Saturday, July 28, 2018

Steven Pearlstein - The junk debt that tanked the economy? It's back in a big way.

Loans to highly indebted businesses — that are packaged into securities — are up 38 percent this year.

Was further deteriorating the banking sector a good idea? Whose idea was it anyway? KV

Like most people, you probably assume that the level of lending done by banks at any moment is largely driven by how much demand there is from borrowers. But in the world of modern finance, that’s only part of the story. For just as important is the level of demand from investors — pension funds, hedge funds, mutual funds, sovereign wealth funds and insurance companies — to buy the loans that banks make. Indeed, there are times when there’s so much demand for loans from investors and the profit from selling them is so lucrative that bankers are only too happy to go out and make bigger and riskier loans than they would if they were keeping them on their own books.
That was the situation back in 2006 when investors were so keen to own “mortgage-backed securities” that Wall Street was begging lenders for more and more “product.” You know how that turned out.
Now it is happening again, as investors and money managers scramble to buy floating-rate debt — debt offering interest payments that will increase as global interest rates rise, as they are expected to over the next few years. A big new source of floating-rate credit is the market for “leveraged loans” — loans to highly indebted businesses — that are packaged into securities known as “collateralized loan obligations,” or CLOs. Because the market seems to have an insatiable appetite for CLOs, leveraged lending and CLO issuance through the first half of the year are already up 38 percent over last year’s near-record levels.
Credit-rating companies such as Standard & Poor’s and Moody’s have recently warned that this surge in corporate borrowing and lending has led to a noticeable decline in the quality of the loans. The borrowers have lower credit ratings. The loans contain fewer of the standard conditions that are meant to protect lenders. And the rating companies calculate that lenders should expect to recover less of their money if the borrowers default or go into bankruptcy.
For the most part, however, these warnings have gone unheeded. Although some sophisticated investors have begun to pull back from the CLO market, they have been replaced by retail investors seeking higher yields who have flocked to mutual funds and exchange-traded funds that specialize in CLO debmiss.
Many of the borrowers in the leveraged loan market are midsize companies that most people have never heard of. But some are large companies that you would recognize — Dell, Tesla, Uber, BMC Software, Japan’s SoftBank and office-sharing company WeWork. What they all have in common is that they already have so much debt that their credit rating is below investment grade, or “junk” as it is known on Wall Street. In effect, they are the “subprime” borrowers in the corporate loan market.
The Washington Post

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