The Wall Street Journal-20080206--Anyone for Some Used Corporate Debt--- Why Leveraged Loans That Financed Buyouts Are Causing Bottleneck

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'Anyone for Some Used Corporate Debt?'; Why Leveraged Loans That Financed Buyouts Are Causing Bottleneck

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A new problem is rippling through credit markets: Many of the corporate loans used to finance giant buyouts in the past few years are reeling in secondary market trading, making it virtually impossible for banks to unload other commitments they have made.

The loans of First Data Corp., which was taken private in September by Kohlberg Kravis Roberts & Co. for about $28 billion, were sold into the market this past fall at a 4% discount to their par value; they now trade in the market at a steep 11.5% discount to par value, according to Reuters LPC.

Loans of Freescale Semiconductor Inc., taken private by a consortium of private-equity firms in December 2006 for about $28 billion, are trading at a 15.5% discount to their original value; Tribune Co., which was taken private in April by investor Sam Zell for $8.2 billion, issued loans now trading a 26% discount.

The loans are known by investors as "leveraged loans," used by companies often with low credit ratings to raise money, often for buyouts. They are issued by banks and sold to investors like junk bonds, though leveraged loans tend to be safer because their investors get paid off in a bankruptcy before junk-bond investors.

Double-digit declines in the market value of these loans are very unusual, and a big problem for many banks, which sit on a pipeline of $152 billion in loans that they have promised to make but have yet to sell to investors.

With the prices of existing loans tumbling, investors have little incentive to buy new loans unless they are sold at steep discounts, something banks are reluctant to do.

The result: More assets building up on bank balance sheets, growing tensions among rival bankers who had grown accustomed during the buyout boom to cooperating with each other and a deepening crisis in the market for buyout debt.

The crisis started last summer, when investors turned up their noses at billions of dollars in buyout debt, just after many buyout firms and their bankers made commitments to history-making megadeals. Many investors say January was the worst performance for this market since those summer months.

"This is bizarre and baffling," said Thomas Ewald, chief investment officer of Invesco Senior Secured Management, on a panel at a Loan Syndication and Trading Association event Monday. "Loans trading in the 80s are typically on the verge of bankruptcy or a major restructuring event."

It is far from clear that many of the companies behind these loans are flirting with that kind of distress. Private-equity firms say that in most of these cases their portfolio companies are performing well.

Nevertheless, investors are jittery about corporate performance, because defaults are starting to rise as the economy slows. Already this year, nine companies -- mostly smaller ones -- have defaulted on leveraged loans, more than the two defaults all of last year.

Another problem is that a source of investor demand for these loans has dried up. Investment vehicles called collateralized loan obligations were huge consumers of corporate loans in 2006 and early 2007.

CLOs, as they are called, hold bundles of loans and are sold to investors in slices with varying levels of risk and return. As defaults rise, demand for the riskiest pieces of these instruments is undermined.

"We've lost a major source of funding, and the market is still struggling to find an alternative," says Steve Miller, managing director at Standard & Poor's Leveraged Commentary & Data.

Investment banks last year touted new investors in the loan market -- hedge funds and high-yield bond investors that crossed over into loans. Many investors were burned on their bets in buyout-related loans when their secondary market values dropped.

Falling short-term interest rates pose another challenge. Interest rates on leveraged loans typically rise and fall with the short-term London interbank offered rate, or Libor. Libor has fallen sharply in recent weeks, thanks to Federal Reserve interest-rate cuts, meaning these loans are giving their investors smaller returns. Libor at the end of December was 4.7%. It now stands at 3.2%.

Some investors are turning to moving out of loans to find better yields in fixed-rate junk bonds.

Hedge funds are also being pushed out of the market as facilities called total return swaps unwind.

Total return swaps are set up by banks for hedge funds and other investors to buy loans with borrowed money. As the value of the loans declines, provisions in these swap agreements are being triggered that act like margin calls to unwind the contracts.

The saga of Harrah's Entertainment Inc.'s loan sale is a sign of the distress in the market. Credit Suisse broke from a group of banks lined up to sell $7.25 billion in loans tied to Harrah's buyout. It offloaded its commitment of about $1 billion through derivatives transactions in December, says a person briefed on the transaction. The move sent other banks scrambling to sell some of their own Harrah's loan commitments in January, and the price of the loans dropped to between 91 and 92 cents on the dollar, bankers said.

The transaction roiled other underwriters involved in the deal who were unable to sell their portions of Harrah's debt, but didn't want to sell it at such a steep discount.

The deal "reset the market," said Invesco's Mr. Ewald. He says he now doesn't want to buy any other comparable offerings at anything over 92 cents on the dollar.

Last week a Lehman Brothers-led group abandoned its three-week effort to sell CDW Corp.'s $2.2 billion loan to buyers. The deal failed to generate interest even though they were offering to sell the loans in the low 90s. In October, Madison Dearborn Partners LLC and Providence Equity Partners acquired CDW, one of the country's largest technology-equipment resellers, for $7.3 billion.

Some banks have decided that they would prefer to hold some of the loans on their books as investments, rather than sell them at deep discounts.

"At these price levels we think some of them may be terrific long- term assets to hold," said James Dimon, J.P. Morgan Chase & Co.'s CEO, on a conference call with analysts last month.

The New York bank was holding about $26.4 billion in leveraged loans at the end of the fourth quarter, after shedding about $16.5 billion of the debt during the period.

J.P. Morgan executives said they are considering hanging onto about $5 billion of the loans, which Mr. Dimon said appear to be "recession- proof," until they mature.

Muni-Bond Auctions

Feeling the Pressure

The ratings shakeout in the bond-insurance industry has helped cause the failure of municipal-bond auctions -- the first known instance of this since 1991.

At least six sales of tax-exempt auction-rate securities -- one of them by Georgetown University in Washington, D.C., and all insured against default -- failed to draw sufficient investor interest the past two weeks. Trouble in this $250 billion market could mean higher financing costs for governments, just at a time when they are already facing slower revenue growth as the economy weakens.

The auction failures shed new light on how vulnerable some municipal-bond issuers have become in the current credit-market shakeout.

"The market for this paper is in disarray," said Joseph S. Fichera, chief executive officer of Saber Partners, a New York City-based financial adviser to public entities and corporations.

Georgetown is "reviewing the current volatility of bond auctions" and considering the "appropriate course of action" to best meet its long-term financial position, said the university's chief financial officer, Christopher L. Augostini, in an emailed statement.

Sierra Pacific Resources Finance Chief Bill Rogers, who also saw an auction fail for a Nevada Power Co. unit, said he has considered alternatives, such as issuing longer-term tax-exempt bonds at a fixed rate, but added, "We're hopeful that this particular experience is a blip."

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Stan Rosenberg and David Enrich contributed to this article.

AUCTION RESULTS

Here are the results of the Treasury auction of four-week bills. All bids

are awarded at a single price at the market-clearing yield. Rates are

determined by the difference between that price and the face value.

Applications .................................. $65,621,397,000

Accepted bids ................................. $26,000,020,000

Accepted noncompetitively ..................... $378,897,000

Foreign noncompetitively ...................... $100,000,000

Auction price (rate) .......................... 99.828111(2.210%)

Coupon equivalent ............................. 2.251%

Bids at market-clearing yld accepted .......... 34.17%

Cusip number .................................. 912795D24

The bills are dated Feb. 7, 2008, and mature March 6, 2008. (See related article: "A Year of Reckoning: Junk-Bond Defaults Are Seen to Multiply" -- WSJ Feb. 6, 2008)