Delaying the moment of truth

August 21, 2009

Procrastination is not a virtue, except when it involves billions of dollars of debt.

A mantra has taken hold of lenders sitting on loan piles: amend and extend. Or as lawyers involved in negotiations between borrowers and lenders say: delay and pray.

The $6.7 trillion U.S. commercial real estate market has been a standout for such tactics and in part explains why, despite the rapid deterioration in property prices and cash flow, delinquencies and defaults so far have been relatively low.

In the smaller but once-powerful leveraged loan market, such tactics have also allowed some companies, many of whom tapped this market to finance some of the biggest leveraged buyouts this decade, to avoid default this year. That’s a good thing because rapid-fire defaults could have kept credit markets clogged for longer and the financial system on precarious footing.

But such tactics just postpone the day of reckoning. They don’t avoid it.

Amend and extend is essentially a short-term deal that allows a company to extend loan maturities that it can’t possibly pay off in the current climate, while it agrees to stiffer terms such as adopting tougher loan covenants and paying higher interest payments.

Though areas of the credit markets are cranking out new debt deals, the leveraged loan market is a shadow of its former self. Collateralized debt obligations, which had accounted for roughly 60 percent of loan demand during the years of LBO madness, have vanished, as have hedge funds that used a healthy amount of leverage to snap up this secured debt.

That has left many companies with little choice but to go back to lenders and ask for more time to pay off debt that saddled many leverage buyout targets with debt ratios well above 6 to 1 — traditionally seen as the do-or-die threshold.

The trouble is, the extensions have dumped many of these companies into the 2012 to 2014 hot zone when competition will be fiercest for refinancing dollars.

Bank of America Merrill Lynch analysts have found that the bulk of loans getting a new lease on life are now slated to mature between 2012 and 2014, when 85 percent of outstanding loans are due to mature.

Yet, the leveraged loan market is unlikely to return to its former glory, given the moribund state of CLOs, so borrowers will have to find the funding elsewhere. The lucky ones this year have found some solace in the high-yield bond market, where they’ve been able to refinance about $40 billion. But there’s a wall of $545 billion of loans coming due between 2012 and 2014, according to Thomson Reuters data. It’s going to take a strong economic recovery to get investors interested in snapping up the debt that needs to be refinanced in addition to the new loans that companies will need to fuel the expansion.

“If the economic recovery is not strong and these companies can’t refinance, you’re going to see an increase in defaults,” said King Penniman, president and high-yield debt analyst at bond research shop KDP Investment Advisors.

So far, markets don’t seem too bothered by the prospect but they should be. Such an overhang could mean the excesses of the credit boom will take much longer to wring out. And the road to recovery will be much longer than investors currently believe.


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