Stock market prop loses lustre

by Levi Folk | July 30, 2007

The credit cycle appears to have turned, and that spells trouble for private-equity deal flow and for the broader equity markets. The turmoil in housing is indeed spreading to the broader U.S. economy, not through lower consumer spending but through tighter lending as investors are becoming more risk averse.

Private-equity buyout deals are continuing at a frenzied pace despite the increased aversion by investors to financing these deals in recent weeks. Deal volume has nearly doubled year-over-year over the past six weeks, totalling US$184-billion globally, according to research firm Dealogic.

The LBO firms are still wheeling and dealing, so an important prop for the global equity boom remains intact. The math for these deals is straightforward: Issue low-yielding debt to finance buyouts of higher-yielding equity. So long as private-equity funds can offload the risky debt to complacent investors for only minor premiums over government debt, the deal train keeps moving.

The problem for this story is that investors are less complacent. They have been getting a strong whiff of what those U.S. mortgages behind the hundreds of billions of collateralized debt obligations (CDOs) they bought are really worth. The lesson learned, they are now realizing that 250 basis points of yield pickup over government debt is not worth their troubles.

In February, I suggested in this column that high-yield bond premiums were “razor thin” and did not justify their risk. It appears that only now are high-yield investors sympathizing with this view. Perhaps they are doing their own math, similar to the numbers forwarded by Bill Gross, manager of PIMCO, the world’s largest bond fund, in his latest Investment Outlook.

The math that high-yield bond investors should care about is the product of historical default rates (5%) and the loss of principal due to bankruptcy (60%). The resulting 3% is the expected loss to investors on a portfolio of high-yield debt. With less than 300 basis points of yield premium back in February, these investments added up to something short of common sense.

Most recently, high-yield investors have been staging a revolt to the leveraged buyout deals they have been gorged with. One of the biggest deals, the acquisition of Chrysler Group by Cerberus Capital Management is in danger of not being financed. The US$20-billion in loans has not been fully financed in the case of the US$12-billion in loans for the auto business or priced significantly lower in the case of the US$8-billion for the company’s financial arm.

The bonds are looking likely to be partially financed by the investment banks that are underwriting the deal. The Wall Street Journal reports that the Chrysler debt financing is not the only one that has been postponed or bridged in recent weeks. Several billion in unsold debt was a factor in financing for takeovers of Thomson Learning and Allison Transmission, to name two. All told, roughly US$16-billion in all has been postponed this summer, according to Fitch rating, not counting the Chrysler deal.

Losses on CDOs backed by mortgages have sent that market grinding to a halt with no deals having been done in recent weeks after reaching US$19.9-billion in sales up to July 20, reports the Financial Times. In contrast, June saw US$50.6-billion in CDO deals completed.

The U.S. housing market is still weakening and is at the mercy of the hundreds of billions of dollars of adjustable rate mortgages (ARMs) that were issued at teaser rates and are due to reset this year and next. Roughly US$300-billion of subprime mortgages with adjustable rates (ARMs) are resetting to higher rates in 2007 alone, as reported in this column in March of this year, and the peak of those resets occurs at the end of the year.

The continued losses in the mortgaged-back security market will not go unnoticed by high-yield bond investors who will likely require better terms for absorbing the billions of dollars of debt supplied by LBO firms. This will undoubtedly lead to fewer deals being financed exclusively by debt and perhaps more deals being absorbed by the investment banks, making their businesses ever more risky.

An important prop to the stock market is losing its lustre over the next few months. It is no secret that firms being taken out through private-equity and M&A transactions have done so at premiums to prevailing prices, and that has been driving the stock market higher. That trend should cool, just one more reason that equity markets could falter.