By Peter Cohan
Financial crises take about a decade to be born. Having lived through four of them, I see the raw materials for a fifth one — flowing from the collapse of so-called leveraged loans — debt piled on top of companies with weak credit ratings.
Before examining the latest news on leveraged loans, let’s take a quick tour down the memory lane of financial crises I’ve lived through.
My first one was in 1982 — that’s when banks lent too much money to oil and gas developers in Oklahoma and Texas as well as local real estate developers.
At the suggestion of McKinsey, money-center banks like Chemical Bank thought it would be a great idea to buy a piece of those loans. It’s all described nicely in a wonderful book — Belly Up.
Too bad the price of oil and gas tumbled, leaving lenders in the lurch and causing a spike in bank failures that gave me the chance to spend a balmy summer in Washington helping the FDIC develop a system to manage the liquidationof those failed banks.
By 1989, it was time for another banking crisis — this one was pinned to too much lending to commercial real estate developers in New England and junk-bond-backed loans for what used to be known as leveraged buyouts.
The government shut down Bank of New England and was threatening my employer, Bank of Boston, with the same. I worked on a government-mandated strategic plan intended to save the bank from a similar fate.
Next up— the dot-com bust — which introduced me to the idea that not all bubbles are bad if you can get in when they’re forming and exit before they burst. I invested in six dot-coms and had a mixed record — the three winners offset the three wipe outs.
It brings back all the memories — from my first story on subprime mortgages back in December 2006 in which I recommended selling short shares of subprime lender, NovaStar Financial when they traded at $106 apiece.
(NovaStar changed its name to Novation in 2012 and you can pick up a share for 17 cents.)
The key causes of the crisis that Bernanke describes as the worst in history were weak subprime regulation, liar loans, global securitization, too little capital, limited transparency, skewed banker and ratings agency incentives, and lame risk management.
What does this little financial crisis tour have to do with leveraged loans? I have often cited the Mark Twain’s expression that history does not repeat itself, but sometimes it rhymes.
I think leveraged loans rhyme with junk bonds and subprime mortgages. Banks make leveraged loans “to companies that have junk credit ratings in the hope of quickly selling the debt to investors, including mutual funds, hedge funds and entities called collateralized loan obligations,” according to the New York Times.
Why the rhyme? As in the late 1980s, leveraged loans are made to companies with bad credit ratings; like subprime mortgages they are being packaged into securities that supposedly give investors a diversified portfolio; and like the early 1980s crisis, there is excess debt on the books of energy and mining companies.
What’s more, leveraged loans are not small potatoes. Since the end of 2008, Thomson Reuters calculates that corporations have used them to borrow a whopping $4.6 trillion.
Leveraged loans are slowing down. Last year, companies used them to borrow $940 billion but so far in 2015, they’ve taken on a mere $700 billion worth of that debt, according to Thomson Reuters.
And more borrowers are not paying up. In September, Fitch Ratings forecast that leveraged loan default rates could approach 2% by the end of 2015, after five August defaults totaling $1.4 billion.
With oil prices down over 60% since June 2014 and a general decline in commodities prices, it is no surprise that energy and mining borrowers are inspiring the most investor fear, according to Fitch.
looks like investors have less of an appetite for the current crop of leveraged loans than the supply of them created by Wall Street banks like Goldman Sachs, JPMorgan Chase, Morgan Stanley, Bank of America, and others, according to the Times.
Citing anonymous sources — usually a sign of fear — the Times estimates that banks will take $600 million in losses from leveraged loans that they’re holding on their books that nobody wants to buy.
Three such deals provide a flavor for the borrowers involved. Carlyle Group is using leveraged loans to acquire software company Veritas for $5.5 billion; Sycamore Partners is using them to buy department store Belk for $3 billion; and generic drug maker, Lannett, is using them to buy rival Kremers Urban for $1.23 billion, according to the Times.
And the Times is very careful to point out that if demand for leveraged loans increases, those banks could take lower losses or even end up making money on them.
But with interest rates rising and something causing investors to shy away from leveraged loans, this cannot be greeted as good news by Michael Dell — who was hoping to borrow $50 billion to acquire EMC.
If you have never seen NYPD Blue, you should watch the Hearts and Souls episode that aired almost exactly 17 years ago in which Bobby Simone, played by Jimmy Smits, dies from infection after a heart transplant.
The image at the beginning of the episode starts with a little drop of blood on his t shirt and ends with the screen going white after he dies.
I would not be surprised if recent shakiness in the leveraged loan market is like those little drops of blood on Simone’s t shirt.
Because of banks’ exposure to leveraged loans and their presence in investors’ portfolios, it’s going to spread throughout the economy.
In June 2007, the Wall Street Journal quoted me on how a leveraged loan temporarily saved Bally Total Fitness. The parallels between that article’s description of the leveraged loan market — when its default rate was below 1% but expected to hit 2.7% – and the current situation are worth noting.
It remains to be seen how bad this could get. But if it gets worse, it may be harder to claim — as Dick Cheney did after the 2008 financial crisis – that no one warned government leaders.