Sunday, 27 February 2011

Play it again Ben - The "dubious" return of Cov-lite financing and other leveraged plays...

While every one is focused on Oil's recent surge linked to the contagion of unrest in the Middle-East, Bahrein, Lybia and co, looks like crazy leverage credit is rearing its ugly face again.

Remember 2006 and the craze for LBOs financed with Cov-lite loans? Well guess what, the boys are back in town!

Albert Einstein Quotes - Insanity: doing the same thing over and over again and expecting different results...

Definition of Credit Market insanity:

"Any statistician will tell you, a good outcome for a bad risk doesn't mean the risk wasn't bad; it just means you happened to get lucky."

Below is a link to what was discussed at the latest Wharton School of Business annual restructuring conference in February:

"The overwhelming consensus among Panelists and Speakers was that we are experiencing a credit bubble and precipitous drop in risk premiums across asset classes, particularly in High Yield Bonds and Leveraged Loans."

"The consensus was that 6.7% was far to low a yield for HY bonds, even thought it is not an all times low on a spread basis, and that it did not portend well for those long HY at these prices."

Get ready for a bumpy ride ahead:

"The longer-term outlook gives cause for apprehension. Some of the concerns evidenced were: the large maturity wall between 2012 and 2015 which is currently comprised of debt trading well below par and unlikely to be refinanced; earnings going up against much tougher 2010 comps in 2011, large fiscal deficits and federal debt in the US combined with state and municipal debt; US bank balance sheets with large amounts of distressed and defaulted debt marked as hold-to-maturity with bid ask spreads so far apart that it is not getting worked off; regional banks sitting on commercial real estate loans that have been amended and extended that are likely to be the next shoe to drop in terms of debt restructurings; and European Sovereign Debt concerns along with skepticism regarding European bank balance sheets."

In respect to the US credit markets:
"With respect to the US credit markets, panel participants shared the view that we are nearing a top and that there will be a second distressed wave in the not so distant future."

Pre-flight "investor" safety briefings:

Keep your seat belt fastened
Before take-off and "hard" market landing ensure that your:
Seat belt is tightly fastened...
In the event of a crash landing, adopt the recommended brace position.
Place your hands on your head with your elbows on the outside of your thighs and your feet flat on the floor.

The panelists went on according to the same article:
"An interesting term was used for current state of bank amendments, “Amend and Pretend”, indicating that there is still an unwillingness on the part of banks to acknowledge certain problem credits."

One of the most important point of the article:

"The Distressed Hedge Fund Panel participants lamented the return of some of the worst practices such as HoldCo PIK dividend recaps and the triumphant return of cov-lite deals so shortly after many had believed the credit markets had learned from its past excesses."

Yes, Cov-Lite deals are back. Lessons learned? Doesn't seem like it.

This is what Bethany McLean, known for her work on the Enron scandal and the 2008 financial crisis, had to say in her article - Corporate Subprime
The default crisis that never happened

"When most of us think about the credit bubble that burst in 2008, we think about the lax terms of mortgage loans. But many corporations, particularly those that were bought out by private equity firms, also got debt on lax terms. This debt was known as "covenant-lite," because the normal terms of corporate credit—such as a requirement that a company, say, maintain a certain level of profits—were waived by deal-hungry lenders.

After it all went pop, banks regretted the cov-lite loans almost as much as mortgage originators regretted their "no documentation" loans to home buyers. Cov-lite loans plunged in price. At his retirement dinner in May 2007, Anthony Bolton, Fidelity's investment guru, said, "Covenant-lite borrowing … will come back at some stage to haunt the banks." Indeed, Goldman Sachs and other big firms took massive losses when they sold or marked down the price of the bonds they were stuck holding. One person involved in negotiating these deals says his banking clients swore, "Never again."

But less than three years later, cov-lite loans are back. "With a vengeance," my friend David Pesikoff, a Texas-based hedge-fund manager, assures me. Has the world of finance gone insane? Not necessarily. The return of cov-lite loans makes a certain sense in the current financial environment. But I find myself wondering what that says about the current financial environment."

Well, Bethany me too, I am also asking myself if they have gone insane again.

Looks like the street smart (Hedge Fund community...) attended the Wharton conference...

Gwen Robinson posted on the 5th of June 2007 the following article on Cov-lite loans:

Cov-lite loans: bubble-time or a sign of maturity?

Secondary spread of covenant-lite loans has narrowed dramatically:

The answer was bubble Gwen...

