The
Federal Reserve Board announced in its Senior
Loan Officer Survey for
the first quarter that banks experienced “stronger demand” for
commercial loans, and that they “eased their lending policies.”
They eased everything: premiums charged on riskier loans, loan
covenants, collateralization requirements…. The primary reason for
the lower underwriting standards was “more-aggressive competition
from other banks or nonbank lenders.” Fewer banks cited a more
favorable economic outlook. And then there was an “increased
tolerance for risk.”
It shows. The bank-lending bubble before the
financial crisis peaked in October 2008, with total credit
outstanding at all commercial banks at $9.56 trillion. When it all
fell off a cliff, some of it turned into toxic waste and was written
off or shuffled to the Fed in a maddening series of bailouts. It hit
bottom in February 2010. Since then, it has been rising. In November,
it started soaring at a similar rate as in mid-2008, the time when
all heck was breaking loose. And by April 23, total bank credit hit
the lofty all-time record of $10.6 trillion:
But
much of this borrowed money isn’t making it into the real economy,
into plant and equipment, inventories, etc. It’s siphoned off by
M&A activities and other forms of financial engineering, or by
Wall Street alchemists to create some sweet-smelling substances, once
again.
Turns
out, banks have a problem, and these alchemists are going to help
solve it. Banks carry on their books $136 billion in triple-A rated
Collateralized Loan Obligations, the Wall
Street Journal reported.
These CLOs are similar to the triple-A rated mortgaged-backed
Collateralized Debt Obligations that turned into toxic waste during
the financial crisis. But unlike their subprime-mortgage-backed
brethren, CLOs are backed by junk-rated corporate loans, some of them
malodorous “leveraged loans.”
PE firms use leveraged loans as a device to
suck cash out of their overleveraged portfolio companies. These
companies borrow money that they then, instead of investing it in
productive assets, pay out as a special dividend to their owners. The
procedure leaves the company deeper in the hole, the PE firm loaded
with new cash, and the bank with a “leveraged loan.” The bank can
then package that loan with other low-rated corporate debt into an
enticing CLO.
Total
outstanding CLOs in the US amount to $300 billion, of which $136
billion languish on the books of banks. So far this year, $35
billion in
CLOs have been created, just a notch behind the $36.5 billion created
in the same period in 2007, on the eve of the great bank implosion.
An additional $16 billion are in the pipeline.
New regulations, designed to keep banks from
imploding again, force banks to sell some of these CLOs over the next
few years. But that has been tough. The threat of these regulations
alone has put downward pressure on prices.
Our heroes at these banks have come up with an
ingenious solution: lend money to hedge funds so that they buy these
CLOs from the banks. A number of banks, including RBC Capital
Markets, Société Générale, and our local bank here, Wells Fargo,
are doing just that. To make the deals more attractive, banks have
lowered rates and lengthened the terms of the loans – in line with
the looser underwriting standards that the Fed reported in its
quarterly survey.
Some
banks have offered to lend as much as nine
times the
amount that the buyer would invest in the CLO. The risk? Even a minor
downdraft in the market, multiplied by leverage, can produce
breath-taking losses for hedge funds and force them to put up more
cash or other collateral or dump some of these securities back into
the lap of the bank … and we’re right back to 2008, of forced
selling into a suddenly illiquid market.
But there is an advantage: by lending hedge
funds money to take these CLOs off their books, banks are hoping that
they will create enough artificial demand to pump up prices, thus
generating some paper profits, though banks would remain exposed to
these CLOs via the loans. The advantage to hedge funds? If their
collective buying does drive up prices even a little, their profits
will be multiplied by leverage. At least until reality sets in.
These
dizzying layers of leverage and risks, all based on junk-rated loans
by already over-leveraged companies aren’t a problem, the Wall
Street Journal tells
us to soothe our tattered nerves. Because this time it’s different:
“Overall, borrowed money is mostly being used to buy triple-A-rated
CLOs, say bankers and investors. That contrasts with the run-up to
the 2008 crisis, when huge sums were borrowed to finance bets on
assets such as subprime mortgages….” Indeed, these mortgages had
been sliced and diced and packaged into CDOs, whose infamous triple-A
rating didn’t keep them from turning into toxic waste overnight.
For
years, nothing could slow the tsunami of junk debt. But suddenly,
something happened, and investors in leveraged-loan mutual funds,
where the crappiest junk debt accumulates, ran scared and started
pulling their money out. Consequences were immediate. Read….Biggest
Credit Bubble in History Cracks, Trips Up The Smart Money
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