Wall Street Blocked By Buyout Debt
Banks Find Few Takers for Loans Funding Deals

By David Cho
Washington Post Staff Writer
Thursday, January 31, 2008

Wall Street banks have failed to unload $220 billion of debt, which financed a wide range of major corporate buyouts initiated over the past two years, and that backlog is choking the credit markets despite recent efforts by the Federal Reserve and Treasury to invigorate the economy.

The troubles have ensnared such major acquisitions as Harrah's Casino Hotels, Alltel and Chrysler. Some deals could unravel if banks cannot find backers for the buyout loans they committed to funding. This could further shake investors' confidence in a financial system reeling from massive losses in home mortgages.

The institutional loan market, where buyout loans are priced and traded just like stocks on an exchange, has remained frozen far longer than top private-equity investors predicted. Last summer, some of these investors said it would take about six months for the credit markets to clear the logjam of buyout debt.

Instead, loans for deals as old as Clear Channel Communications, which was swung in 2006 for $18.7 billion, are still getting the cold shoulder from debt investors.

"Six months ago, we were saying it's going to take six months to work through this debt," said Christopher Donnelly, vice president of Standard & Poor's Leveraged Commentary & Data. "Well, what happened was none of this paper was sold . . . and now we think it's going to take much longer to clean this up."

Debt investors, which include hedge funds, specialized investment firms and big brokerages, have for years been major buyers of loans from Wall Street banks, freeing banks to lend even more money. This is a key reason lending surged in the past five years, leading to a boom in mortgages, car loans, credit cards and big private-equity deals.

But after absorbing massive losses from their portfolios of subprime mortgages, the investors have become unwilling or unable to buy loans of any kind.

"People woke up after they got spooked by subprime," said Colin Blaydon, director of the Center for Private Equity and Entrepreneurship. "The mortgage markets got souped. That's why investors ran away from them, and many of these investors were the same ones who were holding leveraged loans."

Banks, including nearly all of the biggest names on Wall Street, are being forced to hold onto that debt. This has a chilling effect on their operations and hurts earnings, similar to the way large inventories of unsold clothes dampen profits at retail stores. A major source of income for banks is the fees they generate from making loans, repackaging them as securities and selling them to debt investors.

Now they face a difficult choice. They can either sell these loans at extreme discounts and take the losses or hold onto them and hope the appetite for buyout debt revives.

As of this week, the banks were struggling to sell $152 billion in buyout loans and $68 billion of buyout bonds, according to Donnelly. With such a massive amount in the pipeline, these financial firms have little money or desire to back new buyouts.

"You won't see any more gigantic deals for a while," Donnelly added.

The stock markets could also suffer because private-equity deals almost always boost the share prices of companies that are being acquired. What's more, after owning a firm for several years, a buyout firm often recoups its investment by putting the company back on the public stock markets. Last year, private equity was responsible for 44 percent of all initial public offerings, according to data collected by Dealogic, an independent research firm. In general the stocks in those offerings did much better than other IPOs, the researcher said.

The credit crunch has already scuttled major deals and called others into question. This week, the $6.8 billion takeover of Alliance Data Systems collapsed after its buyer, private-equity giant Blackstone Group, told the firm it was backing out. The banks underwriting that deal have been unable to find backing for $3 billion worth of financing. ADS sued Blackstone yesterday in an attempt to force it to complete the acquisition.

Two of the first failed deals involved Washington area firms. The $8 billion buyout of electronics maker Harman International unraveled days before the $25.3 billion acquisition of student lender Sallie Mae. More than a dozen others ran into trouble as private-equity firms endured bouts of buyers' remorse.

The shares of several firms that had agreed to takeovers have dropped significantly below their acquisition price, a sign that investors are skeptical that the buyouts will go through. Thomas H. Lee Partners and Bain Capital Partners had agreed to pay $37.60 a share for Clear Channel in 2006, for instance. But yesterday the stock closed at $29.04, more than 22 percent lower than the buyout price.

Treasury officials have proposed several measures to shore up confidence in the credit markets, including a mortgage relief plan that may lead to more mortgage lending. The Fed also has been cutting rates aggressively, reducing a key short-term lending rate yesterday by 50 basis points barely a week after an even steeper cut.

U.S. Treasury Assistant Secretary Anthony Ryan said this week there are signs these moves are starting to work. As evidence, he pointed to the asset-backed commercial paper market, which is beginning to stir after being shut down for months.

He added that it may take time for other segments of the credit markets to return to normal.

"This is certainly not an 'all-clear' signal, but perhaps the beginning of the transition to an improved state," Ryan said at a financial conference in New York. "This process will take more time."