Bank of England Warns: If Just One Major Private Equity Deal Collapses, It Could Trigger a Global Debt Crisis
June 18, 2007 (LPAC)--The Bank of England (BoE), in its latest quarterly review of market conditions, issued today, warns that the collapse of one major equity deal could trigger a general economic crisis.
The report highlights the fact that the debt markets which fund United States leveraged-takeover deals by private equity funds, have come to be dominated by so-called "covenant-lite" loans. These loans, often in the multi-billions, lack the basic bond covenants which define default on the debt, and which have characterized all sound corporate bonds for over a century. This is the result of banks and hedge funds lowering standards in order to get to make high-interest loans into the big leveraged buyouts. The banks make these loans and then sell them to investors, knowing just how bad they are. The loans include "toggle" clauses allowing them to be turned into balloon notes--with still higher interest rates--at the request of the indebted firms, whenever they have trouble paying the debt service.
The BoE report warns that "such developments mean that the underlying value of a bought-out firm could be allowed to deteriorate far longer, before its creditors can intervene." BoE says that "In this scenario, a large and pervasive shock might cause asset markets to adjust quite sharply as required-risk premia increased." One of the likely triggers for this crunch "could be the failure of a large leveraged loan deal [to go through], leaving the lead intermediaries [lending banks] with unexpectedly large commitments," and causing the value of existing debt to fall suddenly across the entire high-yield, or "junk" bond markets.
The BoE notes that because "covenant-lite" and "toggle loans" are so clearly similar to "subprime" and "optional payment" mortgages and other exotic mortgages which are popping the housing bubble, "the U.S. subprime mortgage market may provide a useful case study of how lax lending behavior and deteriorating fundamentals can test the structure of a market."
That subprime market was hit with new losses in early June, as revealed June 18 by the index of value of so-called credit derivatives based on subprime mortgages, falling to 61 cents on the dollar (from 72 cents in mid-May), and Moody's Investor Services downgrading more of these mortgage-backed securities.