The Great Deformation (94 page)

During the second Greenspan bubble, by contrast, annual volume soared to $25 billion. Junk bonds and leveraged loans were so cheap and plentiful and the overall financial euphoria so intense that even the great LBO houses succumbed to violating their own investing rules. In fact, $100 billion of dividend recaps on the backs of dozens of companies already groaning under huge debt loads was not just a violation of time-tested rules—it bordered on a derangement and madness of the crowds.

This eruption of leveraged dividend payouts dramatically exposed one channel by which cash from CEW was recycled to the top 1 percent. More importantly, however, it also laid bare the whole self-feeding web of bubble finance that the Fed's monetary central planners unleashed while attempting to levitate asset prices.

In this instance, the stock market bust of 2000–2001 and the modest economic slump which followed brought the excesses of leveraged finance to a screeching halt. Accordingly, the secondary market for high-yield debt cratered, new loan issuance slumped badly, and LBO activity stalled out at low ebb.

The financial market was attempting to heal itself for good reason. Default rates on leveraged loans soared from an average of 2 percent of outstandings during 1997–1999 to 10 percent during 2001–2002. These high default rates, in turn, sharply curtailed the investor appetites for junk bonds, causing new issues to drop by two-thirds between 1998 and 2000.
In effect, the free market was attempting to close down the LBO business as it had been practiced during the late 1990s boom years when the cash flows of buyout companies had been drastically overleveraged.

Not for the last time, however, the Fed refused to permit the financial markets to complete their therapeutic work. When the federal funds rate was slashed to 1 percent by June 2003, the collateral effects on the junk bond market were electrifying, precisely the opposite of what the doctor ordered.

During the twenty-four-month period between mid-2002 and mid-2004, junk bond interest rates plunged from 10 percent to under 6 percent. Since bond prices move opposite to yield, the value of junk bonds soared and speculators made a killing on what had been deeply “distressed” debt. Indeed, in a matter of months, a class of securities that had been a default-plagued pariah became a red-hot performance leader.

This massive windfall to speculators was not the result of prescient insights about the future course of the US economy. Nor was it owing to any evident “bond picking” skill with respect to the performance prospects of the several hundred midsized companies which constituted the junk bond issuer universe at the time. Instead, junk bond speculators made billions during the miraculous recovery of leveraged debt markets during 2003–2004 simply by placing a bet on the maestro's plainly evident fear of disappointing Wall Street.

Wall Street underwriters, in turn, had no trouble peddling new issues of an asset class that was knocking the lights out. These gains were not all they were cracked up to be, of course, because junk bonds had not become one bit less risky (or more valuable) on an over-the-cycle basis. But the Fed's interest rate repression campaign made these gains appear to be the real thing, demonstrating once again the terrible cost of disabling free market price signals.

Moreover, when the rebounding demand for risky credits enabled the issuance of nearly $3 trillion of highly leveraged bank loans and bonds during the three years ending in 2007, the result was a “dilution illusion.” The junk debt default ratio fell mainly due to arithmetic; that is, the swelling of the denominator (bonds) rather than shrinkage of the numerator (defaults).

Thus, by the end of the second Greenspan-Bernanke bubble the total volume of leveraged debt outstanding was nearly three times higher than in 2001–2002. At the same time, the temporary credit-fueled expansion of the US economy caused new junk bond issues to perform reasonably well. Due to this happy arithmetic combination, the measured default rate plummeted sharply, dropping all the way down to 0.6 percent by 2007.

Yet this was a preposterously misleading and unsustainable measure of junk bond risk, since it implied that the Fed could prop up the stock market and extend debt-fueled GDP growth in perpetuity. Nevertheless, having quashed the free market's attempt to cleanse the junk bond sector in 2001–2002, the Fed had now enabled the leveraged financing cycle to come full circle.

