Straits Times: Loan defaults: The worst is yet to be

NEWS ANALYSIS
Loan defaults: The worst is yet to be

NEW YORK: The weak go first, and people take comfort from the very weakness of the fallen. The fact that it is only the weak who are suffering is taken as proof that there is no general problem.

That is how it is with the mortgage mess, still called the sub-prime crisis though it has long since spread. There are more prime mortgages going into foreclosure than there are sub-prime ones.

Now the world of corporate loans looks like mortgages, circa 2007.

Defaults are on the rise, but they are concentrated among small companies in industries with big problems.

Standard & Poor’s (S&P) reported this week that the default rate – the percentage of leveraged loans in default – rose to a five-year high of 3.3 per cent last month. At the end of last year, the rate was a tiny 0.24 per cent, or about one in 400 loans.

‘There have been no high-profile, high-impact defaults,’ S&P reported. It pointed out that while 3.3 per cent of loans are in default, those loans amount to just 2 per cent of the money lent. Few big loans have gone bad.

The loans that have gone bad have been concentrated in two industries – real estate and car parts. S&P calculates that they have accounted for almost half of this year’s defaults. Gambling has also had problems, as it turns out that there are too many casinos in some places.

It has been easy to write off as unimportant most of the recent defaults. WCI Communities? What did you expect from a home builder with major operations in Florida? Intermec? It is a car parts supplier overburdened by debt when it came out of its previous bankruptcy in 2005.

But the trends that felled those companies are present for many others, and just as good times can reinforce themselves, so can bad times.

Linens ‘N Things is a retailer that went private in a 2006 leveraged buyout and went bankrupt earlier this year. It has a reorganisation plan that wipes out some creditors and gives others stock in the company. It is closing a lot of stores, and has negotiated lower rents on others. That won’t help the landlords, or those who lent to them. To make things worse, the banks that were lending with abandon little more than a year ago are now erring on the side of caution.

‘The tightening already appears to be more widespread than it was during the early 1990s, and portends more difficulty in financing business fixed-investment and commercial real estate projects in the second half of this year,’ said president Eric Rosengren of the Federal Reserve Bank of Boston this week.

The leveraged loan market in 2006 and the first half of last year featured banks competing with one another to make foolish loans. There was a flood of ‘covenant-lite’ and ‘toggle-PIK’ loans. The first stopped the bank from stepping in until the borrower missed a payment. The second made it almost impossible for a borrower to miss a payment. If it did not have the cash to pay interest, it could ‘pay in kind’ by taking out more loans.

That has meant that as some leveraged buyout loans have grown dicier this year, the banks have been able to do little except watch nervously. If, or when, those companies do go broke, the losses will be larger than they would have been if defaults could have been declared earlier.

Those who dismiss talk of a credit crunch point out that banks appear to be lending more than ever.

But Mr Rosengren argued that it is one reason the problem is getting worse.

‘Much of this growth likely reflects involuntary lending,’ he said. ‘Swelling bank assets places pressure on capital-constrained banks to pull back in other areas.’ That is Fed-speak for ‘make the banks unwilling to lend, except at high rates to safe borrowers’.

The weak go first. But they will not be alone.

Source: Straits Times – 06 Sept 2008