Biggest Credit Bubble in History Runs Out Of Time

Wolf Richter's picture

Wolf Richter

It has been a feeding frenzy for junk debt. Yield-desperate investors, driven to near insanity by the Fed’s strenuous interest-rate repression, are holding their noses and closing their eyes, and they’re bending down deep into the barrel and scrape up even the crappiest and riskiest paper just to get that little extra yield.

Last year, highly leveraged companies issued $1.1 trillion in junk-rated loans. It’s a white-hot market. Leveraged-loan mutual funds – dolled up in conservative-sounding names and nice charts to seduce retail investors – gorge on these loans. They saw 95 weeks in a row of inflows, week after week, without fail, adding over $70 billion to their heft, as Bloomberg reported, and only the sky seemed to be the limit. But suddenly, that endless flow of money reversed.

“It’s going to be a disaster on the way out,” Mirko Mikelic, who helps manage $7 billion in assets at ClearArc Capital, told Bloomberg. “On the way in, there’s insatiable demand....”

Private equity firms have been ruthlessly taking advantage of that “insatiable demand.” And they have a special self-serving trick up their sleeve: Their junk-rated overleveraged portfolio companies issue new loans, but instead of using the funds for expansion projects or other productive uses, they hand them out through the back door as special dividends. It’s one of the simplest ways PE firms use to strip cash out of their portfolio companies. It loads even more debt on the already highly leveraged portfolio company without adding productive capacity. And those who end up holding this debt – for example, the mutual fund in your portfolio – have a good chance of losing it all.

“It’s kind of like an epidemic,” explained Martin Fridson, a money manager at Lehmann, Livian, Fridson Advisors LLC, in an interview with Bloomberg. “Once an investment banker sees that, he’s going to go to his clients and say, ‘Here’s a window of opportunity, you can take a dividend and get away with it.’”

And they’ve been getting away with it. Default rates on junk debt hovered at 1.7% in the first quarter, a near record low. But that’s always the case when liquidity sloshes through the system and years of interest rate repression turns yield investors into brain-dead zombies, always willing to replace troubled debt with new money. But the historical average is 4.5%, and when things tighten up, as they did during the financial crisis, default rates jump into the double digits [read.... Biggest Credit Bubble in History Flashes Warning: ‘Seek Cover’]. 

They’re all doing it. Junk-rated mobile-phone insurer Asurion finagled a $1.7 billion loan in March. But instead of doing something productive with the funds to generate cash flow to service the loan, it blew the money out the back door as a special dividend which it owners – PE firms Madison Dearborn Partners, Providence Equity Partners, and Welsh Carson, Anderson & Stowe – pocketed with gusto.

BMC software borrowed $750 million via one of the riskiest forms of debt, payment-in-kind (PIK) notes, where, if push comes to shove, BMC can chose to pay interest not with cash but with more of the same debt. The amount it owes gets larger, as its chances of survival shrivel. Instead of defaulting, the company will simply hand the lender more paper that’s increasingly worthless. BMC promptly forwarded the $750 million to its owners, a group of PE firms let by Bain Capital that had acquired BMC only seven months earlier.

Time is of the essence. Platinum Equity, which had acquired Volvo’s rental car division, waited only a week after closing the deal before sucking $262 million out that the company had obtained by issuing PIK debt.

So far this year, companies have issued nearly $21 billion in junk-rated debt for the purpose of paying special dividends to the PE firms that own them – the most since the bubble of 2007, before it all blew up spectacularly. Of that, $3.5 billion were these reeking PIK notes. When a default occurs, the PE firms have the cash, and the lenders get stuck with largely worthless paper.

That’s what invariably happens when the Fed’s interest rate repression pushes investors out toward the thin end of the risk branch. During normal times, no sane lender would go along with this without demanding a confiscatory yield. The door would be closed to these sorts of glaring wealth-transfer shenanigans. But these are not normal times. This is the greatest credit bubble in history.

