A private equity fund of funds manager last week puzzled over the apparent contradiction between the state of his portfolio, which was in rude health, and the tumult in the debt markets, which are effectively shut for new leveraged loan business.
“It’s all about sentiment,” he told PEO. And that has become a self-fulfilling prophesy of despair.
“How can Alliance Boots, the UK pharmacist and retailer, have a record Christmas and still be an impaired credit?”
Contagion is the answer and the accounting compulsion to mark to market. Distressed sellers have driven down even good credits as they are marked to market. Credit vehicles, such as collateralised loan obligations, face fire sales as the fall in the value of their underlying collateral forces them to liquidate assets.
The price spirals down with each reflex jerk of the market.
News yesterday that Warren Buffett, the legendary US value investor, had put together a rescue package for the monoline insurers gave some succour to the market. But Buffett was only interested in the gilt-edged contracts insuring loans to municipal authorities, not those to riskier CLOs. The structured vehicles were one of the driving forces behind the leveraged loan boom.
And yet although the debt may be trading at distress levels off-putting to Buffett, as Standard & Poor’s LCD research points out, there is quite a lot of default risk already priced into US current prices which are heading towards 85 cents on the dollar.
S&P LCD estimates default rates would have to rise to roughly 10 per cent, well beyond the 2000 high of 8.2 percent, to wipe out the excess risk premium priced into current US loans.
Back then to our private equity fund of funds manager: “Whoever ends with the paper is going to make a killing in three to four years. This is just profit deferred. Someone is going to look very clever.”
But if not Buffett, the sage of Omaha, then who? It will take nerves of steel to step in and relieve the banks of the burden, especially if the economic outlook worsens. Even robustly performing businesses such as Boots will struggle to buck the prevailing trends indefinitely. It looks like the banks will be licking the wounds for a while yet.