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Monday, June 25, 2007 3:04 AM

Toggle Bonds - Yet Another High Wire Act

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While doing some research on "toggle bonds" and “covenant light” deals, I came across an article in the GlobeAndMail called Private Equity's High-Wire Act that describes both nicely. This following excerpt is further proof of just how insane credit lending has become.

Behind the veneer of the self-congratulation, jaw-dropping riches and plain excess – witness Blackstone Group chief Steve Schwarzman, who made $400-million last year and hired Rod Stewart to perform at his 60th birthday party – the first cracks are beginning to appear. Some private equity players say too many deals are getting done at prices that are too high; on average, buyouts firms in the U.S. are paying roughly 50 per cent more for assets than they were in 2001.

The bidding wars are great for shareholders of public companies, but afterward, they also leave those businesses encumbered with far too much debt, much of it borrowed under looser terms than ever. Some of the biggest buyout deals of the past few years – Freescale Semiconductor in the U.S., Masonite International in Canada – are already showing some financial strain.

Today, a few bankers have publicly voiced concern about foolish lending, among them Bank of America chief executive officer Ken Lewis, who recently got the attention of the world's banks when he said: “We are close to a time when we'll look back and say we did some stupid things.”

In the U.S., banks hold just 20 per cent of “leveraged loans,” a term that describes not just buyout loans but other junk debt, according the Standard & Poor's.

The other 80 per cent is held by institutional investors – hedge funds, mutual funds, pensions, insurance companies and so on. The biggest buyers are financial engineers who acquire a bunch of loans, pool them together as collateralized loan obligations, or CLOs, and sell them off in pieces – very often to those same hedge, mutual and pension funds.

CLOs didn't exist during the big buyout wave of the late 1980s, and they didn't become “dominant” buyers of high-risk loans until 2002 and 2003, says Steven Miller, who analyzes the speculative loan market for S&P. While they've been a haven for the banks as a place to easily offload speculative loans, the presence of CLOs creates a longer daisy chain – middlemen upon middlemen – dividing those loans up into ever-smaller slices.

The result is that the banks, now acting more as loan brokers, are less vigilant about the kinds of loans they arrange, since they know that they likely won't be holding the loan for long.

Does this sound familiar? It should – because it's similar to the way the U.S. subprime mortgage operated during its high-growth years. Mortgage brokers, scurrying to sign up clients as quickly as they could, were lax in weeding out customers with poor credit. When those borrowers began to default in large numbers, the usual buyers for subprime debt quit purchasing it, and those left holding billions in poor-quality loans – companies like New Century Financial – went broke, out of business, or swallowed their losses.

The fees for arranging loans are as alluring for the commercial banks as they were for subprime lenders.

“It's like crack cocaine for them,” says the unnamed private equity partner. In LBO deals, “the banks don't care any more about the [quality of] credit. As long as they can sell it all, they're fine.”

Large private equity firms know this and are taking advantage. The heated competition for their business means not only cheap money, but easy terms.

So-called “covenant light” deals, such as Kohlberg Kravis Roberts & Co.'s $26-billion takeover of First Data, remove many of the usual conditions attached to loans; borrowers aren't required to keep their debt below 6 times their annual EBITDA, for example, or to ensure that their interest payments consume no more than half of their cash flow. (EBITDA is earnings before interest, taxes, depreciation and amortization.)

The idea is to “make it harder for the banks to find a default that would allow them to call the loan,” says Jay Swartz, a lawyer at Davies Ward Phillips & Vineberg LLP who works on private equity transactions. How many big LBOs are being done covenant light? When it comes to deals by KKR, Blackstone Group and other large private equity shops, “virtually all” are done this way now, confesses a New York-based banker for a large Canadian financial institution.

Three years ago, U.S. firms taken over in LBOs had free cash flow that equalled 2.6 times their interest expense - so if the business took a dive and cash flow fell by half, they could still make their payments. That's no longer the case. The cash-flow coverage ratio has shrunk to 1.7 times, according the S&P's Mr. Miller, the lowest level since the bull market of the late 1990s.

