LBO to the head

Standard & Poors recently did a study in Australia (which unfortunately is not publicly available on their site) that discusses what is driving the risk profile of a particular segment of debt capital markets here. In summary, the study believes that the risk profile is being driven by:

- benign economic conditions (low interest rates, high and growing earnings, low default rates); and
- unprecedented bargaining power in the borrowers' hands, as banks aggressively fight for market share,
which feeds into:
- inflated asset values (if you can borrow more, you can bid a higher price); and
- mispriced debt (i.e. interest charged is too low compared to the risks being borne by the banks),
thus substantially increasing the risk profile for the banks and debt investors.

The question for you is, is it talking about residential loans, or leveraged buyout (LBO) debt?

My title would have given it away: it is indeed discussing LBO debt. But what I wanted to highlight was that it could have equally applied to residential mortgages. The reason I wanted to draw the parallels is that, as of right now, the residential mortgage market in the US is in turmoil (the current poster boy for this being the Bear Stearns hedge funds that spectacularly collapsed in recent weeks).

While it appears that Australia has been able to escape such spectacular failure in our residential mortgage market, it is not a stretch of the imagination to see that it could happen to our corporate debt market. And I am unsure if we can pull a similar Houdini act again.

The LBO market in Australia is relatively young, though it is developing rapidly and adopting many features of the US and European LBO debt structures (e.g. heavy reliance on pro-forma forecasts, equity cures, generous covenant headroom, and not long from now, covenant-lite structures). Often, of course, this is because the client demands these terms, and a bank who wants to participate has no choice in the matter. The terms are great for the client because of the flexibility it offers them, thus they can concentrate on their core competency: improving businesses (or overpaying for assets, if you are cynically inclined).

But in finance, risks are transferred, not eliminated; because of the debt structures, banks are increasingly taking on risks that would have made them vomit not even two years ago. It is the classic "frog in slow-boiling water" (though whether frogs are really that stupid, I don't know yet). Debt levels in deals have been slowly but steadily increasing (while returns earned from them decline), and as they continue to compete aggressively, debt appetites are also slowly (if reluctantly) increasing. It does not help that there is a gross mismatch between the long-term sustainability objectives of a bank (i.e. minimise loss of capital) and the short-term performance objectives of its bankers (i.e. do the biggest deals, charge the highest fees, gain the best dealmaking reputation). Given the tight market, I highly doubt any banker who writes deals now will be around to see those deals flounder or flourish - by then, they would have either moved on to another bank or taken residence in the Caymans. The only impact these bankers see is the provisions charge against the profits they generate - and with default rates at current lows, these provisions are not onerous enough to prevent mispricing of risk.

Should there be a severe shock to the system, the self-fulfilling nature of our financial markets means things could rapidly get ugly for participants (which was what the S&P study was driving at). Of course, it is these same financial markets, demanding ever-higher returns while desiring little risk (or ignoring it altogether), that drove banks to this kind of risk-taking behaviour. So in a way, there is a poetic justice to it all, a vivid reminder that high risks do not mean high returns... such is the painful but necessary reality of our markets.