Why banks are facing billions in ‘blocked debt’ when the deals are cool

One of the most lucrative deals in investment banking has suddenly become a very expensive headache for US and European banks. They face big potential losses from about $80 billion in acquisition debt that they promised to raise to facilitate mergers and leveraged buyouts when financial conditions were better. Companies like Bank of America Corp., Credit Suisse Group AG and Goldman Sachs Group Inc. could each face a $100 million loss on so-called suspended debt from a single such financing deal. It’s not the first time banks have been burned when so-called committed funding quickly turns sour. Banks are better able to withstand such losses now than they were during the 2008 financial crisis. But as has happened before, the experience appears to be helping to cool transactions.

1. What types of offers go wrong?

These are financings for mergers and leveraged buyouts (debt-heavy acquisitions) that involve what is known as leveraged financing, a term that refers to corporate debt with ratings below investment grade – so-called junk food. Banks used to give these loans directly, but they now operate as an intermediary helping these companies raise capital from investors. This approach has become increasingly important for banks and the ‘arranging’ of this debt has accounted for around a third of investment banking revenue in recent years. But a crucial part of the process involves banks actually acting as a back-up lender, offering committed funding – and in doing so, putting themselves in charge of the money needed to get a deal done, ideally briefly.

2. How does committed funding work?

Look closely at a merger announcement, the type issued when company A announces that it is buying company B or that private equity firm C is taking control of company D. Below the overall purchase price is often a section detailing the debt used for the acquisition. It is in this section that Wall Street banks are listed as providing “committed” funding. A lot hinges on that word “committed” because it’s a legal obligation banks make to a potential buyer in a leveraged buyout. This commitment is an essential part of the M&A world because it reassures the target companies that the deal will not fail due to the buyer’s inability to raise the debt necessary to make the purchase.

3. What are the challenges for banks?

Banks take a risk when they provide committed financing because they are now committing to sell the debt in the future. This is called fully underwritten financing, which means that they cannot back out of their promise if market conditions change. While the promise of future funding is meant to advance a deal, banks can find themselves stuck with debt if interest on those bonds and loans dries up while the deal is in progress. If a bank chooses to fund and hold the debt rather than sell at a loss, it’s called an escrow deal. For risk, these transactions incur fees ranging from 2 to 2.5% of the total size of the debt envelope.

4. Are hanging chords important?

On Wall Street, many veterans still remember the episode that became known as “the hot bed.” In the late 1980s, suspended funding brought down First Boston, once ranked as one of the top investment banks in the United States. First Boston had provided $457 million in the form of a bridge loan for the acquisition of the mattress company Sealy, an amount which represented 40% of the bank’s equity. When the buyout debt market crashed soon after, he was stuck with the loan. The bank demanded a bailout from co-owner Credit Suisse, which already owned 44.5% of First Boston and took it over completely in 1990. Blocked deals happen individually in good times and bad when a bank appeals to a company that investors turn to disagree with. But they periodically occur in droves when market sentiments change rapidly. After the 2008 financial crisis, banks had more than $200 billion in debt locked up on their balance sheets, mostly for leveraged buyouts. When sub-prime mortgages collapsed, the massive losses banks suffered on committed deals contributed to balance sheet weakness that eventually led to government bailouts for many of them.

5. What caused the problem this time?

In this case, high inflation has persisted longer than banks had expected late last year and early this year. This means funding was secured before it became clear that most central banks, including the US Federal Reserve, European Central Bank and Bank of England, would lay out plans for aggressive interest rate hikes. interest. As a result, investors are now demanding much more to lend to companies. Yields in the investment grade bond market, high yield bond market and leveraged loan markets have all more than doubled since the start of the year. Since the agreements entered into oblige the banks to provide financing on agreed terms, they are responsible for making up the difference. While banks can accept requests from borrowers to change prices and terms – to provide what is called flex or cap in Wall Street parlance – they don’t have enough leeway to match what lenders can get elsewhere.

6. How big is the problem for the markets?

US and European banks are on a stronger footing than they were during the Great Financial Crisis. The rules that forced them to raise their level of capital also prevent them from holding on to unwanted debt, making them more likely to sell it at a loss. Although it is painful, they should be able to absorb the hit to their capital. But if the past is predictive, they will be chastised and probably less willing to enter into similar deals, at least for a while. Dealings are likely to dry up, both because buyers and sellers are less interested in M&A deals and because banks are more reluctant to finance them. Walgreen’s bid to sell its UK pharmacy chain Boots was partly foiled by potential buyers’ difficulties convincing banks to secure financing. Of course, in some ways, reducing the market’s appetite for debt-fueled trades is consistent with what the Fed and other central banks had in mind when they raised interest rates and started to tighten financial conditions.

• A Bloomberg article on the potential for big losses on blocked debt.

• An article on how the risks for banks compromise the credit needed for acquisitions.

• A 2008 article on how banks worked through a $200 billion stack of suspended loans from transactions that deteriorated in 2007.

More stories like this are available at bloomberg.com

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