A Pull-back in Liquidity-Driven Lunacy? Let's Hope So

I'll be the first to admit it - a market awash in liquidity scares the hell out of me. Why? Because it leads to irrational decisions. And one need look no further than the high-yield debt markets to get a sense of just how crazy conditions have become. And the private equity firms have known this and have fully availed themselves of access to cheap capital, paying valuations for businesses that could only make sense at a time when capital - both debt and equity - is dirt cheap. Bully for them and their investors, to be sure. But at some time the music will stop and someone will be standing. The question is: will that person simply go home, or pull out a baseball bat and start swinging? Nobody really knows how this debt bubble will be resolved, but if the investor push-back noted in a few interesting articles earlier this week comes to pass, the bubble might simply lose its volume gradually instead of popping in an orgy of goo covering a wide swath of market participants. And this would be a good thing for all - debt investors, equity investors and LPs in private equity and hedge funds. Not that pain won't be incurred, it just won't be immediate and crippling for most. Such a gradual deflation would make Alan Greenspan proud.

My recent cynicism about the debt bubble was most resonant in two posts I had written in the past few months about the private equity industry:

• 03/21/2007: Listen to the Leaders of the PE World: They See the Big Picture

• 03/18/2007: Blackstone Going Public? Watch Your Wallet, Brothas

And then I read two stories in Bloomberg, one from the markets perspective and one from the banking perspective, that gave me a measure of hope. Hope that maybe people are waking up to the magnitude of the risks we are facing in the wake of a pervasive global debt bubble, a bubble that hasn't just led to a tightening of debt spreads but fueled the worldwide private equity boom. I have provided some key soundbites from each of these articles below.

From Bloomberg.com 05/09/2007: Goldman, Lee Stymied as Investors Jettison Covenants      

May 9 (Bloomberg) -- The high-yield loans that provided the most favorable terms to Kohlberg Kravis Roberts & Co. and Thomas H. Lee Partners LP as they completed the biggest leveraged buyouts are drying up.          

Investors have scaled back such credit to LBOs by about 33 percent since February, according to ratings company Standard & Poor's.

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Lenders who sacrificed safety for higher yields last year are becoming skittish after KKR, TPG Inc., Goldman Sachs Group Inc. and Boston-based Lee led a record $188 billion of takeovers in the first quarter. Not only are investors charging more for the riskiest loans, they're also resisting LBO firms that try to lower payments on existing debt.

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Hedge funds and mutual funds said tighter lending conditions were inevitable after the increase in buyouts.

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Leveraged loans became more popular as corporate defaults dropped and yields on corporate bonds declined.

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Borrowers who sought to refinance or reprice leveraged loans at lower rates are down 75 percent from the first quarter, said analysts at Bank of America, the second-biggest arranger of the debt. Barclays PLC estimates that borrowers haven't had such a hard time since mid-2001.

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``Investors are being more disciplined,'' said Thomas Finke, who manages more than $10 billion in loans as head of Babson Capital Management LLC's U.S. bank loan team in Charlotte, North Carolina. ``The market is a little more rational.''

All I can say is, hallelujah! Skittish lenders? More disciplined investors? Scaling back LBO credit? This is great stuff. This is the kind of stuff that will hopefully, and gradually, cause spreads to widen as concerns over lofty equity prices take hold and global market volatility increases.

From Bloomberg.com 05/09/2007: Bank of America's Lewis Calls for Lending "Sanity"

May 9 (Bloomberg) -- Bank of America Corp. Chief Executive Officer Ken Lewis said a so-called credit bubble is about to break after six years of historically low interest rates and relaxed lending criteria.         

``We are close to a time when we'll look back and say we did some stupid things,'' Lewis said, speaking at a lunch at the Swiss-American Chamber of Commerce in Zurich. ``We need a little more sanity in a period in which everyone feels invincible and thinks this is different.''

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Lewis, 60, said ``We need a deal to go bad, as long as we're not in it.'

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Some bank executives, including Barclays Plc President Robert Diamond, say the credit rally may run longer.         

``I think the liquidity is probably a little bit more sustainable than he would think,'' Diamond said in an interview today. ``Only time will tell.'' He said bond yields are increasing and volatility ``will be back.''

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Lewis's comments were preceded by some pessimism from Wells Fargo & Co. Chief Executive Officer Richard Kovacevich who said in December that ``I am not a forecaster of the future; I'm a historian. And history says this will blow up. It always has. And there will be some blood on the street.''

Notwithstanding my optimism from the previous article, this story kind of brings me back to earth. Ken Lewis is a great manager and a super-smart guy, and I completely agree with his sentiments, but they are just words. It is the language of the markets that matter. He's right - we do need some deals to crap out and for some people to get hurt pretty badly and very publicly. I think Bob Diamond may well be right that this liquidity-driven credit rally has more room to run before things moderate. And I know that Richard Kovacevich is right because his historical perspective is correct - bubbles like these generally don't end in a scuffed knee and a few tears, but with a near-death experience. Hopefully this won't be the case this time. But hope alone won't help us. Only the rationality of market participants will. And if history is any guide, rationality will wane until it is forced upon unwitting dupes. The debt holders, in this story. While the equity guys go laughing all the way to the bank.