Source: www.breakingviews.com is Europe’s leading financial commentary service.
Distressed debt has gone mainstream. Since the second quarter of this year, commercial banks have been offloading unsafe loans at an accelerating pace. The loans have found their way into the hands of institutional investors and pension funds, not just hedge funds or vulture investors. The upshot has been a lucrative boom in distressed debt trading for a handful of investment banks.
According to one head of a distressed debt trading operation, his bank expects to make three times as much revenue from trading distressed debt this year as in 2002. The main reason for the surge is banks’ new-found willingness to crystallize losses on bad loans, rather than cling on while the likely loss ticks up.
Regulatory pressures This is not to say that banks are becoming more rational and cutting their losses. They are selling because regulators are forcing them to clean up their portfolios. It only takes one member of a loan syndicate to sell its exposure for the others to be galvanized into action. After all, when a corporate loan in default starts trading as a security with its own value, the loss being concealed by the original lender ceases to be a secret.
Distressed debt has satisfied institutional investors’ demands for a return from alternative investments at a time when private equity, the most commonly held alternative asset, has disappointed. It is comfortable and familiar. Many of the underlying corporate entities, such as WorldCom and Xerox, are well-known names. Until recently they were A-rated credits. Their ratings may have plummeted, but the companies are not unknowns.
Amid this abundance of buyers and sellers of distressed debt, the real winners are the investment banks that act as middlemen. Deutsche Bank, Credit Suisse First Boston, Goldman Sachs and JPMorgan are reckoned to be the most active players. They not only make a turn on the loan portfolios they acquire but also attractive commission revenue. Spreads on distressed debt securities can stretch to 4%.
Of course, a proportion of business – sometimes as much as a quarter – requires that a distressed debt is taken onto the trader’s own book. But the risks of doing so are not that high relative to the rewards. This is because the commercial banks dumping the assets are willing to sell them in tiny chunks, typically of about e5 million or e10 million. These may parcel together portions of debt from several companies, some more toxic than others. So the trader is never exposed to very large individual positions for long.
How long will the boom last? One risk is that the supply of loans coming onto the market might dry up as the economy recovers. And even while the party lasts, there is the possibility that the fat spreads on offer will attract so many new entrants that super returns are quickly arbitraged away.
The forces impelling banks to clean up their books are unlikely to abate soon. Most of the banks in question are German. They appear to have agreed hard plans with regulators and ratings agencies to cut their risk-weighted assets. Nascent signs of economic recovery are unlikely to prompt banking supervisors to change tack. And any recovery will not heal the German banking system’s wounds overnight. If anything, it will make it easier for banking boards to agree to the disposal of loans because they will be facing up to booking relatively smaller losses.
Moreover, the creation of a liquid market in bad loans has made it possible for banks to extract profits from assets that previously would have been stuck on their books. That liquidity is likely to breed further liquidity.
The real risk to high-rolling debt traders comes from new entrants to the market. Barriers to entry are low. There is no shortage of commercial bankers who might be willing to turn poacher given the returns that seem to be on offer. And the idea that this is a highly technical market where barriers to entry are intellectual doesn’t wash. Distressed debt traders have been making unusually high returns. If these persist for any time, they will be eroded by competition.
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