Some wonder what squelched the hunger of potential lenders so abruptly, while in the same breath suggesting that the subprime crisis is "isolated" and not contagious to other markets or even the overall economy. Not so, and the sudden liquidity crisis in the high yield debt market is just the latest sign that there is a connection, a chain that links all markets and ultimately their prices and yields to the fate of the U.S. economy. The fact is that several weeks ago, Moody’s and Standard & Poor’s finally got it into gear, downgrading hundreds of subprime issues and threatening more to come. "Isolationists" would wonder what that has to do with the corporate debt market. Housing is faring badly but corporate profits are in their prime and at record levels as a percentage of GDP. Lenders to corporations should not be affected by defaults in subprime housing space, they claim. Unfortunately that does not appear to be the case.
As Tim Bond of Barclays Capital put it so well a few weeks ago, "it is the excess leverage of the lenders not the borrowers which is the source of systemic problems." Low policy rates in many countries and narrow credit spreads have encouraged levered structures bought in the hundreds of millions by lenders, in an effort to maximize returns with what they thought were relatively riskless loans. Those were the ABS CDOs, CLOs, and levered CDO structures that the rating services assigned investment grade ratings to, which then were sold with enticing LIBOR + 100, 200, 300 or more types of yields. The bloom came off the rose and the worm started to turn, however, when institutional investors – many of them foreign – began to see the ratings downgrades in ABS subprime space. Could the same thing happen to levered structures with pure corporate credit backing? To be blunt, they seem to be thinking that if Moody’s and Standard & Poor’s have done such a lousy job of rating subprime structures, how can the market have confidence that they’re not repeating the same structural, formulaic, mistake with CLOs and CDOs? That growing lack of confidence – more so than the defaults of two Bear Stearns hedge funds and the threat of more to come – has frozen future lending and backed up the market for high yield new issues such that it resembles a constipated owl: absolutely nothing is moving.
Bond managers should applaud. It is they, after all, who have resembled passive owls for years if not decades. If, as I pointed out in my opening paragraph, wealth has always wound up in the hands of those that take risk with other people’s money, then private equity and hedge fund managers have led the charge in recent years. Of course they have been aided and abetted by those monsoon forces of globalization and innovation, producing worldwide growth that led to escalating profits and equity prices, often at the expense of labor. But the Blackstones, the KKRs, and the hedge funds of recent years also climbed to the top of the pile on the willing backs of fixed income lenders too meek and too passive to ask for a part of the action. Covenant-lite deals and low yields were accepted by money managers as if they were prisoners in an isolation ward looking forward to their daily gruel passed unemotionally three times a day through the cellblock window. "Here, take this" their investment banker jailers seemed to say, "and be glad that you’ve got at least something to eat!"
Well the caloric content of the gruel in recent years has been barely life supporting and unhealthy to boot – sprinkled with calls and PIKS and options that allowed borrowers to lever and transfer assets at will. As for the calories, high yield spreads dropped to the point of Treasuries + 250 basis points or LIBOR + 200. Readers can sense the severity of the diet relative to risk by simply researching historical annual high yield default rates (5%), multiplying that by loss of principal in bankruptcy (60%), and coming up with an expected loss of 3% over the life of future loans. At LIBOR + 250 in other words, high yield lenders were giving away money!