NewSpeak Watch: What Does "Sale" Mean? (LBO Loan Edition)

Ah, how distant early 2007 seems. Remember how the private equity business was going gangbusters, M&A was at record levels, and no deal was too big to get done. Then the credit markets hit the wall, leaving a lot of investment banks holding LBO debt that they hadn’t sold (the most common mechanism had been collateralized loan obligations.

But then the clouds parted and banks reported that they were selling the LBO debt that had been crudding up their balance sheets, admittedly at a loss. Everyone agreed that this was a Good Thing, that the banks were putting their problems behind them.

Of course, there was the inconvenient fact that some, perhaps many, of these so-called sales were in fact financed, but few appeared inclined to question the sunny view that progress was being made.

The Financial Times has unearthed some juicy details of the terms of these financings. In particular, the amount of the loan relative to the nominal amount of the sale is, shall we say, impressive.

To review typical terms:

Loan was sold for 85 cents on the dollar

Sale was 80% financed. This means that the sale proceeds were a mere 20% of the discounted amount; the rest of the loan balance is contingent on whether the loan performs (ie, the buyer takes the first loss, which is equal to the cash paid; the FT isn’t explicit, but it appears further losses result in a dollar for dollar reduction in the loan balance).

The interest on the loan is at less than market rates. In economic terms, that means the bank got even less than the mere 20% cash amount (you’d need to reduce that amount by the value of the discount on the financing)

I suspect this item will not get the attention it warrants. It’s another illustration of the fact that much of the supposed improvement in the credit markets is a function of smoke and mirrors and unprecedented central bank interventions.

From the Financial Times:

Citigroup and Deutsche Bank are still retaining some of the risk from billions of dollars in loans backing leveraged buy-out deals that they have sold in recent months to private equity firms…

This year, banks including Citi, Deutsche and Royal Bank of Scotland have sold $25-30bn in buy-out loans to three private equity firms – Apollo; Blackstone, through its GSO Capital arm; and TPG…

Deutsche Bank acknowledged that it retained exposure to the original loans, but said that any further losses would be negligible.

For the bank to book more losses, it said, the old loans would have to drop to about 65 cents on the dollar – a calculation reflecting the 15 per cent writedown on the sales and the 20 cents on the dollar invested by private equity.

Of course, even if companies default or file for chapter 11 bankruptcy protection, lenders usually get some money back. In the bankruptcies this year, lenders have recovered an average of up to 60 cents on the dollar – less than in earlier economic cycles.

While that loss recovery factoid is no doubt accurate, Nouriel Roubini maintains that loss recoveries for corporate bankruptcies in a growing economy are 60-70 cents on the dollar, but in a recession, when defaults and bankruptcies rise, recoveries fall to 30-40 cents. So in a downturn, the exposure to loss on these supposedly sold loans is significant.

Back to the FT:

In a regulatory filing, Citi said its loan sales “substantially mitigate the company’s risk related to these transferred loans”, implying it retained some risk. The bank said it hedged retained risk by buying derivatives called total-return swaps but it declined to say how much it has paid for the instruments.

Analysts say such hedges can be expensive – sometimes costing more than the position being hedged. They say banks can be willing to pay so much because it is easier to tell shareholders they spent money on hedges than to report loan losses.

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  1. Ginger Yellow

    I wrote a comment piece on Merrill’s CDO “sale” making much the same point a couple of weeks ago. My publication should be putting it and our other comment pieces online for free soon. I’ll post a link if and when we do.

  2. etc

    When yves and others talk about a discount on the sale price, are they talking about (i) pretending the buyer had personal liability in an entity with significant real assets other than the purchased loans, (ii) asking what the seller would charge the buyer for a put obligating the seller to buy the loans as par (i.e., a liquidity put), and (iii) discounting the purchase price by the premium for the liquidity put?

    Or are people hypothesizing something else to get to a lower purchase price than the stated purchase price?

  3. Vermont Trader

    First time comment.. love the site and read it every day.

    All they are doing is doubling down. Their models are telling them that these things are cheap still but the models are based on the past 20 years and the future may not unfold as the models predict.

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