The State of the Corporate Credit Markets

Kass is correct to point out that were a flight from risk to occur, all asset classes would sell off (something the quants seem to overlook time and time again). But having been active in the leveraged loan market since its inception, and being intimately familiar with hundreds of individual loans as well as with the history and evolution of the Collateralized Loan Market, the LCDX and the leveraged finance markets (both secured and unsecured), HCM would respectfully suggest that Mr. Kass’s argument would be better aimed at the unsecured corporate credit market, which shares many of the same risk attributes of the equity market, and not the leveraged loan market.

Unsecured, subordinated high yield bonds are often nothing more than “equities in disguise” and as such could be expected to suffer equity-type losses. Senior secured bank loans (not second lien loans) are senior obligations that retain a senior claim on the assets of the borrower.

Even covenant-lite loans are, for the most part, issued by large companies (”fallen angels by design”) that have the characteristics of investment grade companies and therefore are much higher in quality than equities or subordinated debt.

Accordingly, trying to call attention to the possibility of a massive equity sell-down triggering an equally gruesome collapse in the loan market may make good reading for those who want to believe the world is ending, but is far less useful an exercise than pointing out the likelihood that an equity market collapse would likely trigger a drop in high yield bond prices. When you’ve been a bear as long as Mr. Kass has, maybe everything starts to look like honey. It is true, as Mr.

Kass points out, that the leveraged loan market experienced its worst performance in history in July (the Credit Suisse Leveraged Loan Index returned -3.3 percent). But there are both technical and fundamental reasons why that performance is unlikely to be repeated, and why loans currently present a buying opportunity, not a reason to panic and run for the hills. Loans traded down sharply in July as a result of the fact that loan prices are unduly influenced by the newly introduced LCDX index.

This index was used by dealers in July and early August to hedge the $300 billion or so forward calendar of LBO deals to which they have committed their balance sheets. By selling short the LCDX index, they were also attempting to hedge potential losses on CLO warehouses. This created a self-reinforcing selling pressure that dropped the index to the low 90’s, leading loan prices (especially on low-spread and covenant-lite loans) down into the low 90’s.

The index has recovered to the 95-96 level, but loan prices are lagging in their recovery as buyers remain in command of the market as they await the huge fall calendar of LBO deals. Bonds and loans continue to enjoy a default-free environment (Fedders finally bit the dust after stumbling around like a drunk in a bar for the past few years) and really have no fundamental reason to trade down until defaults pick up.

Moody’s recent prediction that defaults will increase to 3.5 percent by July 2008 and 4.5 percent by July 2009 should give bond investors some reason to demand more spread than 400 basis points, but the cash bond market is a moribund place while most of the activity in corporate bond credits has migrated to the credit default market. Until the market sees some visibility on defaults, HCM doubts spreads are going to widen much further on an overall basis.

After Labor Day, the markets will be facing an unprecedented pile-up of financings that are scheduled to come to market before the end of the year. In addition to the chart below, potential mega-deals include The Blackstone Group’s purchase of Alliance Data ($7.9 billion), the buyout of Canadian telecommunications giant BCE Inc.

by a consortium of private equity players and the Ontario Teachers’ Pension Plan ($48.8 billion), the possible going private transaction of Cablevision Systems led by the Dolan family ($13.9 billion), and the renegotiated buyout of Home Depot’s wholesale supply unit ($8.3 billion). Obviously, not all of these transactions will be completed, potentially weighing down the balance sheets of the banks and investment banks that were lured into firm underwriting commitments earlier in the year.

The recent wrangling over Home Depot’s sale of its wholesale supply unit is only the first skirmish between private equity firms and those who have been so generous with them over the past few years.

The interplay between the banks and the private equity firms are living proof of the Wall Street maxim, “if you want a friend, get a dog.” The banks are now telling the private equity firms to cut the prices they are paying for companies or they won’t finance their deals; just two months ago, the private equity firms were telling the banks how much they were going to lend them, how much they would charge, and how much equity they would have to invest in the deal for the right to do so.

How the worm turns! HCM believes it was Bill Gross who pointed out that the private equity firms are now going to have to share the “vig” that they’ve been skimming from their deals with the lenders, which bodes well for lenders but poorly for buyout firms and for sellers of companies who, like Home Depot, are going to realize significantly lower sales prices.

