Will the $4.6 trillion leveraged loan market cause the next financial crisis?

Financial crises take about a decade to emerge. Having lived through four of them, I see the raw materials of a fifth – stemming from the collapse of so-called leveraged loans – debt piling up on top of companies whose credit ratings are weak.

Before we look at the latest news on leveraged loans, let’s take a quick look at some of the financial crises I’ve been through.

My first 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 McKinsey’s suggestion, money banks such as Chemical Bank thought it would be a great idea to buy some of these loans. Everything is well described in a wonderful book — belly up.

Too bad the price of oil and gas plummeted, leaving lenders in the lurch and causing a spike in bank failures that gave me the chance to spend a mild summer in Washington helping the FDIC develop a system to manage the liquidation of these bankrupt banks.

In 1989, it was time for another banking crisis – this one was linked to too much lending to commercial real estate developers in New England and junk bond-backed loans for what used to be called leveraged buyouts. .

The government shut down Bank of New England and threatened my employer, Bank of Boston, with the same. I worked on a government-mandated strategic plan designed to save the bank from a similar fate.

Next
up — the dot-com bust — which led me to the idea that not all bubbles are bad if you can get in when they form and get out before they burst. I invested in six dot-coms and had a mixed record – the three winners made up for the three failures.

Finally there is the last and greatest – the so-called Great Recession of 2008. Now I come to the end of Ben Bernanke’s story The courage to act.

It brings back all the memories – of my first article on subprime mortgages in December 2006 in which I recommended shorting shares of subprime lender NovaStar Financial when they traded at $106 apiece.

(NovaStar changed its name to Novation in 2012 and you can take a slice for 17 cents.)

The main causes of the crisis that Bernanke describes as the worst in history were weak subprime regulation, lying loans, global securitization, lack of capital, limited transparency, biased incentives from bankers and agencies ratings and flawed risk management.

What does this little tour of the financial crisis have to do with leveraged loans? I have often quoted 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. According to New York Times.

Why the rhyme? As in the late 1980s, leveraged loans are granted to companies with poor credit ratings; like sub-prime mortgages, they are grouped into securities intended to give investors a diversified portfolio; and like the crisis of the early 1980s, there is excess debt on the books of energy and mining companies.

Moreover, leveraged loans are not small potatoes. Since the end of 2008, Thomson Reuters calculates that the companies used them to borrow the colossal sum of $4.6 trillion.

Leveraged loans are slowing down. Last year, companies used them to borrow $940 billion, but so far in 2015 they’ve only taken on $700 billion of that debt, according to Thomson Reuters.

And more and more borrowers are not repaying. In September, Fitch Ratings predicted leveraged loan default rates could approach 2% by the end of 2015, after five defaults in August totaling $1.4 billion.

With oil prices down more than 60% since June 2014 and a general decline in commodity prices, it is no surprise that borrowers in the energy and mining sector are the most feared among investors. investors, according to Fitch.

According to Time.

Citing unnamed sources – usually a sign of fear – the Time estimates that banks will suffer $600 million in losses on leveraged loans they have on their books that no one wants to buy.

Three of these deals give flavor to the borrowers involved. Carlyle Group uses leveraged loans to acquire software company Veritas for $5.5 billion; Sycamore Partners uses them to buy the Belk department store for $3 billion; and generic drug maker Lannett is using them to buy rival Kremers Urban for $1.23 billion, according to the Time.

And the Time is very careful to point out that if the demand for leveraged loans increases, these banks may suffer lesser losses or even end up making money from these loans.

But with interest rates rising and something pushing investors away from leveraged loans, that can’t be welcomed as good news by Michael Dell, who was hoping to borrow $50 billion to acquire EMC.

If that deal goes through, it could mean nearly $800 million in fees for Morgan Stanley and JPMorgan — $210 million in advisory fees plus $500 million to $575 million in loan origination fees, according to Freeman & Co..

But what if those banks can’t sell their share of that $50 billion leveraged loan and have to write off a decline in its value?

If you have never seen Blue NYPDyou should watch the hearts and souls episode aired almost exactly 17 years ago in which Bobby Simone, played by Jimmy Smits, dies of an infection after a heart transplant.

The image at the start of the episode begins with a small drop of blood on his t-shirt and ends with the screen turning white after he dies.

I wouldn’t be surprised if the recent jerks in the leveraged loan market look like those little drops of blood on Simone’s t-shirt.

Due to banks’ exposure to leveraged loans and their presence in investors’ portfolios, this will spread throughout the economy.

In June 2007, the the wall street journal quoted me how a leveraged loan temporarily saved Bally Total Fitness. The parallels between this article’s description of the leveraged loan market – when its default rate was below 1% but was expected to reach 2.7% – and the current situation is worth noting.

It remains to be seen how bad it could get. But if the situation gets worse, it may be more difficult to claim – because Dick Cheney did after the financial crisis of 2008 – that no one warned the heads of government.

Priscilla C. Carnegie