Wall Street Shifts Risk of Burning Bed in Loans

Investors chasing yield are taking on more and more credit risk without being compensated for it.

Wall Street banks, burned by commitments to fund leveraged buyouts before the credit crisis, are reducing the chances they’ll be stuck with junk-rated loans again by getting investors to take on that risk.

Banks and borrowers are benefiting as investors agree to set aside money to finance acquisitions, such as Carlyle Group LP’s takeover of Ortho-Clinical Diagnostics Inc., weeks before deals are closed. Money managers often get paid nothing for being in limbo while letting issuers lock in their interest rates. Usually, banks give investors their allocations only days before providing loans.

The terms reflect investor willingness to take on more and more risk as they compete for higher-yielding assets in a sixth year of near-zero interest rates from the Federal Reserve. Bankers are taking advantage of such demand to make it less likely they’ll be stuck with a deal like the 1989’s “Burning Bed,” the junk financing for Ohio Mattress Co. that left First Boston Corp. in need of a bailout from Credit Suisse Group AG.

“This is really a situation where [investors] are taking risk off the banks’ balance sheet for free,” Beth MacLean, a money manager at Newport Beach, California-based Pacific Investment Management Co. (Pimco), said in a telephone interview. “We think it’s bad practice.”

The trend is one of the latest signs of investors lowering their standards in the $750 billion leveraged-loan market that regulators have said is getting frothy. The Fed and Office of the Comptroller of the Currency are increasing pressure on banks to improve the quality of their loans after a record amount of the debt last year lacked standard protections for lenders such as limits on debt relative to earnings.

During the financial crisis, banks were stuck holding $200 billion of loans financing buyouts including KKR & Co.’s takeover of First Data Corp. and KKR and TPG Capital’s acquisition of TXU Corp.

Leveraged, or junk, loans are rated below Baa3 by Moody’s Investors Service or lower than BBB- by Standard & Poor’s.

Banks, increasingly sensitive to their capital commitments, started syndicating leveraged loans more quickly during the last two years amid strong demand for the debt, according to Craig Arcella, a partner in Cravath, Swaine & Moore LLP’s corporate department in New York.



“Those two things put together result in banks wanting to get risk off their books as quickly as possible,” Arcella said.

Investors poured a record $61.3 billion into loan mutual funds in 2013 while $82 billion was also raised from issuance of collateralized loan obligations (CLOs) that bundle the debt, the third-biggest year ever for those deals, according to Morningstar Inc. and Royal Bank of Scotland Group Plc data.

There have been $217 billion of new loans issued in the U.S. this year, compared with $176.8 billion during the same period in 2013, according to Bloomberg data.

Money managers are accepting the long waits to ensure they actually get a piece of a loan because there’s so much demand, Arcella said. Many financings are still completed like they used to be, where banks allocate a loan days before providing it.

During the buyout boom of 2006 and 2007, banks were sometimes paid an additional fee on top of their underwriting payment when they were forced to commit to financings for several months before acquisitions would close, according to Arcella. Now that they’re syndicating loans to investors earlier, banks aren’t usually being paid those extra fees, he said.

The push to syndicate deals as early as possible is primarily “driven by underwriters looking to minimize risk,” Kevin Lockhart, co-head of global leveraged finance at Jefferies LLC in New York, said in an interview. “Borrowers also want to lock in rates since they don’t know what will happen in a matter of weeks.”

Borrowing costs in the loan market have fallen. The average interest rate on institutional loans was 4.05 percentage points more than lending benchmarks in June, down from 5.87 percentage points in 2009, according to S&P’s Capital IQ Leveraged Commentary & Data.

Barclays Plc led a group of banks arranging a $2.175 billion term loan this year for Ortho-Clinical Diagnostics to fund the company’s buyout by Washington-based Carlyle. The deal was allocated on May 9 and wasn’t funded until June 30, according to data compiled by Bloomberg. The manufacturer and distributer of medical instruments locked in interest margins of 3.75 percentage points above benchmarks.


Interest Payments

“You are making a commitment without being paid for being on the hook for that risk,” Scott D’Orsi, a money manager at Boston-based FOC Partners, which oversees about $2.1 billion, said in a telephone interview. “You start to take on some real credit risk in these situations.”

Lenders aren’t receiving interest because the debt hasn’t been funded. Investment firms are starting to demand fees after weeks of setting aside money with no returns, all the while having to make distributions to their own investors, D’Orsi said.

Ortho-Clinical Diagnostics agreed to make full interest payments to investors after 30 days, according to Bloomberg data. It originally offered to pay no fee for the first 45 days, then 50 percent of the fee from 46 to 75 days, and the full rate after that, the data show.

Randall Whitestone, a Carlyle spokesman, and Brandon Ashcraft, a Barclays spokesman, declined to comment.

Citigroup Inc. led a group of banks that took six weeks to give investors the $700 million Time Inc. term loan they bought to fund the publisher’s spinoff from its parent, according to Bloomberg data. The deal was allocated on April 17 and funded on May 29, the data show.

Scott Novak, a Time spokesman, and Rob Julavits, a Citigroup spokesman, declined to comment.

The delays may be especially costly for CLOs, which bundle high-yield corporate loans and slice them into new securities of varying risk and return. Investors who buy CLO slices receive interest payments.

Pimco’s MacLean says investors should be compensated for relieving banks of some of the risk of a hung deal. The infamous $457 million loan for the takeover of Ohio Mattress by investment firm Gibbons, Green, van Amerongen left First Boston in need of a capital injection from Credit Suisse.

“The loan market has agreed to essentially free financing for 30 to 45 days,” said MacLean, who oversees about $14 billion in bank loans. “We are trying to push for investors to take a tougher stance.”

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