Commentaries

Nothing says recovery like par

It’s not there yet, but the derivatives index that references leveraged loans – the debt of choice for big corporate buyouts during the boom – is just a few cents away from par.

The new, cleaner Markit LCDX index that launched earlier this month is already at 98 1/2 cents, while the older series 10 that included such bad boys as bankrupt General Growth Properties, is trading a little over 97 cents. Astonishing really, considering the series 10 tanked to below 80 cents last year.

Such lofty levels are sure to entice new deals since companies hate to pay a discount when raising funds. Makes you wonder if new collateralized debt obligations are around the corner.

Another EQT buyout goes under the hammer

Banks will shortly conduct an auction to settle credit default-swaps on debt issued by SSP, the catering group owned by private equity group EQT. SSP recently failed to make a debt payment, according to derivatives trade body ISDA.

It’s not the first EQT-controlled leveraged buyout to run into trouble and trigger a credit event. The first loan CDS in Europe was for EQT’s ceramics products manufacturer Sanitec. The Sanitec recovery was a miserable 33 percent, but that is still by far the highest recovery to date in a European leveraged loan CDS auction.

Leveraged loans making a comeback?

The $4 billion financing for Warner-Chilcott’s acquisition for P&G’s drug business is another sign of credit markets coming back to an even keel, but it’s not clear how much juice the banks have to keep the momentum going if they don’t find investors for the debt.

The Wall Street Journal reports that six banks, including JP Morgan and Bank of America, will provide the financing, $3 billion going to the acquisition and $1 billion to refinance existing Warner-Chilcott debt.

This would be the fourth-largest “leveraged loan” of 2009 in the U.S. and the largest globally for an acquisition, according to data provided by Dealogic. The last leveraged loan of this size for a deal in the U.S. was in April 2008, when Mars Inc. announced its planned purchase of Wrigley.

What’s not clear, however, is whether the banks are planning to hold on to the debt or pass it on to investors. Demand for leveraged loans has dried up since the collateralized debt obligation machine – which vacuumed up roughly 60% of leveraged loans- sputtered to a halt. If the banks aren’t re-selling the debt, I imagine there’s a limit to how much they can pony up for new deals, even with juicy fees.

The banks are in part attracted to the transaction because they can demand higher underwriting fees than during the last big deal-making cycle in the middle of the decade, said one person familiar with the deal.

According to Thomson Reuters, leverage loan volume so far this year has reached just $136.6 billion, through Aug 21, compared with $463 billion in 2008 and $1.1 trillion in 2007.

Delaying the moment of truth

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.

from Neil Unmack:

Finance’s 80s experiment shows cracks

We may never see mullet hairstyles or other weird fashions again, but in finance, there is a 1980s revival.     The International Accounting Standards Board has gone back to the future, allowing banks to reclassify assets they previously had to mark to market as loans and receivables, valued at amortized cost. That effectively allowed them to avoid the embarrassment of mark-to-market and return to the historic cost accounting of a quarter-century ago.     The reasons are plausible enough: many asset classes were quoted at nominal, distressed sale prices only. But you ignore market prices at your peril: problems loans are left to fester, exposing investors to the cost of loan managers (understandably) taking a rosy view of advances they may have approved.     Many European banks took advantage of the IASB's lenience to whip doubtful assets off their trading books -- not just plain debt, but collateralized loan obligations, leveraged loans and other doubtful exotica. Now Deutsche Bank <DBKGn.DE> has indicated how this stuff is doing, and the answer is: badly.     Deutsche's pretty figures would have been quite spoiled had it taken a further 1.4 billion euros of unrealized losses on the 37 billion euros of assets it reclassified since last October.     The discrepancy between the carrying value and fair value shouldn't be a surprise -- that was the whole point of the changes. Unfortunately, the market is proving to have been right in pricing some of these assets as junk, because the losses in the reclassified book are starting to show.     More than half of Deutsche's 1 billion euro provisions for credit losses in the second quarter derived from these reclassified assets. Some 2 billion euros of the 3.2 billion euro rise in problem loans had previously been reclassified.     Deutsche is not alone. RBS' <RBS.L> impairment losses on reclassified assets rose to 747 million pounds in the first three months of the year, up from 466 million at the end of last year. UBS is carrying assets reclassified last year at 24.7 billion Swiss francs, versus the fair value of 20.6 billion.     The accounting changes are not designed to bamboozle investors, even though that is frequently the result. Losses may have been deferred, but they will happen. The question for banks is whether they can generate profits quickly enough to offset them. Market prices that seemed ridiculous in the depths of the panic may turn out not to have been the equivalent of the mullet after all.

Junk bond market, you’re the only hope

Ok, that may be overstating it, but Fitch Ratings released a report on leverage loan recovery ratings – ie how much loan holders can expect to get back should a company default and the findings are hardly surprising: many investors can expect to get back less than they had thought when they invested in this secured debt.

RR1 means investors can expect a recovery of 90-100%, and RR6 0-10%.

A big reason for this is there’s often a lack of unsecured junk bonds below the leverage loans to absorb losses in case of default – another symptom of the boom time.

But with unsecured junk bonds the flavor of the year – up nearly 40% in the last year – there’s hope that at least some companies with heavy dollops of leverage loans outstanding will be able to refinance them into junk bonds rather than default. That could at least slow the deterioration recovery rates.