Now it may need to be sold on at a loss and in the meantime is clogging up banks’ balance sheets, reducing their appetite to lend further and potentially choking off the boom in leveraged buyouts.
At the moment, the risks really relate to problems in the subprime mortgage and the leveraged finance markets, said Richard Barnes, a director at Standard & Poor’s and one of the authors of the report. As a result, the agency says this is a “painful scenario, but banks should be able to absorb the effects at their current rating levels.”
However, it warns that banks stuck with unsold positions will face mark-to-market losses that will show up in third-quarter earnings.
“If it spreads to investment-grade corporate credit, then it would be much more painful for the banks,” Barnes said. “It’s something we’re monitoring very closely, but at the moment it’s too early to reconsider the ratings.”
The question now is whether the market is just repricing to a more sustainable level, or whether volatility will continue, possibly leading to value losses on large underwriting positions, he said. “It’s really September and October that will be the test,” Barnes said.
S&P said in the report that the market so far seems to be becoming more rational, although it warned that there was a great deal of nervousness about.
Financing leveraged buyouts has been a major money-spinner for banks in recent years, meaning that risks from a downturn are not limited to the freshly generated exposure they hold now on their balance sheets.
“Even if the current market hiatus turns out to be a mild correction, it seems certain that the LBO market’s glory days are over and the future environment will be more challenging for sponsors and banks alike,” the agency wrote.
Banks may face litigation from investors who might not have fully understood the risk they are taking on with structures such as covenant-lite loans, which contain few restrictions on borrowers, S&P said.
S&P estimates that the bank with the largest share of leverage finance revenues as a proportion of recurring groupwide revenues is Credit Suisse CSGN.VX, followed by JPMorgan Chase (JPM.N) and Lehman Brothers LEH.N.
However, it said that banks would be able to cut costs related to leverage finance, largely in the form of staff compensation, if there was a steep decline in expected revenues.