Steve Rattner’s Jeremiad on Lax Lending

Steve Rattner, best known as the heir apparent at Lazard Freres who overplayed his hand, and is now the head of a private equity firm, Quadrangle Partners, wrote a rather curious piece, “The Coming Credit Meltdown,” that ran in Monday’s Wall Street Journal (apologies for being on the late side in posting it).

The odd thing isn’t the message of the piece itself – that lending to junk credits is taking place at historically unprecedented terms (as in hugely favorable to the borrower) and volumes. Nor is it Rattner coming out against his industry (he has political ambitions and has commented on excesses before, although I have no doubt he is taking advantage of this situation as much as any of his competitors).

No, it’s the tone of the article. It’s overwrought, and while he fulminates about the risks being taken on by creditors, he gets cautious when he gets to the part of the article where he has to speculate as to how it will come out.

The reason that Rattner’s sabre-rattling comes up a bit short is that the consensus in his field is that the increasing use of “cov lite,” meaning loans with no or few covenants, means that it will be hard for creditors to push a company into bankruptcy (I’m not sure exactly how these cov lite deals work, but normally, a default will allow the creditors to accelerate the principal, meaning demand to be repaid in full. A company that can’t meet its interest payments clearly can’t repay principal, so that gives the creditors grounds to push for involuntary bankruptcy). The private equity firms I know expect even failed deals to limp along rather than wind up in bankruptcy.

How this will affect the financial system is unclear, hence Rattner’s hesitancy. Most fiduciaries are required to mark to market these days. A loan or bond that missed payment would trade down a lot, particularly if there was no prospect of a workout. Where the debt would trade would depend on the likelihood of the company resuming interest payments and paying back its arrearage. If a borrower wasn’t expected to shape up soon, I could see the debt trading at very distressed prices. And the loss is a hit to equity if the bagholder is a bank, or a reduction in fund assets if it’s a fiduciary.

To Rattner:

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.

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