http://online.wsj.co...;ojcontent=otep
By STEVEN RATTNER
June 18, 2007; Page A17
Mr. Rattner is managing principal of the private investment firm
Quadrangle Group LLC.
The subprime mortgage world has been reduced to rubble with no lasting
impact on another, larger, credit market dancing on an equally fragile
precipice: high-yield corporate debt. In this fast-growing arena of
loans to business -- these days, mostly, private equity deals --
lending proceeds as if the subprime debacle were some minor skirmish
in a little known, far away land.
How curious that so many in the financial community should remain
blissfully oblivious to live grenades scattered around the high-yield
playing field. Amid all the asset bubbles that we've seen in recent
years -- emerging markets in 1997, Internet and telecoms stocks in
2000, perhaps emerging markets or commercial real estate again today
-- the current inflated pricing of high-yield loans will eventually
earn quite an imposing tombstone in the graveyard of other great past
manias.
In recent months, lower credit bonds -- conventionally defined as BB+
and below -- have traded at a smaller risk premium (as compared to
U.S. Treasuries) than ever before in history. Over the past 20 years,
this margin averaged 5.42 percentage points. Shortly before the Asian
crisis in 1998, the spread was hovering just above 3 percentage
points. Earlier this month, it touched down at a record 2.63
percentage points. That's less than 8% money for high-risk borrowers.
So robust has the mood become that providers of loans now rush to
offer "repricing" at ever lower rates, terrified that borrowers will
turn to others to refinance their loans, leaving the original lenders
with cash on which they will earn even less interest. Between Jan. 1
and April 19, $115 billion of debt was repriced, representing 29% of
all bank loans in the U.S.
The low spreads have been accompanied by less tangible indicia of
imprudent lending practices: the easing of loan conditions
("covenants," as they are known in industry parlance), options for
borrowers to pay interest in more paper instead of cash, financings to
deliver large dividends to shareholders (generally private equity
firms) and perhaps most importantly, a general deterioration in the
credit quality of borrowers.
In 2006, a record 20.9% of new high-yield lending was to particularly
credit-challenged borrowers, those with at least one rating starting
with a "C." So far this year, that figure is at 33%. No exaggeration
is required to pronounce unequivocally that money is available today
in quantities, at prices and on terms never before seen in the 100-
plus years since U.S. financial markets reached full flower.
Led by private equity, borrowers have rushed to avail themselves of
seemingly unlimited cheap credit. From a then-record $300 billion in
2005, new leveraged loans reached $500 billion last year and are
pacing toward another quantum leap in 2007.
Even leading buyers of loans, such as Larry Fink, chief executive of
BlackRock, say "we're seeing the same thing in the credit markets"
that set the stage for the fall of the subprime loan market.
Why should so many theoretically sophisticated lenders be willing to
bet so heavily in a casino with particularly poor odds? Strong
economies around the world have pushed default rates to an all-time
low, which has in turn lulled lenders into believing these loans are
safer than they really are. Just 0.8% of high-yield bonds defaulted
last year, the lowest in modern times. And with only three defaults so
far this year, we've luxuriated in the first default-free months since
1997. By comparison, high-yield default rates have averaged 3.4% since
1970; higher still for paper further down the totem pole.
Like past bubbles, the current ahistorical performance of high-yield
markets has led seers and prognosticators to proclaim yet another new
paradigm, one in which (to their thinking) the likelihood of
bankruptcy has diminished so much that lenders need not demand the
same added yield over the Treasury or "risk-free" rate that they did
in the past.
To be sure, the emergence in the past 20 years of more thoughtful
policy making may well have sanded the edges off of economic
performance -- what some economists call "the Great Moderation" --
thereby reducing the volatility of financial markets and consequently
the amount of extra interest that investors need to justify moving
away from Treasuries.
But to think that corporate recessions -- and the attendant collateral
damage of bankruptcies among overextended companies -- have been
outlawed would be as foolhardy as believing that mortgages should be
issued to home buyers with no down payments and no verification of
financial status.
And just as the unwinding of the subprime market occurred at a time of
economic prosperity, the high-yield market could readily unravel
before the next recession. With the balance sheets of many leveraged
buyouts strung taut, a mild breeze could topple a few, causing the
value of many leveraged loans to tumble as shaken lenders reconsider
their folly.
The surge in junk loans has also been fueled by a worldwide glut of
liquidity that has descended more forcefully on lending than on equity
investing. Curiously, investors seem quite content these days to
receive de minimis compensation for financing edgy companies, while
simultaneously fearing equity markets. The price-to-earnings ratio for
the S&P 500 index is currently hovering right around its 20-year
average of 16.4, leagues below the 29.3 times it reached at the height
of the last great equity bubble in 2000.
Some portion of this phenomenon seems to reflect tastes in Asia and
elsewhere, where much of the excess liquidity resides: Foreign
investors own only about 13% of U.S. equities but 43% of Treasury
debt. In search of higher yields, these investors are moving into
corporate and sovereign debt. Today, the debt of countries like
Colombia trades at less than two percentage points above U.S.
Treasuries, compared to 10 percentage points five years ago.
Perhaps the mispricing of high-yield debt has been exacerbated by the
surge in derivatives, a generally useful lubricant of the financial
markets. Banks hold far fewer loans these days; mostly, they resell
them, often to hedge funds, which frequently layer on still more
leverage, thereby exacerbating the risks.
Another popular destination is in new classes of securities where the
loans have been resliced to (theoretically) tailor the risk to
specific investor tastes. But in the case of subprime mortgages, this
securitization process went awry, as buyers and rating agencies alike
misunderstood the nature of the gamble inherent in certain
instruments.
Assessing the likely consequences of a correction is more daunting
than merely predicting its inevitability. The array of lenders with
wounds to lick is likely to be far broader than we might imagine, a
result of how widely our increasingly efficient capital markets have
spread these loans. No one should be surprised to find his wallet
lightened, whether out of retirement savings, an investment pool or
even the earnings on their insurance policy.
The bigger -- and harder -- question is whether the correction will
trigger the economic equivalent of a multi-car crash, in which the
initial losses incur large enough damages to sufficiently slow
spending enough to bring on recession, much like what happened during
the telecom meltdown a half-dozen years ago.
But we have little choice but to sit back and watch this car accident
happen. It would have been a mistake to dispatch the Federal Reserve
to deflate the dot-com mania or the housing bubble. And it would be a
mistake now for the Fed to rescue imprudent high-yield lenders. They
have to learn the hard way. Hopefully, not too many innocent
bystanders will share their pain.
Insider
