Saturday, August 4, 2007

Leverage and Its Uses

During the Universal Debt Bubble (UDB), corporations borrowed a lot of money, so where did it go? Quite a bit of it went into buying other companies as worldwide buyouts reached a record $4.06 trillion in 2006, with about 40% of that in the USA. That was well above the previous record $3.3 trillion in 2000. The difference was that the M&A boom in 2000 was done largely with stock; this one is funded with debt. When things went bad in 2000, the equity didn't have to be paid back, but the debt from the current frenzy will.


While a lot of money went to buy other companies' stock, another big chunk funded companies who bought back their own stock. Naturally, all of this debt-funded stock buying has served to prop up equity prices. Many shareholders came to believe that they were in a no-lose position because of continuous demand from buybacks. And if anything went wrong, someone else would swoop in and buy the whole company as part of the M&A wave. That sort of overconfidence is usually a setup for a big fall - which looks to be starting now.


Until very recently, we were on pace for takeovers to be even higher in 2007 than last year. Then someone apparently had a blow to the head that restored rational thought processes. The interest payments on many of these deals could barely be supported in the current good times. What might happen in bad times is something I don't like to think about. Apparently, many market participants agreed and collectively decided not to think about it - until forced to as buyout deals started to go sour. There are apparently some $300 billion worth of deals that still need funding and can't get it.
-----
"Investment banks including JPMorgan Chase & Co. and Citigroup Inc. have promised to sell about $300 billion in bonds and loans to fund takeovers of companies including TXU Corp. and First Data Corp. Investors have balked at buying much of the debt offered so far"

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aK_K.Nq65USQ



The banks have stuck their necks way out there and are not anxious to increase their exposure further. In fact, they are trying hard to get out of the deals they've already committed to doing. There will be little M&A activity for the foreseeable future. To a significant extent, company stock buybacks are also dependent on debt. The clearest case of this was Expedia, which was forced to cancel 80% of its buyback when their borrowing fell through.
http://www.reuters.com/article/marketsNews/idUKN2333911620070723?rpc=44


With the takeover wave in full retreat and much of the fuel for stock buybacks being choked off, the two key pillars supporting the stock market are looking very shaky. For now, that should be more than sufficient the keep stocks weak.

Once we go out a few months, the far larger fundamental problems will start to become apparent. First, is the large number of companies that should already be bankrupt but have been kept on life support by cheap debt.

-----

"The persistently large volume of 'CCC - C' rated bonds in combination with a historically low default rate suggests that liquidity more than fundamentals kept defaults in check."

"'CCC - C' issuers are generally only able to service their significant debt burdens by tapping external funding and have no cushion to sustain them if business or borrowing conditions soften. "

http://www.thefreelibrary.com/Fitch%3a+U.S.+Deep+Speculative+Grade+Issuers+Living+on+Borrowed+Money%2c...-a0157197082

Well, borrowing conditions have already softened and these companies can no longer borrow more money to pay off the interest like they've been doing. In addition, we have just over 2 months until the reports for the 3rd quarter start to come in. That will be when many financial firms are going be forced to report just how much the end of the UDB has cost them. It could get ugly, but that's another topic.