Liquidity Liquidity Everywhere

[uranasss]

Don't do it, you'll end up buying puts on everything and expecting the world to end!



Haven't heard him comment on CPDO's yet, but that ought to be a fun one.

[kr]

Questions raised over how long buy-out funding can last



By Paul J Davies



Published: May 24 2007 20:11 | Last updated: May 24 2007 20:11



Richard Bernstein expressed a thought this week that is almost complete heresy in current markets. The chief investment strategist for Merrill Lynch in New York wondered whether liquidity was actually starting to ebb?



The thought came from two pieces of anecdotal evidence suggesting the cost of leveraged buy-outs could be on the rise: firstly that US debt financing for some deals was rising and secondly that equity investors were demanding higher premiums to pass companies into private hands.



His comments echo the concerns recently expressed by the noted British fund manager Anthony Bolton; namely that cheap debt is fuelling higher asset prices and that this state of affairs is not permanent.



“My point was that if the cost of financing is starting to rise and investors are beginning to demand a higher premium, then LBOs will get more expensive,” Mr Bernstein says.



“People talk about the ‘private equity put’ on the stock markets like they used to talk about the ‘Greenspan put’. Who knows how long it will last, but the notion that it’s permanent is not true.”



He says today’s market is a lot like 1988-90’s.



“There is a huge LBO boom, a huge real estate boom and people then ascribed permanence to the liquidity that was financing it and they forget now how quickly that dried up when it did.”



There is very little evidence so far from the US or European loan markets that the cost of leveraged finance is beginning to rise in the way that Mr Bernstein’s “knowledgable sources” have told him it is.



There has been some talk of investors pushing back on deals they did not like. Chemicals company Ineos this week narrowly avoided a showdown with creditors over cutting the interest on it loans while increasing their size and there were rumours earlier this year that many investors would protest over the removal of subordinated debt in the loans to Numericable, a French cable group, although they kept quiet in the end. But such examples are few.



However, there are signs that investors in specialist investment vehicles that buy much of this debt on both sides of the Atlantic are demanding higher premiums since late February or early March (see chart).



Furthermore, many bankers in the leveraged finance industry are aware that in the heat of the competition to get a slice of the private equity action, they are underwriting increasingly aggressive structures.



It is often said that banks do not have to worry about underwriting standards in this market because they can quickly sell it on to other investors.



But this is far from the case, according to bankers. They say that a lot can change in the long lead times between committing to underwrite a deal and reaching the point when the debt can be sold– the warehouse period.



“Deals are increasing in size and structurally becoming more complex. As a consequence, we are extremely focused on disciplined risk management,” says Kristian Orssten, head of high yield and loan capital markets at JPMorgan in London.



Hamish Buckland, head of European leveraged finance origination at JPMorgan, adds: ”Whenever a bank underwrites a deal, it is taking market risk and operating risk until the loan is syndicated [or sold] into the market. Anybody who remembers the last turn in the cycle knows that changes in risk appetite or a company’s performance can quickly affect the success of transactions.”



Other leveraged finance bankers on both sides of the Atlantic identify this as their biggest single concern about the current loan markets. It is the “warehousing” risk that caused significant pain for a number of banks in the US subprime mortgage market recently.



That crisis illustrates just how quickly a market for selling loans on to investors can shut down. Furthermore, the close inter-relations between different securitised debt markets – the vehicles that provide liquidity to leverage loans, mortgages and other types of debt – mean that subprime mortgage has had an impact on the funding for leveraged loans and other kinds of debt.



Spreads – or risk premiums – on the more junior notes issued by collateralised loan obligations, the vehicles that buy a significant portion of leveraged loans, have widened significantly. Part of this is due to concerns among investors that there could be similar problems with lax underwriting standards as in subprime mortgages.



Another part of the problem for CLOs is that structured finance collateralised debt obligations – which are dedicated to investing in the junior slices of mortgage backed securities along with CLOs and other types of securitisation – have seen demand almost entirely disappear because of their direct exposures to subprime-backed bonds.



Removing a source of demand for junior CLO debt has made funding the entire vehicle more difficult – and expensive.



Finally, the competition among CLOs to buy debt is one of the things that has encouraged lower costs and looser protections for lenders. This makes it more difficult for CLOs to generate the returns they have promised investors without taking on more exposure to riskier kinds of debt, which in turn leads investors to ask for higher premiums.



This is all happening while many CLO managers – particularly newer ones – are already concerned about their ability to generate good enough returns to pay their investors.



It is far from certain how CLOs and their investors will react to these dynamics even before a rise in default rates. Mr Bernstein’s warning about the current surfeit of liquidity seems well worth heeding.



Copyright The Financial Times Limited 2007

[AndyM]

Uranass, you don't have to believe everything you read Wink



But reading bearish authors is always a bracing corrective to all the happy talk we get fed every day.



JG is a first-rate historian with a droll wit and a fantastic eye for great anecdotes. Always worth a read... (I suspect you agree).

[uranasss]

Wouldn't own the book otherwise--signed copy to boot!

[IAmEric]

Remember those old "Jack in the Box" toys? Those things always phreaked me out. You wind the crank and that song plays menacingly, the more it winds the more intense the anticipation becomes.



[img]/User%20Files/257/ANIjackInBox.gif[/img]



Does anyone else feel that way about the state of the (global) markets today?

[jungle]

You bought a sandwich board yet?  Jus' playin'... Wink

[apine]

iae - it seems like that, but when it is time to allocate capital, the tide against you seems so strong. not only do you risk losses, but then everyone else looks at you (boss, investor, or otherwise) and questions your judgement. it really is taking a big stand.



one strange thing is that it seems like such a strong trend and then apparently John Henry, a trend follower, is not doing well. go figure.



one other thing that i have talked with people about is that everyone is aware that "this is unsustainable." and while it keeps going on, of course, the argument is that it is priced in. after all, the market is aware. but i'm not sure that this time it matters whether the market is aware. i think that participants have no choice but to jump on the ride. unlike in prior years, players HAVE to be fully invested or they get penalized by their investors or simply are required by mandate to be fully invested. so everyone is riding along at 105mph (yes, the American non-metric standard) without their seatbelts on knowing that their will be massive pile-up at some point but unable to use the brake no matter how much they would like to. any comments on this?

[uranasss]

JWH and most other large "trendies" have the bulk of their assets in G10 FX & Rates with smaller allocations to energies, metals, stocks, etc...  The real juice has been in "risk assets" like emering mtk stocks, commodities (read: base metals/grains/energy), and fx carry (emerging mkts vs. yen/swissy).  Campbell is actually down on the year, and they are probably the best in that space for their asset size.

[dgn2]

I 100% agree with apine's last statement. I will add that the forces that make this necessary will also make it worse when it comes apart in my opinion.

[Scotty]

The tech boom:  in 1997 there was a lot of talk about it being unsustainable.  Except it continued for another couple of years.  Although it did end in a big way.



Nevertheless...



Competitive pressure between investment banks seems a strong, almost irresistible force.  "GS is making a lot of money in private equity and prop - we need to compete!" (regardless of whether we have the culture, skills, infrastructure in place).  I presume hedge funds have a similar dynamic.  It guarantees an overshoot (too much money into riskier than expected deals with less and less protection).



Hmmm...what can you do with senior management?