This also bodes poorly for the stock market to the extent that stock prices continue to be sustained by hopes that companies will continue to fetch high prices in auctions fueled by private equity firms overpaying for companies based on the availability of cheap financing. HCM would like to think that the banks will not merely dump these loans in the market at large losses unless they are experiencing overall credit problems that have not yet been publicly disclosed.

All of these buyout loans will be paying interest and performing for the foreseeable future and will have senior claims on the assets of the borrowers. There are a couple of transactions that are so highly leveraged that the private equity firms and banks are going to end up going to the mat to come up with terms that make sense for themselves and the marketplace.

But for the most part, the most prudent course of action would be to leak these deals out over the next year or two as the market can absorb them. Having said that, however, HCM expects these deals to be rushed to market at the first sign they can be moved off these banks’ balance sheets at the smallest possible loss. This is, after all, Wall Street, where patience and greed are terminally in inverse supply.

Private Equity and Hedge Fund Returns and Fees Many market observers pointed to The Blackstone Group’s IPO as the top of the private equity cycle. For the foreseeable future, life is going to be difficult for the private equity shops who exploited the availability of easy money in the credit markets. Of course, “difficult” is a relative term in this context, since private equity firms have attained wealth and status that invited a correction.

“Aggravating” is probably a better term, since these power brokers are going to be engaged in difficult negotiations with their lenders and their investment banks. In the end, however, they will emerge largely unscathed as a result of the fact that they have largely structured their world in a “heads we win, tails you lose” kind of way.

A recent article in breakingviews.com argued that the new world for LBOs could reduce projected private equity returns by more than 50 percent, as shown in the following chart: Private equity enthusiasts will certainly dispute these figures, but the point remains that higher financing costs are going to squeeze private equity returns significantly.

The returns to the private equity firms themselves are much higher, of course, since the chart does not take into account the generous fees they charge to their investors. It should also be noted that academic studies have shown that private equity returns, on a liquidity-adjusted and leverage-adjusted basis, are generally far less exceptional than they appear at first blush. If they are further adjusted for inflation and normal market returns, they are even less impressive.

The same can be said about the returns of the majority of hedge funds. Moreover, the unspoken truth about the private equity and hedge fund businesses is that they serve the managers much better than they serve the clients. It’s hardly an accident that more private equity and hedge fund managers keep showing up on the list of the Forbes 400. This was less of an issue in the early days of the business, when investors in these vehicles were largely wealthy individuals and institutions.

But as the business attracts money from non-profit institutions, this issue is going to gain an increasing amount of political attention. We are already seeing this occur with respect to the issue of the taxation of private equity carried interests. Jeremy Grantham made a similar point in his most recent quarterly letter when he criticized the payment scheme that rewards private equity managers for returns that are attributable to normal market increases.

The same argument applies to hedge fund managers, who used to have to earn a return above a hurdle rate before receiving performance fees in order to avoid rewarding them for returns attributable to inflation and a rising market. Private equity and hedge fund managers, at least early in their careers, earn their fortunes primarily through their fees and the skim they earn off their investors’ capital.

Only after they have accumulated capital and become substantial investors in their own funds do they really share some of the same risks as their investors. But their fee structures still place them in a much more advantageous position than those whosemoney they manage. Neither private equity managers nor hedge fund managers are required to hand back fees if later investments go sour and their investors end up giving back all of their earlier gains.

Somewhere along the line, “one and twenty” or “two and twenty” (and there are more egregious structures out there as well) became a kind of birthright for managers able to convince investors to ignore the fact that a significant amount of the so-called “outperformance” or “alpha” they are paying for is attributable to a rising market or inflation.

Forgive our lack of surprise when many of the managers charging these exorbitant fees distinguished themselves by losing large sums of money in the recent market meltdown and then blamed everybody but themselves for their difficulties. The markets are nervous because they can’t figure out where the risks lie. There is leverage overflowing the financial system both inside and outside the subprime mortgage world, but nobody can figure out where it all went.