These are the subprime borrowers of the corporate world, and they, too, have their own inventions for making a heavy debt load a little bit easier. The housing industry had adjustable-rate mortgages; Wall Street has "toggle bonds," which allow the borrower to choose to pay interest by issuing more bonds, paying even higher interest, instead of cash.

Toggle bonds are not a totally new concept, but they tend to be issued only in exuberant times. They have proven to be dangerous in an economic downturn.

It's easy to understand why a company would want to sell a toggle bond, but harder to reckon the appeal for those buying them. Who wants to lend money to a company that's so strapped for dough, it can't even pay its interest in cash?

The reasons are simple. Many hedge funds use borrowed money themselves to amplify returns. So all they need to do is find some debt that's yielding, say, 10 per cent, buy a lot of it with money they've borrowed at 7 or 8 per cent, and collect a healthy spread - and fat fees - in between.

And if that strategy explodes in their faces because they end up holding some worthless junk debt? So be it. For as long as it lasts, it's an easy route to profits. Hedge funds get into trouble and are forced to close shop all the time, but no one ever asks them to return their fees (generally 2 per cent plus 20 per cent of the investing profits).

"Why would you not just take the highest possible risk with other people's money? If there's literally no downside, it's the rational thing for you to do," says Mr. Fridson.

The history of such lowly debt like that is not very encouraging; usually, more than one-third of it goes into default within the first three years. It's not a question of whether a large LBO implodes, but when it will happen and who will be left holding the bag.
It's no secret there have been relatively few defaults on even the junkiest of junk so far this year. The reason is simple: companies that would (and should) have been wiped off the face of the earth by default were given a lease on life by investors willing to refinance that debt on insanely favorable terms to the debtors, regardless of risk.

“The process feeds on itself until the patient dies”

The speculative action in LBOs, junk financed buybacks, and toggle bonds is indeed quite like that of junkies hooked on crack cocaine. It's fitting that the words junk and dealers both apply. The only difference is this high comes from debt leverage instead of cocaine. And why not pile on the risk and shoot for the stars with as much leverage as possible? After all it's OPM (other people's money) being bet. In both cases the next fix takes more and more leverage to generate the same high. And in both cases the process feeds on itself until the patient dies. But before this all blows up, enormous fees are generated for the dealers, in this case investment bankers and hedge funds.

Fantasy Land for Corporate Treasurers

The Standard discusses toggle bonds in Junk bonds spark jitters.
"Defaults are almost non-existent today and, well, we know that doesn't hold forever," said Thomas Lee, who stepped down last year from Thomas H Lee Partners, the Boston-based takeover firm he founded 32 years ago.

"When the economy goes bad, defaults will spike up from 1 percent into the 9 percent level," Lee said at the Milken Institute Global Conference in Los Angeles last month. "If that happens then the financing part grinds to a halt" for LBOs, he said. More than half of the junk bonds sold this year were used to pay for leveraged buyouts and mergers and acquisitions, notes Barclays Capital.

Money is so easy to come by that for the first time some investors agreed to let borrowers choose to make interest payments in cash or in additional bonds. "This is fantasy land for corporate treasurers," said Edward Altman, a professor of finance at New York University's Stern School of Business.

The growth of toggle bonds is a symptom of too-easy credit, Fridson said. Giving companies the ability to pay interest with more debt rather than cash shows they "have a reasonable likelihood of needing to exercise that option," he said.

Companies are piling on debt even as the economy slows. Total debt for about 300 companies rated BB and B rose by 16 percent last year, double its growth in 2005, according to Fitch.

Ford Motor lost US$282 million in the first quarter and is US$23 billion deeper in debt than it was a year ago. The Dearborn, Michigan-based company's US$3.7 billion of 7.45 percent bonds due in 2031 trade at a yield premium of 4.63 percentage points, down from 5.38 a year ago, according to Trace, the bond-price reporting system of the NASD. Ford is rated Caa1 by Moody's.

More than US$108 billion of so- called covenant-lite loans, or those that do not hold borrowers to limits on quarterly debt, have been completed this year, compared with a total of US$36 billion in the previous 10 years, according to S&P's LCD.