Bethany goes on in her article:

"This calculus shifted in 2006, because the financial world was awash in credit. Yields on debt were so low that investors were searching for something, anything, that paid just a little bit more. Subprime mortgages were one answer, but so were cov-lite loans made to highly indebted takeover targets, which paid just a wee bit more in interest (and at the peak of the mania, it really was just a wee bit) than super-safe debt. A big market for these loans existed in so-called "collateralized loan obligations," or CLOs, which were a sister of the "collateralized debt obligations," or CDOs, that snapped up subprime mortgages. Investors such as insurance companies bought slices of the CLOs, which were assigned varying levels of risk by the rating agencies, just as they bought slices of the CDOs.

Another reason for the rise in cov-lite loans was the relationship of mutual convenience between private equity firms and Wall Street banks. Private equity firms wanted cheap money on easy terms to finance all those big buyouts. Because private equity firms made such great clients—all those fees generated by buyouts!—Wall Street banks vied to give them what they wanted. Cov-lite loans were used to finance some of the biggest, best-known deals of the era, like KKR's buyout of Alliance Boots and Thomas H. Lee and Bain Capital's buyout of Clear Channel. According to the credit rating agency Standard & Poor's, $32 billion in cov-lite loans were issued between 1997 and 2006. Most of that came in 2006. In the first six months of 2007, cov-lite volume hit a stunning $97 billion, according to an S & P piece called "The Leveraging of America: Covenant-Lite Loan Structures Diminish Recovery Prospects."

Bethany adds:

"There are other similarities between the credit bubble and the current credit market. Banks still want to please their biggest clients, the private equity firms. And CLOs are once again a brisk market for whatever higher-yielding debt that can be found. That's because CLO managers aren't paid to have cash on hand, and all that refinancing of risky debt has resulted in an inflow of cash. They have to invest the money somewhere—and in order to justify the existence of the CLO in the first place, it has to be somewhere that offers a decent yield."

Some facts as per Bethany's great article:

"According to S&P, more than 25 percent of first-lien loans (those that have the first call on a company's assets) issued in 2011 have cov-lite structures. The $8.8 billion in such issuance so far this year already tops the total for all of last year, and it isn't even March. Among the private equity deals that used cov-lite loans are the buyouts of Del Monte and J. Crew, according to market participants."

And Bethany concludes:

"The fact that the Fed rode to the rescue doesn't necessarily mean that cov-lite loans were a good risk to begin with. You also might see in the desperate hunt for yield some uncomfortable parallels to the bubble years. Weren't we all supposed to have learned that too much debt is bad for us? Whether the cov-lite deals getting done right now will face a day of reckoning is anyone's guess. But at the very least, these deals strike me as a sign that some kind of reckoning is in store. I hope I'm wrong about that."

I hope too.
From the Standard & Poors website:

Full Index analysis: Loans return 10.13% in no-drama 2010

"If, on the other hand, the economic recovery fizzles for whatever reason – the known worries have been recounted in this space many times – loans would likely slip as risk-margins widen and the asset class loses its luster with retail investors, which poured a record $16.2 billion into prime funds in 2010, according to Lipper FMI, pumping up demand."

At the Wharton Restructuring conference, the panelists commented:

"One panelist noted the CityCenter refinancing at over 8x leveraged through the first liens and 12x through the seconds as one of the “worst deals ever done”, and a strong indication of an over-heated credit market. Another instrument highlighted as being fundamentally unsound are the surplus notes being issued by mono-lines, these are deeply subordinated securities that have little security and function more like preferred stock. They are being marketed to aggressive credit investors reaching for yield, a strategy that most agreed would end badly for those investors. Distressed investors were cautioned against style drift into chasing large-cap HY."

They went on:

"The Distressed Hedge Fund panelists identified the low quality refinancing being done over the last year as a strong source for potential distressed names over the next 18-24 months. Steve Moyer noted that between 2012 and 2016 there are $650bn dollars in maturities coming due, $150bn of which is Ca1 or below. Many of these issues are trading well below par and are unrefinanceable which will present opportunities for distressed investors. Moreover, Shawn Foley of Avenue Capital cited a JP Morgan report indicating that the majority of CCC rated paper has less than 1 turn of equity beneath it, a proposition he considered unsustainable."

Want a perfect storm?

"The primary concern among all conference participants for both credit instruments and the economy is the anticipation of a substantial increase in inflation. With PPI up almost 9% and CPI up only 3%, companies are suffering margin compression. Companies will be forced to raise prices which will eventually lead to wage increases to compensate for that higher price level. Commodity prices for cotton, wheat and corn are all near record highs while industrial commodities and oil have also moved higher signaling inflation in the pipeline. In addition, food price rises in non-producer countries in the third world are a major source of global instability and are large factor in the civil unrest in the Middle East. Mid-caps are particularly vulnerable due to a lack of pricing power and international diversification."