Risk, it seems, is everywhere and nowhere, and that is what has the markets spooked. Financial Times columnist Tony Jackson made the point very well in a column on August 27, 2007 when he said that “[t]he originators of risk – hedge funds, private equity, investment and commercial banks – are not in the business of holding [risk].

That job falls to investors who are prepared for the long haul.” 3 One thing is for sure – private equity and hedge fund managers spend a great deal of time managing their own career and compensation risks. Sometimes one has to wonder if they devote as much time to worrying about the risks that really ought to matter, like those to their investors and the financial system at large.

The Conundrum of the Central Banks In a recent interview in welling@weeden, Mark Faber makes the compelling argument that “if Mexico hadn’t been bailed out in ‘94, the resulting crisis in emerging economies would have been nowhere as severe as it then became in ‘97.

Because the excesses were allowed to expand between ‘94 and ‘97 as those monetary policies continued.” This is the dilemma facing the Federal Reserve today as it approaches the September 17th Open Market Committee Meeting, where it is widely expected to reduce the Federal Funds rate by 50 basis points.

A bailout of the credit markets is a two-edged sword: it prevents a systemic collapse, but it rescues a lot of participants who contributed to the problem in the first place and should not be permitted to repeat their errors. From HCM’s standpoint, merely bailing out the markets – particularly the subprime mortgage market - through monetary policy maneuvers would be a colossal public policy error, although a complete solution really lies outside of the mandate of the central bank.

A real solution to the subprime mortgage problem requires a combination of monetary policy action and legislative reform to remove abusive lending practices from the system. This problem should not be left in the hands of the individual states to handle; a hodge-podge of different state regulations is insufficient to address the problem.

Instead, there should be federal mortgage legislation to address the flaws that led to the current subprime meltdown, which was completely foreseeable and therefore completely avoidable.

Without such legislative action, the Federal Reserve will be left in a situation where it will merely be lighting the fuse for another series of abuses and a future conflagrations in the credit markets that could make the current one pale incomparison, much like the 1998 near-death experience of the financial markets rendered the 1994 Mexico bailout almost forgettable.

While it is too soon to determine whether we have seen the worst of market volatility in this crisis, we have certainly been reminded once again of the paramount importance of liquidity. Several commentators, including Henry Kaufman and Mark Faber, have made the important point that the concept of liquidity has undergone a sea change in recent years. While liquidity used to mean cash and cash equivalents, its meaning was expanded to include borrowing power over the past few years.

HCM wouldn’t bet the farm that this concept is going to change as quickly as some commentators would have us believe. Anybody who believes that hedge funds and investment bankers have stopped thinking about using as much leverage as possible should think again. The wounded securitization edifice was constructed on the ability to turn illiquid financial instruments into newly tradable and liquid ones.

Two of Morgan Stanley’s economists, Richard Berner and Joachim point out that this brings both benefits and risks: “The dispersion of risk resulting from financial innovation across financial markets and institutions is a two-edged sword: It diffuses credit risks across markets and may reduce risk concentration by putting such risks in the hands of those who want and are better equipped to hold them.

But the structure in structured subprime and other forms of credit makes it appear that such securities carry less risk than the underlying collateral, encouraging investors to increase leverage. That leverage provided the kindling for a liquidity crisis; deteriorating credit quality and a forced re-intermediation of credit to banks lit the match.” 4 Investors and lenders convinced themselves that financial alchemy would turn illiquid securities into liquid securities in all market conditions.

But leverage and liquidity require two participants. A borrower needs a lender, and a buyer needs a seller. Otherwise each is just a ship at sea. Liquidity is a human phenomenon, a psychological phenomenon. Investors made the mistake of believing that financial technology had repealed the laws of human nature.

But, as Bill Gross wisely pointed out in his September Investment Commentary, “[n]othing within the current marketplace allows for the hedging of liquidity risk and that is the problem at the moment.” 5 This point is so obvious that it can be overlooked. Wall Street spends so much of its intellectual and financial resources trying to figure out how to hedge every kind of risk it can imagine.

But the one kind of risk that repeatedly brings down markets and the biggest and boldest players in those markets is liquidity risk. The only true hedge against liquidity risk would be to cut out man’s greed gland. Kass is correct to point out that were a flight from risk to occur, all asset classes would sell off (something the quants seem to overlook time and time again).