HOW THE GREAT MODERATION SPURRED A DAISY CHAIN OF DEBT

During the final stretch of the bubble in 2006–2007, the junk bond yield stood at about 7 percent and was juxtaposed against what appeared to be negligible default rates. Not surprisingly, this generated a vast inflow of yield-hungry money into the junk bond market, and a blistering expansion of the market for securitized bank loans.

The latter were called CLOs, for collateralized loan obligations, and were another wonder of bubble finance emanating from the same financial meth labs that produced mortgage-based CDOs. In this instance, however, Wall Street dealers sold debt to yield-hungry Main Street investors that had been issued by what amounts to financial “storefronts.” These shell companies were stuffed with LBO junk loans rather than subprime mortgages.

The daisy chain of financial engineering was thus extended one more notch: leveraged buyouts were now financed from the proceeds of bank debt which, in turn, was funded with the proceeds of CLO debt. Nor was that the end of the leverage chain. Not infrequently, these CLO “storefronts” also employed leverage to enhance their own returns. Thus did the true equity in the system retreat ever deeper into the financial shadows.

By the top of the cycle in 2006–2007, the CLO market of debt upon debt upon debt was expanding at a $100 billion annual rate, compared to less than $5 billion at the prior peak seven years earlier. In its headlong pursuit of asset inflation, therefore, the Fed was spring-loading the financial system with a fantastic coil of debt.

As it happened, however, the miniscule 2007 default rate for junk loans was no more sustainable than had been the initially low default rates for subprime mortgages. By 2009 defaults were actually back above 10 percent, signaling the third junk market crash since 1990.

Accordingly, investors and traders fled the leveraged loan markets even faster than they had stormed into them. Junk debt issuance plunged by 85 percent from peak levels. The CLO market disappeared entirely.

This cliff-diving denouement should have come as no surprise. Near the end of the boom, many issuers were simply borrowing to pay debt service and few had sufficient excess cash flow to withstand a sharp economic
downturn. The massive coil of LBO debt fostered by the Fed's financial repression policies had thus been an accident waiting to happen.

Yet the leveraged finance boom went on right until the eve of the 2008 Wall Street meltdown because risk asset markets had been sedated by the myth of the Great Moderation. If the Fed had indeed abolished the risk of steep and unexpected business cycle downturns, as Bernanke claimed, the corollary was that deal makers were free to push leverage ratios to new extremes. This was a matter of spreadsheet math: the banishment of recessions obviously meant that the cash flows of leveraged business wouldn't plunge in a downturn.

It also meant that the junk bond interest rate spread over risk-free treasuries would stay narrow, owing to reduced expectation of recession-induced defaults. So the junk market's read on the Great Moderation was that it meant a floor under cash flow and a cap on default risk. Better still, since many junk bonds now had the “toggle” feature, they couldn't default; they could just add the coupon to what they owed.

If defaults were thus minimized or eliminated, the hefty yield on junk bonds would be pure gravy. Not surprisingly, the leveraged loan market became fearless, happily assuming that the Fed had infinite capacity to prop up the economy and peg the price of risk. Nearly two-thirds of all the junk bonds issued in 2007 were of the so-called covenant lite variety, and that was another canary in the coal mine.

The purpose of covenants is to trap an LBO's cash flows inside a company's balance sheet for the benefit of the bondholders. So when these protections were permitted to fall away, it meant that high-yield investors were no longer looking to the borrower's cash to keep themselves whole. Instead, they assumed that borrowers who didn't have the cash to redeem their debts at maturity would simply refinance; that is, investors would get their money back not from original issuers but from the next punter in the Ponzi.

Likewise, purchase prices for larger LBOs soared to more than 10X cash flow, compared to 6.5X when Mr. Market was endeavoring to heal the excesses of the previous leveraged finance bubble back in 2001–2002. Indeed, the light was flashing green for issuance of every manner of risky credit. These included second-lien loans, which effectively meant hocking an LBO company's receivables and inventory twice.