What about banks balance sheets?

"It was estimated that banks are still sitting on $2 trillion of mostly middle market loans that they have yet to take a write-down on. And while the Fed has pressured financial institutions to deal with their books with respect to residential housing, construction and building products, they have been far more lenient with respect to other sectors. That is particularly the case with commercial real estate, most of which is on the balance sheets of regional banks. When commercial real estate will start restructuring en masse was also a prime topic for discussion. The 2005-2007 vintage LBOs were considered to be the best class of candidates for restructuring opportunities now and in the future."

And finally the icing on the cake:

"The key take away from a distressed investor’s point of view, is that while there are currently some opportunities in less liquid middle market names, the overall HY and leverage loan markets are experiencing a 2005-2007 type bubble."

Good night and good luck:

Tuesday, 15 February 2011

Fixed Income - Floating Expenses - Inflation still creeping up in the UK

Inflation in the UK is still on an upward trend and Mervyn King is getting more and more nervous now than before, conceding inflation will be high for the next two to three years. His hand must start to be tired given he has to write yet another letter to the Chancellor. Inflation for January is now at 4% in the UK.

I don't want to sound like a broken record but there are more than enough posts on my blog dealing with the UK inflation problems where I argued QE in the UK would be inflationary down the line:

Mr King testified today: "Inflation is likely to continue to pick up to somewhere between 4 per cent and 5 per cent over the next few months, appreciably higher than when I last wrote to you."

Dear Mervyn, as I remember last time didn't you forecast inflation pressure falling from January 2012 onwards in your last letter to the Chancellor?

"King in his last open letter to the Chancellor of the Exchequer indicated that inflation will "probably" (most likely if you ask me...) stay above the bank's target of 2% till the end of next year."

Given the already high leverage of households in the UK, it comes to no surprise that the Bank of England is trying to buy as much time as possible to avoid hiking rate. The consequences would clearly be a double-dip.

Deflating debt via inflation is the name of the game dear Mervyn.

As I previously wrote:

"The great bank robbery runs unabated...Inflation is purely and simply theft on a large scale."

Truth is, Mervyn King has no choice.

Just the facts:The UK had one of the worst household debt to GDP ratios and debt to disposable income ratios in Europe.

and in the entire G7:

For an additional visual approach on the UK debt problem please have a look at the below link:

46% of personal debt in the UK is on Credit Cards.

Average UK household debt: 57,706 GBP per household.

Total Earnings VS Total Debt: Debt = 126% of average earnings.

Total personal debt in the UK - 1,454 Billion GBP: Individuals owe more in personal debt than the country's annual output.

Now with VAT to 20% in January and the high rate of inflation, household budgets are being stretched even further. Reduced income due to benefit cuts and continued redundancies only add to the current problem.

Two thirds of UK Household Debt is tied directly to the Bank of England’s short term interest rates, therefore Mervyn King has no choice but to try to delay as long as possible a rise in interests rates as indicated in the below WSJ article by Alen Mattich:

"CreditSights, an independent research house, outlined the stark facts the Bank of England is confronting in a note this week.

Between 2000 and 2008, U.K. households’ total debt burden rose by 133%, with borrowing rising to 161% of gross household disposable income from 99%.

The Bank of England’s emergency rate cuts reduced the amount of interest payments U.K. households make to just £2.2 billion, from £19.4 billion in 2007. CreditSights estimates that just a 50 basis point hike in the Bank’s base rate would increase borrowers’ interest costs by £7.5 billion."

Not only would a rate hike be very difficult for UK Households but would also have a serious impact on public finances to the estimated tune of 15 Billions GBP for a 100 bps increase in Gilt Yields over the next five years.

So there you have it, the quiet inflation robbery game will continue. Mervyn King won't have the time to let the ink dry given the additional letters he is going to have to write to the Chancellor in the near future.

Welcome to Stagflation redux à la 70s...