"The normal thing is two to four years after the issuance for defaults," said NYU's Altman. "Deals with little covenants, toggles, push back the timeline. But it's gotta happen."
Note that as Ford went $23 billion deeper in debt the presumed risk of default dropped given that spreads fell by 75 basis points.

Postponing the Day of Reckoning

Investment News describes toggle bonds and distressed debt in general the situation in Returns on distressed debt piquing investor interest.
Distressed debt can be risky, but that hasn’t stopped investors from turning to it in search of extra yield, industry observers say. Returns on distressed debt — junk bonds with a very high likelihood of default — were a strong 11.4% in the first quarter, outstripping all other asset classes, according to a recent report from Standard & Poor’s in New York.

But there isn’t a lot of distressed debt available for those investors who hope to jump on the bandwagon, said David Keisman, an analyst at Moody’s Investors Service in New York.

There is so much liquidity in the market right now that financing is easy to come by, he said. Companies that normally would have found themselves in default have been able to refinance their debt, Mr. Keisman added.

But are these “rescues” permanent or are defaults merely being pushed off for a later date? That is a distinction Mr. Keisman said is impossible to determine until it is too late. “No one is forecasting much of a default rate in 2007,” he said.

There have been 10 sales of toggle bonds this year, totaling $5.14 billion — a record, according to S&P.

The effect of toggle bonds, as well as some of the rescue financing, however, will be to push off junk bond defaults to a later date, said Martin Fridson, chief executive of FridsonVision LLC, a New York high-yield research firm.

Junk bonds — and distressed debt, in particular — will continue to win fans, because it is hard to predict what the catalyst might be for a rise in defaults, said Rick Fulmer, a Denver-based vice president and bond trader with D.A. Davidson & Co. of Great Falls, Mont.

Because spreads between high-yield bonds and U.S. Treasuries are much tighter than normal, investors have to take on more risk for less reward. But the economy still is strong, and companies still are able to pay off their debt, Mr. Fulmer said.
The Catalyst

Here's an interesting sentence from the above article: "It is hard to predict what the catalyst might be for a rise in defaults."

I strongly disagree. The catalyst is easy to predict (even if the timing itself is difficult). It will be a sudden change in risk tolerances of hedge funds, investors, and/or others to do these deals.

I talked about sudden changes in sentiment in Consumer Sentiment Wanes as Housing Slumps.
Flashback Summer 2005

Floridians were camping out overnight in lines to buy Florida condos. Prices were soaring. Did prices start falling or did the pool of fools willing to buy Florida condos at increasingly absurd prices dry up first?

Flash Forward Summer 2007

Will stock prices drop first or will the pool of fools willing to finance increasingly absurd leveraged buyout deals and debt financed stock buybacks dry up first?
In 2005 the conventional wisdom was that it would take much higher interest rates to sink housing. Conventional wisdom was wrong: the catalyst was a sudden and sustained change in the willingness of fools to invest in Florida houses . In short: the pool of greater fools simply dried up.

Whether it's housing, leveraged buyouts, toggle bonds, distressed debt in general, or stock prices, it will be a change in appetite for risk that leads the charge.

With that thought in mind let's turn or focus on the question: "But are these 'rescues' permanent or are defaults merely being pushed off for a later date? That is a distinction [that] is impossible to determine until it is too late."

Too Late Already

I suggest that it is possible to determine whether or not it's too late. Furthermore I suggest that it's already too late.

Flashback December 13 2005: It's Too Late. This is what I wrote:
I think it's too late.
In fact I know it's too late.
How do I know?
The following Email I received tonight should explain it nicely.
When you see stuff like this, not only is it too late, it's way too late.

Just and there was too much housing and subprime garbage in 2005 to be unwound, there is now too many toxic CDOs, toxic CLOs, toxic toggle bonds, toxic LBOs, and simply too much toxic stuff in general to be unwound. And when the unwinding attempt really gets going (it has now barely started) there simply will not be any bids for most of this toxic garbage. Want proof? Just ask Bear Stearns. The debacle at Bear Stearns is but a drop in the bucket for what's to come.

Mike Shedlock / Mish

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