THE CORNUCOPIA OF PRIVATE EQUITY: EXIT AND RELOAD

Owing to this outpouring of leveraged finance, all of the deal markets were on fire during 2005–2007, thereby instigating a fantastic feedback loop. Owing to the debt-fueled explosion of buyouts, buybacks, and M&A takeovers,
the S&P 500 was levitated to an all-time high north of 1,500. In turn, the booming stock market facilitated a surge in so-called “exit” transactions by sponsors of existing private equity deals through IPOs or M&A auction sales. In turn, these “exit” transactions, along with dividend recaps, permitted sponsors to return huge amounts of cash to their institutional investors such as pension funds and insurance companies.

Not surprisingly, these large distributions to investors helped reignite the cycle all over again. Whereas only $30 billion of new private equity commitments were made by institutional investors in 2003, this number went on a tear, rising to $160 billion in 2005, followed by $200 billion in 2006 and nearly $300 billion in 2007. The latter single-year total was so astonishingly large that it exceeded all of the private equity ever raised from the time of the first famous private equity deal, the Gibson Greetings home run in 1983 through the end of 1999.

It is well-nigh impossible to exaggerate the speculative firepower implicit in this tenfold escalation of annual new commitments. The $1 trillion of new private equity money during 2004–2008 was off the charts by orders of magnitude, but it was just the high-powered apex of the leveraged-deal pyramid. At the going rate, LBO balance sheets required a 20–30 percent equity contribution, meaning that the $1 trillion of new private equity could fund $3–$5 trillion of leveraged buyouts and recapitalizations. No more powerful stimulant to the speculative mania already rampant in the deal markets could have been imagined.

It would have been virtually impossible to put this much money to work in the $200–$400 million sized “middle market” deals prevalent during the first two decades of LBO history. Consequently, the era of the mega-LBO was born, but the resulting $10–$50 billion scale deals had faint resemblance to the entrepreneurial management model which had been the original rationale for leveraged buyouts.

THE $300 BILLION CARRIED INTEREST JACKPOT AND THE RISE OF MONSTER LBOS

These mega-LBOs were simply opportunistic exercises in leveraged speculation. They arose because private equity sponsors were not about to allow their immense new inventory of committed capital to sit idle. The economics of private equity investing were too compelling.

Over a five-year holding period, for example, this $1 trillion of new capital implied private equity fund profits of $1.5 trillion, assuming an industry minimum 20 percent annual rate of return. In turn, the 20 percent “carried interest” share of profits allocable to general partners who ran private equity firms would have been worth $300 billion. It goes without
saying that a jackpot of that magnitude, even if only theoretical, presented what were truly stupefying incentives for deal making.

The fact of the matter was that 80 percent of these massive new private equity commitments were attributable to a few dozen major LBO firms. The implicit $300 billion carried interest jackpot, therefore, would have been realized by a few dozen senior partners and a few hundred principals overall. Never before in history had a central bank deformation of financial markets delivered such massive opportunities for speculative gain to so few.

Rather than a dot-com bubble, the deformation this time was a runaway string of supersized leveraged buyouts. Even a cursory review of the facts establishes that these massive transactions had no rational purpose except to strip-mine cash from the business sector and recycle it to the hedge funds and private equity firms which had come to occupy the center of the nation's financialized economy.

STRIPPING THE YELLOW PAGES: HOW CEW HAPPENED

The order-of-magnitude increase in deal size that materialized in the leveraged buyout market was kicked off in 2003 by the $7.5 billion Dex Media transaction. Since the company had only $1.6 billion of revenue and its yellow pages were a dying business in the Internet age, the deal price of nearly 5X revenues was truly astonishing.

It was also a forewarning of the speculative mania to come. Within just a few months of the deal, its private equity sponsors led by the Carlyle Group took out a $1 billion dividend by piling more debt on the $6 billion from the initial transaction. Yet, in a world the Fed favored with 1 percent interest rates and a renewed policy of stock market levitation, this growing mound of debt made no waves at all.