Monday, 7 February 2011

Ben Bernanke - The illusionist and the year of the rabbit - The illusion of wealth

The illusion of Wealth:

We all know what happened during the financial crisis, a lot of Americans used their house as an ATM. Today the ATM is broken, following the dramatic impact of the crisis on households balance sheet and the collapse of the housing market. Thanks to QE2 and the rise in all asset prices, Ben Bernanke seems to be succeeding in creating the illusion of wealth. It is indeed the year of the rabbit and the magician is clearly Bernanke, pulling the wealth rabbit out of a hat.
THE ILLUSION OF HOUSEHOLD WEALTH - 15th April 2005 - Chris Leithner

"By borrowing against a home whose price is rising, sometimes substantially, households have been able to "extract equity" and consume the proceeds; and the growing magnitude of extraction has enabled them to increase their consumption at a rate that has greatly exceeded the increase of household income. But all financial transactions incur risk, and the most immediate risk of this behaviour is the sturdiness of the assumption that the prices of households' assets, particularly houses, can continue to rise much more quickly than income. A less immediate but ultimately much more significant risk is the weakening of the capital structure. A weaker structure today implies sluggishly growing or stagnant or even falling living standards in the future."

In this excellent article Chris also adds the following:

"Using American data from 1952 to 2003, Kasriel has charted the relative importance of savings and capital gains as components of households' net worth. In the mid-1990s, the impact of capital gains began to outstrip savings by a wide margin. From 1995 to 1999, a steady increase in the prices of the household's portfolio of stocks drove the increase of its net worth; and since 2000, increases in the market price of the family home have done so. During the period 1952-1994, capital gains on stocks or real estate were, on average, 1.7 times greater than household saving; and from 1995 to 2003 these gains averaged 4.4 times household saving. Consumers, cheered by politicians, concluded that capital gains are – and that savings are not – the route to higher net worth."

The Concept of Capital:
In his contribution, Chris Leithner discusses the critical concept of capital, quoting Peter Kasriel, chief economist at Northern Trust.

"Far better than most contemporary economists, who seem to comprehend it not at all, Kasriel understands the concept of capital. He notes that capital stock is conventionally defined as the sum of business assets, private residential housing, consumer durables and government property. Although he does not explicitly say so, he seems to recognise that residential real estate, consumer durables and government property are not capital goods – and therefore that they should not be regarded as components of the capital stock."

This is probably one of the most important concept to understand. To some extent, it explains why there was a huge misallocation of capital during the financial crisis which validates the Austrian Business Cycle Theory.

Here is a reminder of the Austrian Business Cycle Theory:

"According to the theory, the business cycle unfolds in the following way: Low interest rates tend to stimulate borrowing from the banking system. This expansion of credit causes an expansion of the supply of money, through the money creation process in a fractional reserve banking system. This in turn leads to an unsustainable credit-sourced boom during which the artificially stimulated borrowing seeks out diminishing investment opportunities. This credit-sourced boom results in widespread malinvestments, causing capital resources to be misallocated into areas that would not attract investment if the money supply remained stable."

Chris goes on an quotes Kesriel:
"Just because an existing house goes up in [price] does not necessarily mean that the more expensive house 'produces' more actual housing services. Does a rise in the price of the house enable more people to live in it? Does the increase in the price of an existing drill press necessarily mean that the drill press is now capable of drilling more holes in an hour?
The economic wealth of a nation is related to an increase in the number of drill presses, not the nominal value of the existing stock of drill presses. The more drill presses an economy has, the more holes can be drilled in the production of other goods. The greater the capital stock of an economy, the more productive is its labour force. In short, the greater the capital stock of an economy, the more goods and services that economy is likely to be able to produce".

The relationship between capital stock and household net worth is a very important one: the more households save the faster the capital stock subsequently grows:
"Two critical insights into the nature and causes of the growth of wealth. The first is that it owes much more to savings than to capital gains. The second insight is that wealth also depends heavily upon the composition of capital stock."

Chris concluded:
"Policies that encourage saving and investment – and do not sanctify spending and consumption – are required. But to expect politicians to change their profligate spots is to suppose that leopards will become vegetarians. As a result, potentially severe disorders have been bequeathed to the future."
This what Chris Leithner had to say in April 2005.

But back to today's macro environment.
In relation to the latest quarterly publication of the US GDP, it transpires that the reason why Personal Consumer Expenditure (PCE) rose Month to Month 0.7% in December, was because savings rate fell:
In the final quarter of last year, consumers spent more and saved less. Americans saved 5.4 percent of their disposable income, compared with 5.9 percent in the third quarter.

Truth is, continuous fall in home prices in the US will hurt both consumers and banks, counteracting the wealth effect generated by QE2 and the rise of assets prices.

Banks still face unexpected losses from their on-balance sheet mortgages, from commercial and residential mortgages. A slower growth in the US combined with a stable unemployment level could entice the FED to go for QE3.

Although western Central banks, namely the FED, Bank of England and the ECB will remain accomodative in 2011, you can expect further tightening in the emerging market space, due to inflationary pressures growing relentlessly on their economies.
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