More Debt Stress: Aggressive Leveraged Loan Liquidations

Don’t ask how I missed this story,, “Debt fears heighten in US and Europe,” in my early a.m. survey of the Financial Times; it’s the lead page one item in the print edition. As far as I can tell, the underlying news story, the dumping of leveraged loans at distressed prices, has not been picked either in the US financial media or the major blogs.

Note one of the triggers was flight from mutual funds, a sign of deep-seated investor worry. And because Wall Street holds large unsold inventories of LBO loans, these sales will force them to value their holdings even lower, leading to further writedowns and hits to their already-impaired capital bases.

On a mundane level, we are witnessing a classing pattern: the credit markets expect another leg down of economic activity, while the stock market is not (yet) of that view. Most Wall Street analysts are forecasting some deterioration in corporate profits during the year, but a return to business as usual by the fourth quarter.

From the Financial Times:

Fears about corporate and commercial property debt reached new heights in the US and Europe on Friday as investors liquidated holdings in a sign of spreading credit turmoil.

The markets were gripped by worries that economic weakness would affect corporate profits, leveraged buy-outs and commercial property. This represents an escalation of the crisis that began with concerns about US subprime mortgages.

The trading was particularly heavy in leveraged loans – used by private equity firms to finance deals.

Mutual funds that invest in these loans have been hit with redemptions, forcing them to dump some of their holdings.

Hedge funds that bet on the likelihood of buy-out deals happening have been among the casualties. The turmoil has also put pressure on banks and other investors who are holding $200bn (£103bn) of leveraged loans that they had been hoping to sell.

Kevin Cronin, portfolio manager at Putnam Investments, said: “The overhang of bank debt from last year’s leveraged buy-out activity is becoming more problematic.

“Loans are being liquidated at distressed prices and banks are looking to reduce risk.”

Loans used to finance two of last year’s biggest buy-outs, utility TXU and credit card processor First Data, were among those hit, Mr Cronin said.

Closely followed measures of credit risk in the US and Europe peaked as investors unwound complex trades that lose money when credit deteriorates.

Europe’s Markit iTraxx index, which measures the cost of buying credit insurance against defaults by investment grade companies, hit a record 97.75 basis points. The US Markit CDX index of 125 investment grade companies hit a record 133bp, up from 78bp at the start of the year.

The triple-A index of the CMBX series, which measures the performance of commercial mortgage bond deals, reached a record 235bp.

Ted Wieseman, an economist at Morgan Stanley, said: “Investor worries about potential further writedowns are shifting in a big way from subprime residential mortgages to commercial real estate lending,”

Investors sought the safety of government bonds, sending the yield on the two-year Treasury down 11bp to 1.94 per cent. The S&P 500 fell 0.4 per cent.

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  1. Anonymous

    In early December, Warren Buffett bought $2 billion of TXU bonds: $1.1 billion of 10.25% bonds at 95 cents on the dollar to give Buffett an effective yield of 11.2%. And Berkshire bought $1 billion of 10.5% PIK-toggle bonds (bonds whose interest can be paid out in cash or more bonds) for 93 cents on the dollar, producing an effective yield of 11.8%.

    How much did the latest batch of TXU debt go for? Surely less than December’s price. Did Buffett catch a falling knife?

  2. Yves Smith

    I can’t say for certain, since I don’t have a Bloomberg terminal, but I have to believe you are right, that even with a favored price two months ago, Buffett is sitting on losses now. Even a guy like him doesn’t win on all his trades. He’s a had a few years when he didn’t perform so well. And wasn’t one of his corporate rescues a turkey?

    But Buffett’s missed call may point to something else. Remember his remark in the last week or so that it was easy to borrow and credit was cheap. Yeah, easy to borrow if you have one of the few real AAAs left. As smart as he is, he may be a wee bit out of touch with the current environment, particularly since he talks to fellow senior people who may be a bit self-deluded (at least the ones in regulatory positions and in the financial sector).

    Although Jim Rogers has turned into a shameless self-promoter, he is a keen student of financial history and has always taken riskier bets than Buffett and therefore has a keen eye for the downside. Buffett’s December buy said at least then that he wasn’t very worried about systemic risk. If I had to choose between the two, I would look to Rogers as the better barometer than Buffett right now.

  3. RK

    Question: Is there a uniform quarterly date across
    the hedge fund universe when redemption requests must be made? And a uniform follow up period before disbursement of investor funds? I ask because, while the banks are sitting on 200B of bridge (or pier) loans, I assume that hedge funds own a chunk of the debt of completed LBO transactions.

  4. Tom

    Interestingly, this is not a credit issue but a demand issue. Those funds that poured into LBO debt, swelling it up, are running for the hills.

    So is the market in “serious trouble”? Depends on your definition.

    Are there indications that the demand profile will have to change dramatically? Of course.

    But are the underlying credits in difficulty? No. Do they all deserve distress-level valuations? No.

    Does this mean that someone out there is working out there are bargains out there? Almost certainly.

    Will be blogging on this later. Will mail the link when I do.

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