Among the most insatiable buyers of this stuff: leveraged-loan mutual funds, and by extension, retail investors. But now, they’re getting cold feet, apparently, and for the first time, after 95 weeks in a row of inflows, they yanked money out, Bloomberg reported. Not a panic just yet, but the flow has reversed. In the week ended April 16, they drained $276 million out of these mutual funds. 

And these funds are starting to bleed. The LS&P/LSTA Leveraged Loan 100 Index, which sports a 5-year annual return of 10.5%, dipped into the red for April and might book its first monthly loss since the taper-tantrum turmoil last summer.

Mutual funds that hold leveraged loans are fearsome products. They entice investors with a little extra yield, but still less than an FDIC insured one-year CD used to pay in the pre-crisis days. That’s how far the Fed has pushed it. But these loans are even less liquid than corporate bonds. Unlike bonds or stocks, they’re not regulated. They’re traded the old-fashioned cumbersome way, via email or even the phone, involving complex paperwork that may take weeks to complete. It’s not easy to transfer a loan. And when belatedly spooked investors start selling these mutual funds, fund managers are forced to dump loans into a market where liquidity just evaporates without notice. Prices plunge on the sales that do go through – and those who get out first, bleed the least.

Yet, former Fed Chairman Ben Bernanke doesn’t regret any of the Fed’s actions, he said, except not explaining them to the people. They “really don’t understand why we did what we did,” he said. But there are a few people who do understand. Read....  Fed’s Wealth Effect: Richest 200 Moguls Made $13.9 Billion Today

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
kchrisc's picture

When the music stops, nobody is going to get a chair.

Nothing will be left to do, but guillotine those responsible.

DR's picture

There is a reason why these bonds are called 'junk'. No deceit assumed.

Why the Fed can influence short term rates, the reason rates are low is because their aren't enough secure investments to match demand-their is simply too much money around with nothing to do...




Evil Peanut's picture

Well shit, if all that money has nothing to do but sit around then they need to give it to me. I will put it to work straight away

elwind45's picture

Who is insuring the paper? Got anything about the future like the first monoline collapse(if its going to repeat you must be in on groundfloor on this one)? Some guy already wrote the book on the last one. You in for helping new authors or just jealous of Michael Lewis?

Seer's picture

This US-ass-sucking idiot needs to come over for a hunting trip with Dick Cheney...

Cthonic's picture

An upvote, for the link.  Looks like Evans-Prichard has fully partaken from the cup of nominalist ambrosia, and not the philosophical kind.

whidbey-2's picture

Will, the big jig is inter-economy credits.  The EU countries will go blind trying to read the Draghi agreements which pay only if he has made a mistake (it is written in Italian-Swiss).  Otherwise, good luck and bank in Cypress or Greece for while.  EU inter-government loans make PIK seem like child's play where the room is rotating as credits are discussed.  The French have discovered that they are lost in credit ratings by S&P yesterday, so sell the French, Spanish and Italian public owned businesses to German.  Who said you need an army to make national conquests? Goodness gracious Germany will have its dreams soon. Grow up, its here no one knew it, except the Germans and Russians.

SAT 800's picture

"--Written in Italian-Swiss."  That's funny. Maybe they should have gone back to Latin; with pages in the front saluting the Pope. They could call it the Holy Roman Empire Bond; sounds saleable to me. LOL.

swmnguy's picture

So, how does an individual retail investor (Of course I'm asking for a friend I know) find out if his mutual fund assortment includes funds holding this crap?  Is there a specific term that's in the prospectus?

SAT 800's picture

There's a simple answer to this question; Tell your "friend" to get out. There isn't any mutual fund that he should be in.

dontgoforit's picture

Good article.  How can this kind of stuff be legal? 

Vendetta's picture

All it takes is a corrupt government

monopoly's picture

And at some point, it all goes...Poof! Just the timing.

russwinter's picture

There is More to the Story of Ultra Junk Finance:


Seer's picture

Nice piece, Russ.

