Tuesday, March 03, 2009
Rates Must Rise
Most senior corporate credit is priced as a spread to a benchmark rate, typically LIBOR. That benchmark rate in turn represents the cost of interbank funding - hence I refer to it as wholesale. Banks then issue credit at a spread, determined in basis points (1 basis point equals 1/100 of 1.0 percent). During the credit-palooza we recently experienced, the consequence of which is the mother of all hangovers/recessions, credit spreads were absurdly low - 50-200 bps. Any credit priced behind or junior to these senior, libor based credits, was similarly mispriced since they price off of each other (a junior credit might be 100 0r 200 basis points behind, or higher than, the senior comparable, for instance).
There are many reasons why the value of senior debt issued by banks and now owned by them, hedge funds, CLOs or other investors have declined in value - a supply demand imbalance (more sellers than buyers) and related illiquidity; a perceived decline in credit quality or higher expectations of default; and very low rates. Very, very low rates. Senior, libor based loans of leveraged credits issued in 2005-2007 may generate 4-5% cash flow. Considering how stretched these credits were, and their now obvious dubious credit quality, these interest payments are simply ridiculous. And they have been declining because LIBOR is so ridiculouly low, fueled by reductions in benchmark rates like Fed Funds, US Treasuries and ubiquitous Fed guarantees.
These low rates are a problem for the holders of the credit, without, in most cases offering a commensurate benefit to the borrower. In a moment, I will review why. But in the meantime, let me also suggest that the new cost of senior credit in today's market is closer to 8-9%. How so? if you want to borrow today, your spread is closer to 500-600bp and it is with reference to LIBOR -- however, you now also get nailed with a 3.0% LIBOR floor. This is a new market development to compensate for the fact that you can't lend and generate a sensible return when LIBOR hovers around 1%.
So, if the new market rate of freshly issued credit is now 2x what it was previously, the value of previously issued credit has certainly declined. Layer on top of that the fact the newly issued credit is today much more stringently underwritten, and it is clear that today's new issuance will offer a much better risk reward ratio. Again, credit issued in 2005-2007 -- in amounts greater than ever before -- has declined tremendously in value. It is poorly priced, poorly structured and now has declining credit quality as earnings decline in this economy.
Typically, you would expect the borrower might benefit from this happy circumstance at least - LIBOR declined, spreads were narrow, interest payments should be lower, right? Not so fast. Most leveraged borrowers swapped out of floating rates and into fixed rates. So the benefit is going to a large bank's swaps desk. JPM and BofA must have made good money there to offset the declining value of the credit they manufactured and largely sold to investors who now hold the bag. I'm not blaming banks here - they lost plenty of money on credit too, and would make better net interest margins if rates would go up, anyway. I am merely observing that borrowers are not reaping a windfall from the LIBOR decline. And most of the credit owners weren't participants in the swaps market.
To fix this anomaly and begin to repair existing secondary credit, which can then help to reduce constraints on issuing new credit, we really need to see benchmark rates rise and spreads come down. Free Fed money, in this context, really loses its ability to help. Rising rates would not hurt existing borrowers but would provide some help to impaired lenders. They could use some help. And not from the government.
5 Comments:
By 
, at
Tue Mar 03, 02:21:00 PM:
Rates will only rise with an increase in demand for credit. A stubborn problem, that. Taxes will have to come down dramatically to improve the economy, and ultimately improve the demand for credit.
By , at
Tue Mar 03, 02:56:00 PM:
Yes, exactly. The cost of money, like anything else, isn't static. It fluctuates inversely to demand.
And demand for credit will be curtailed by any price increases. Credit price increases linked to LIBOR, in today's economy, lead directly to foreclosures.
When LIBOR increases, loans priced and linked to LIBOR increase also, even though the borrower's income didn't increase.
So, when LIBOR goes up, foreclosures go up, forcing credit prices back down again.
In a never-ending spiral.
Thanks FED!
By 
Viking Kaj, at
Tue Mar 03, 04:21:00 PM:
I usually negotiate LIBOR plus 3 in my commercial agreements. So far I haven't had anyone come back with a floor.
By , at
Tue Mar 03, 04:42:00 PM:
I know Geithner went to Dartmouth and all, but he's cementing an impression in my mind as being really pretty stupid.
Yes, there was all the anguish the markets suffered last month over his non-plan plan that initially sparked these thoughts, but that's not really what's bothering me. I wrote that off to a new Treasury Secretary still uncomfortable with having been publicly exposed as a tax cheat and also some misfiring by an amateur administration that thinks the whole economic problem is some sort of PR issue that some COngressional testimony and a few press events should readily clear up.
No, what's bothering me is his testimony on the Hill today, when he vigorously defended raising taxes at the onset of our little depression here by saying that since the tax rate increases don't kick in until 2010, after we're well "into recovery", they shouldn't really retard our ability to recover economically. Aside from the shear dishonesty (since some of the other tax increases begin the minute the bill passes, regardless of when income tax rate changes go into place) it goes without saying then Mr. Secretary, that you think taxpayers won't start anticipating those particular tax increases and start changing behavior until they are actually in place. What a brick.
By , at
Wed Mar 04, 01:46:00 AM:
it goes without saying then Mr. Secretary, that you think taxpayers won't start anticipating those particular tax increases and start changing behavior until they are actually in place
It is a general tenet of liberal thought that taxpayers do not change their behavior in response to changes in tax law.
