In mid July, investors refused to buy $11 billion of new bonds and loans that Goldman Sachs, JP Morgan, Citigroup, Lehman and the other Wall Street banks created to finance major leveraged buyouts (LBOs): DollarGeneral, First Data, TXU, ServiceMaster, US Foodservice, etc. The huge excess supply of unwanted debt created the worst high-yield debt bear market in two years. Institutional investors had globally hit a pivotal point; realizing that they had too much risk in their portfolios, they:
- Determined that they were not adequately compensated for the risk they were incurring
- Refused to buy new low yielding risky paper
- Began to shed risky assets
The cost to the banks of tying up billions of dollars of their capital immediately curbed the flood of LBOs. Compounding the worsening situation, the banks themselves realized that they too needed to shed risk (i.e., sell assets).
A paucity of corporate loans will mean fewer mergers and acquisitions (M&A), private equity deals and stock buybacks, which in turn will impact the fixed income markets. In fact, the capital markets reacted sharply negative when news spread that two private equity deals, the planned acquisitions of Chrysler and Alliance Boots, had trouble raising capital. Expect a stark turnaround from the recent surge in M&A activity, with deals valued at more than $1.5 trillion occurring in the second quarter alone, double the worth of deals in the second quarter of 2006. August will see a drastic re-pricing of risk, which is going to have an impact on anyone who needs to borrow money. The downward trend will become self-fulfilling, with the potential for continued softness for a while.
Home prices have not softened much yet, but they will. The supply of unsold homes continues to build to levels not seen in many years. Meanwhile, buyers are not stepping up to plate as they wait for sellers to slash prices. Simultaneously, the financial options for buyers have been worsening as mortgage rates climb and banks tighten lending standards. The net effect may be that even as sellers slowly cut prices, buyers may not be able to afford the homes. For example, one can afford a lot more home in a 3% environment with no money down than in a 6% or 7% environment with ten to twenty percent down. Unless the government intervenes, prices will probably break down. Simultaneously, homebuilders are finding themselves in even more of a pickle as their inventories increase, financing costs escalate, write offs continue and buyers stay away.
Michael Ashley Schulman, CFA
Hollencrest Capital Management