Where Have All the Checkbooks Gone?
The days of easy money may be over. On July 24 the Dow Jones industrial average tumbled 226 points after mortgage lender Countrywide Financial Corp. warned of more rough times to come in the housing market. The next day, banks pulled an offering for $12 billion in loans to fund private equity firm Cerberus Capital Management's buyout of Chrysler Group. [On July 26, the Dow Jones industrials plunged more than 300 points in intraday trading, dogged by the same credit and housing market worries.]
Painful though the events were, they were only the latest signs of trouble in the credit market. Several other multi-billion-dollar loans to finance buyouts, such as those of British pharmacy chain Alliance Boots PLC and pest control company ServiceMaster Co., have also been delayed or renegotiated. Even ordinary corporate debt is being second-guessed. Online travel site Expedia Inc. was forced to scale back its planned share buyback by 80% after it became too costly to borrow the money to pay for it.
The longer investors boycott debt offerings, the more serious the consequences could be for the markets and the economy. The private equity and stock buyback booms of the past few years, both fueled by cheap debt, could slow. If that happens, the stock market, which has broken records recently, would lose two critical legs of support. And if companies are starved of capital, the economy may slow, too. "We're in a liquidity squeeze, and it's going to take a little while to work out," says James Ferguson of investment management firm Octagon Credit Investors.
Conditions are likely to get worse before they get better. Thanks to the surge in leveraged buyout activity during the past year, there are plenty of loans already in the pipeline. Reuters' Loan Pricing Corp. says the value of leveraged loans waiting to be sold is $231 billion, up from $62 billion this time last year—and 2006 was a record year. "There's a massive amount of supply coming," warns Meredith Coffey, Loan Pricing's director of analysis. "But there are very few buyers." Analysts suggest it could take the rest of the year for underwriters to sell the backlog of loans. "Until the current deals clear, there's going to be a lot of pressure on loan prices," says Steven C. Miller, managing director at researcher Standard & Poor's LCD.
Meanwhile, the market for collateralized loan obligations—exotic securities similar to CDOs but backed largely by leveraged loans—has all but evaporated. CLOs and leveraged loans are the main sources of funding for private equity firms. In the first half of this year, some $58 billion in CLOs was sold. But there's $10 billion or so of CLOs in the works now, according to LCD.
The markets aren't panicking yet. Defaults on corporate debt are still near an all-time low. And no private equity deal has fallen apart. Buyout firm Clayton, Dubilier & Rice Inc. was able to close on its $5.5 billion acquisition of ServiceMaster even after scuttling its $1.15 billion bond offering. Other deals that were announced earlier this year are still getting done—but with some of the terms rewritten to be friendlier to debt investors or with banks eating the loans themselves.
But if conditions get worse, the results could be painful. A deeper credit slump would almost certainly put the brakes on the LBO market. Stock buybacks could be in jeopardy, too. So far this year, U.S. companies have repurchased $240 billion in stock, compared with $85 billion at the same time in 2004, according to S&P's Howard Silverblatt. Some say the stock market, which as measured by the S&P 500 is up 7% for the year, hasn't yet reflected the growing problems in credit. Says one bond trader: "The stock market is close to its record high [at a time when] people don't want to loan money." Something, he says, has to give.