Behind Buyout Surge, A Debt Market Booms

From the WSJ ($)

CLOs, as they're called, are giant pools of bank loans bundled together by Wall Street and sold off to investors in slices. They aim to spread default risk an inch deep and a mile wide. Last year, more than half of the loans behind the record wave of buyouts were parceled out to investors as CLOs, bankers say.

As corporate borrowing soars, however, concerns are growing that CLOs have made it too easy for shaky or debt-laden companies to borrow money. If economic conditions deteriorate, those loans could sour and investors in the riskiest CLO slices could face large losses. That, in turn, could make it harder for buyout firms to borrow money.

"We are witnessing a loan market rife with liquidity and disproportionate power in the hands of borrowers, arrangers and financial sponsors," said credit-rating firm Standard & Poor's Corp. in a June 13 report. S&P expressed concern that loans without strong covenants to protect lenders are showing up in CLOs. The rating company urged investors to "drill down" while researching the investments and to "hold CLO managers accountable" for questionable loans.

These days, banks that arrange large buyout financings hold on to very little of the loans themselves. Bank underwriting standards have slipped as banks have become mere intermediaries, some executives at buyout firms contend. Banks enable and encourage private-equity firms to load up their companies with debt, these executives say.

CLO investors are betting that there's safety in numbers -- that most corporate borrowers will pay off their loans even if a few don't. Last year, just 1.3% of corporations with credit ratings below investment grade defaulted on their debts, the lowest annual rate since 1981, according to Standard & Poor's.

Where have we seen this story before?

1. Originators shift role from underwriters to intermediaries CHECK

2. Credit standards slip to historic lows CHECK

3. Buyers of the security think that diversification of bad underwriting will make everything ok CHECK

4. Illiquid, opaque and poorly understood securities CHECK

5. Period of initial high returns CHECK

5. This will end badly JUST WAIT

Posted on June 26, 2007 and filed under Finance.