"The more digging I do, the more I discover these horrific sorts of connections exist, though they’re rarely reported by the media; perhaps because it seems too fantastic or might harm the sensibilities of average folk."

I"m suprised that you missed this one.  The "media" are also engaged in all of it, so in no way would they expose what would also expose themselves.

And as to Stockman not getting it (the intentional corruption), perhaps he's just leading us to the crime scene without calling it such, letting others roll out the accusations (avoid libel)?

Calculus99's picture

The 'moron' who buys the PIK debt doesn't realise he's bought it. The moron is the poor sap that relies on the professional money managers to manage his money.

Everyone gets paid with zero risk (investment banks who originate the deal, management/owners who pocket the cash via the special dividends etc) and yet ALL the risk is dumped on the (poor) investors.

Like I've always said, if you see an investment banker walk down your drive, run out the back door as fast as possible because if you're not an insider, 90% chance you're about to be setup. This is why ALL investment bankers and ALL politicians, especially Tony Blair, are banned from the small lane I live on.

mvsjcl's picture

Mutual funds are artifices with two primary purposes: First, to herd and control the money of a captive ìnvestor,` e.g., the 401(k) schmuck, and to make it easier to steal from him or her. Second, to control money flows, hence, the market.

SAT 800's picture

Yes. Seriously, fellow Zeros; if you have one sell it. Now.

RaceToTheBottom's picture

This is a very good article.  Especially in that it shows how the FED has totally corrupted price discovery and how the marketplace handles risk when interest rates don't work. 

By extension this shows exactly the deals that allow the 1% -.01%'er to have profited most from the FED's bailouts of the rich.

AdvancingTime's picture

Never before has mankind diverted such a large percentage of wealth into intangible products or goods.  I contend this is the primary reason that inflation has not become a major issue. The modern economy is loaded with interwoven contracts reeking of contagion. If faith drops in these intangible "promises" and  money suddenly begins to flow into tangible goods seeking a safe haven inflation could soar even as debts go unpaid and promises are left unfilled.

Like many people I worry about the massive debt being accumulated by governments and the rate that central banks have expanded the money supply. The timetable on which events unfold is often quite uneven and this supports the possibility of an inflation scenario. A key issue being one of timing. If the price of gas jumps to $8 a gallon overnight do you buy gas and not make your car payment or stop driving the twenty miles to work? Answer, it could be months before your car is repossessed so you buy gas. More on how we have sowed the seeds for inflation to suddenly strike in the article below.

SAT 800's picture

Yes. Very good. When we told you inflation was inevitable; it was true. I'm getting a little tired of people who think it won't happen here just because it hasn't become a huge problem in the few months that have gone bye since the Great Easing; or the Skid Greasing, or whatever you want to call QE.

Racer's picture

"What experience and history teach is this– that people and governments have never learned anything from the study of history. GEORG HEGEL"

Redneck Hippy's picture

 What kind of moron buys PIK debt?  Maybe the Fed has engineered the perfect environment for financial Darwinisim where financial entities too stupid to live are allowed to go extinct.

Marco's picture

Someone who has no skin in the game and who gets bonuses for short term profit ... I don't see any morons though. Just naive people who put up the money through pension funds etc. and the sociopaths busy shoveling it towards the rich while getting their cut.

And no, naive people don't deserve to get taken advantage of ...

Citxmech's picture

You mean other than the TBTFs I guess.

Sambo's picture

Perhaps 95% of Americans will perish in this manner.

mvsjcl's picture

The kind of firm that buys PIK debt is the kind of firm which is dutifully following orders.

SubjectivObject's picture

Which sentiment seeks to justify the practice of the fraud.

Misallocation of capital has social value after all.

What a relief.  Thank you.

Vampyroteuthis infernalis's picture

It looks like the bubble for the rich is finding a needle. Soon, there will be nothing left in our system worth buying when it all crashes.