The next big debt crisis to worry about

By Associate Editor David Stevenson Jun 05, 2008

David Stevenson

We’ve seen a lot of dodgy debt cropping up on our radar screens recently.

As well as all those subprime horror stories, the Bank of England cautioned last month that a £5bn chunk of Britain’s commercial property loans could go bad. Now it looks like there could be yet another area to worry about.

“Is something nasty lurking in the leveraged loan woodshed?” asked the FT’s Gillian Tett late last month. Even as some of the subprime shivers began to ease, fears are growing that the leveraged loan arena, which has seen a dramatic lending surge in recent years, along with a matching fall in lending standards, could soon see increasing defaults as the economy slows down.

In leveraged buyouts (LBOs), firms generally put up about a third of their own money and fund the rest of the purchase with high-yield debt. The credit ratings monitor Standard & Poor's this week warned that the risk of LBO debt default is growing in Europe as companies struggle to meet the record amounts borrowed.

“Investors should be concerned about the fall in cash-coverage ratios, which are lower even than in 2007, when they were already at record-thin levels”, says S&P. “The cash ratio that companies have to cover their obligations dwindled in the first quarter to 2.2 times debt from 2.5 times last year and 4 times in 2003”.

That means there’s less money available to invest in the businesses or to absorb losses, resulting in a greater default risk. What’s more, leverage levels in smaller buyouts hit a record, and purchase price multiples continued to climb.

It’s not that different to the mortgage market in many ways – just as home buyers have been using smaller deposits and borrowing more money to buy houses, companies have been doing exactly the same when they buy other companies.

So far, buyouts are hugely down this year, with $119bn (£61bn) of deals so far announced compared with $403bn in the same period of 2007, according to Bloomberg data, and no high-yield bonds sold in Europe since July. But while bond markets are effectively closed to new LBOs, banks have still provided financing, says S&P, with “ample liquidity available from local lenders to fund private-equity transactions.”

So despite the grim economic environment, overall leverage hasn’t fallen as much as expected, and in fact, lending standards have been loosened: “Just because investors are demanding more conservative structures does not mean they are getting them”.

The average debt/EBITDA (earnings before interest, tax, depreciation and amortization) multiple in this year’s first quarter was 5.8 times, as against 5.9 times in 2007. But some of the smaller LBO deals pose the biggest risks, according to S&P, with companies taking on debt at a record 6.95 times EBITDA on average for buyouts of less than €500m (£400m), compared with 5.8 times last year. Also, average purchase price multiples rose to 10.4 times EBITDA from 9.7 times in 2007.

It all means that the ‘credit quality’ of LBOs has declined, with 93% of 2008’s first quarter deals rated in the ‘B’ category, four steps below investment grade, up from 78% last year.

In subprime, says Gillian Tett, ratings agencies failed to predict the huge default wave in the US because they ignored a change in the way debtors responded to their debts. Households became much more cavalier about walking away from their mortgages.

“Now there’s a risk of something similar happening in leveraged finance, where lots of 'zombie' companies (only alive because lenders have no way of pulling the plug) could suddenly collapse, meaning the default rate could surge dramatically with no warning.”

Why should the man on the street worry about all this? Simple. The knock-on effect. We’ve seen what’s happened in the UK mortgage market, with higher rates and fewer loans from the moment the banks started to worry about the losses they had racked up in the States.

A whole load more write-offs, in an area closer to home, and those bankers will be even less willing to grant you that higher overdraft, or to refinance your mortgage. When the banks get hit, we all do.

Published in Economics | More articles by David Stevenson

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