Another shoe is dropping in the ongoing credit collapse here in this nation of whiners. According to the New York Times, the default rate on so-called Leveraged Loans -- (a very strange name if you ask me since a loan is leverage) that refers to loans used to finance corporate takeovers -- climbed fast from 0.24% in August 2007 to 3.3% in August 2008.
The loans that have gone bad so far are not big ones -- they are more like the canary in the coal mine -- hinting at bigger problems to come. The Times says, "the loans that have gone bad have been concentrated in two industries - real estate and auto parts. S.& P. calculates that they have accounted for almost half of this year's defaults. Gambling has also had problems, as it turns out that there are too many casinos in some places."
The biggest loans have yet to default. But their collapse is inevitable. That's because banks are scrambling to raise capital and shore up their balance sheets. And the leveraged loans were structured to benefit from a lending market in which the name of the game was to keep from losing market share by making it ever easier to borrow. Thus the terms of leveraged loans were easy -- featuring, as the Times reported, a "flood of 'covenant-lite' and 'toggle-[Payment in Kind] PIK' loans."
Covenant lite means "banks [don't step in] until the borrower actually missed a payment, rather than when it violated a financial covenant related to assets or profits." Toggle-PIK allowed a borrower who couldn't make a payment in cash to do so by taking out more loans (that's what PIK means).
When banks took on these leveraged loans they were not worried about the risks because they figured they would just take the fees and sell them so someone else. Unfortunately, they agreed to so-called liquidity puts which contractually obligated them to buy back the loans if nobody else wanted them. Guess what? Nobody else wants them. And the banks don't have the capital to afford to buy them back.
Just as Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson were wrong when they said that subprime was contained, so will be those who dismiss the significance of the collapse in leveraged loans. It happened in the last 1980s and it will happen again -- probably later this year and well into the next several.
The lesson for this nation of whiners -- when an investment bank pitches an investment with a funny new name that doesn't make any sense -- clutch your wallet with both hands.
Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter
Reader Comments (Page 1 of 1)
9-05-2008 @ 11:57AM
william lindblad said...
You are correct, but it is only part of the entire package. I can easily predict that this will extend into the charter areas of government and the commercial loan sector of the banking industry. That is not a guess, it's a coming fact. But there is a good part as at least most people expect this outcome and therefore, it will not be a major shock.
Putting to much credence into the statements of the government and the Fed is a fools game, they have a vested interest in keeping the economy stable and their public statements run from mis-leading to fabrication.
It can be summed up in the "fool the people"quote attributed to Lincoln and that will be in force until after the November elections.
Well over a year ago I said this pill is going to be too big to swallow - even for the government.
9-22-2008 @ 9:04AM
R.PALMER said...
DO YOU HAVE LOAN DEFAULTS ACCORDING TO INDUSTRY AND GEOGRAPHY