Sunday, August 5, 2007

Corporate Finance

The Universal Debt Bubble (UDB) has enabled many activities that could never be sustained in anything resembling a normal environment. Perhaps nowhere is this more clear than in the field of corporate finance and the related debt and equity markets. Let's look at the borrowing side first.

Just as with housing, cheap credit was widely available in the corporate sector. Anybody could borrow and at much lower than normal interest rates too.

One of the most important effects is that it was almost impossible to default on a debt. Since there was almost always another lender lined up to make a loan, companies refinanced instead of going bankrupt. This was very similar to the way homeowners refinanced instead of facing foreclosure. The magnitude of the drop in defaults was astounding. A study by Moody's showed that over 32 years the lowest rated bonds (Caa, Ca and C) averaged 23.7% defaults each year.

With the UDB in effect, the default rates for those risky bonds has fallen to virtually nothing:
"Issuers rated CCC or lower typically default at an average annual rate of 25 percent, as measured by Fitch. In 2006, the default rate for such issuers was 4.5 percent, the lowest in 20 years."

With consequences seemingly abolished, borrowers lenders began to behave badly - just as they did in the mortgage market. More and more of the bond deals funded were in the lowest credit categories: the corporate equivalent of subprime. The structures were increasingly convoluted and risky. Toggle notes were issued, giving the debtor the right to pay interest either in cash or more bonds - reviving the disastrous pay in kind (PIK) structure from the 1980s. This also looks suspiciously like an option ARM or negative amortization loan. Covenant lite loans removed most of the traditional protections for the lender, echoing the no-doc, no verification trend in mortgages. The parallels are uncanny - just as they should be since they were caused by the same UDB forces.

Once all of this foolishness is gone, we should see things revert to their historical levels. If we see anything close to normal, junk bond losses will be substantial.
There are many other resemblances and we may deal with them at a later time. But the next topic for discussion will be what companies did with all of the money they raised in the bond market.

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