Credit Crisis LBOs SIVs

Credit Crisis Spreading to LBO and SIV Markets - Part 3

As you recall in part one we discussed huge supplies of investment dollars that caused the mortgage crisis as described in chapter two.  This chapter will cover leveraged buyouts (LBO) and Structured Investment Vehicles (SIV), other sub-bubbles that make up the massive credit bubble that is quickly leaking air.

Over the past few years, the large supply of cash found its way into the hands of private equity shops. Primarily, these are non-public funds of investment dollars that are used in conjunction with borrowed funds to buy public and private corporations. The intent of an LBO is to buy corporations at a discount, reorganize the entity to be more efficient, pay off their associated debt and sell the improved corporation at a premium. Sounds simple enough and in a normal environment a strong case can be made that private equity shops are a very important piece of the economic landscape. They make companies more economically sound and in the long run contribute to economic prosperity.

That being said private equity firms take a lot of risks.  In return, successful funds pay their investors generous returns. On the flip side they are charged high interest rates when they borrow money through LBO debt due to the nature of the risk. Over the past few years, private equity shops benefited in two ways from the excessive amounts of dollars chasing investments. For one, they were able to easily raise capital to seed private equity funds. Like we saw in mortgages this brought more players into the business which in turn caused the price to rise for potential targets. The result was huge gains in the stock markets. The negative was that potential returns for the private equity shop were diminished due to the higher price paid for investments. Fortunately for them investors were also more than willing to buy the debt they issued, LBO debt. The private equity firms issued LBO debt in order to purchase a company. LBO debt used with some of the investor’s capital allows private equity firms to use leverage to increase returns but also to participate in more investments.  One important thing to note is that banks and dealers front the private equity firm with the cash needed to buy the company and then reap massive commissions through managing the issuance of the LBO debt. 

This is starting to sound like chapter 2. Private equity could borrow at rates that historically did not account for the risk being taken. They drove up the price of equities and chased investments that made less and less sense. The biggest problem, and one that we are facing right now, is that your recall banks and dealers fronted the money to pay for the corporation. Well, the market for high yield LBO debt has vanished and guess what, the banks and dealers are holding the bag. Currently they have over $200 billion of LBO loans on their books and no home in site. Some deals such as Sallie Mae and Harman International have been dissolved while many others are essentially stuck on the balance sheets of the big banks and dealers.

As if the mortgages losses and the LBO credit issues weren’t enough, there is another storm just sitting offshore.  SIVs (structured investment vehicles) are a $320 billion, asset class that is similar in form to a hedge fund. Essentially SIVs are started with capital from investors. They then borrow money through the issuance of debt and buy assets. Most SIVs are leveraged 13 times. In other words they have $13 dollars of assets for every $1 of capital (plus $12 of liabilities). The problem with this structure is two fold.

First, they invested in mortgage products that are now priced at significant discounts. Secondly, they ran asset/liability mismatches. SIVs borrowed for short periods of time and invested for longer periods. As long as you can re-issue debt at reasonable costs this strategy makes sense. They weren’t necessarily taking interest rate risk but were taking liquidity risk. Guess what?  They can’t issue anymore and the market for SIV debt is closed. Even the most prudent of the SIVs, Gordian Knott and the Citibank programs, are unable to issue debt at any cost. This leaves them in the precarious position of having to liquidate their assets to pay maturing debt.  With their assets priced at discounts to purchase prices, the initial capital investors are losing money. For those SIVs with assets worth less than capital the debt holders are also looking at losses. This industry has essentially vanished overnight however there is still well over $300 billion of assets that need to be sold as they wind down. Many SIVs are affiliated with banks. The big question now is will they support their off balance sheet SIVs. They are not legally accountable to salvage those funds but they do raise big risks to their credibility by not doing so. Citibank is at the most risk as they owe approximately $80 billion of SIVs that they created. The bottom line is that there is another $300 plus billion of assets from the rest of the industry that will need a home. Put it together with the hanging LBO debt and the massive capital write downs due to mortgage losses and you are seeing the perfect credit storm.

Tim Ord
Ord Oracle

Tim Ord is a technical analyst and expert in the theories of chart analysis using price, volume, and a host of proprietary indicators as a guide...
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