FLOYD NORRIS

An ominous trend to watch: Corporate loan defaults

Published: September 4, 2008

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NEW YORK: The weak go first, and people take comfort from the very weakness of the fallen. The fact that it is only the weak who are suffering is taken as proof that there is no general problem.

That is how it was with the mortgage mess, which is still called the subprime crisis even though it has long since spread. Now there are more prime mortgages going into foreclosure than there are subprime ones.

The world of corporate loans now looks like mortgages, circa 2007. Defaults are on the rise, but they are concentrated among small companies in industries with big problems.

Standard & Poor's Leveraged Commentary and Data reported this week that the default rate - the percentage of leveraged loans in default - rose to a five-year high of 3.3 percent in August. At the end of last year, the rate was a tiny 0.24 percent, or about one of 400 loans.

"There have been no high-profile, high-impact defaults," S&P reported. "Defaults this year have been more plentiful than painful." It pointed out that while 3.3 percent of loans are in default, those loans amount to just 2 percent of the money lent. Few big loans have gone bad.

The loans that have gone bad have been concentrated in two industries - real estate and auto parts. S&P calculates that they have accounted for almost half of this year's defaults. Gambling has also had problems, as it turns out that there are too many casinos in some places.

One of the three August defaults was Star-Tribune, the publisher of the Minneapolis newspaper. Investors fear that other publishers will follow, and several of them have loans trading at distressed prices.

It has been easy to write off as unimportant most of the recent defaults. WCI Communities? What did you expect from a homebuilder with major operations in Florida? Intermec? It is an auto parts supplier that was overburdened by debt when it came out of its previous bankruptcy in 2005. Those were the other two defaults last month. Neither produced headlines.

But the trends that felled those companies are present for many others, and just as good times can reinforce themselves, so can bad times. Linens 'N Things is a retailer that went private in a 2006 leveraged buyout and went bankrupt earlier this year. It has a reorganization plan that wipes out some creditors and gives others stock in the company, worth perhaps a quarter of what they lent. It is closing a lot of stores, and has negotiated lower rents on others. That won't help the landlords, or those who lent to them.

To make things worse, the banks that were lending with abandon little more than a year ago now are erring on the side of caution. "The tightening already appears to be more widespread than it was during the early 1990s," said Eric Rosengren, the president of the Federal Reserve Bank of Boston, in a speech this week, "and portends more difficulty in financing business fixed investment and commercial real estate projects in the second half of this year."

This is a crisis that appeared in early 2007, as subprime mortgage lenders began to fail. (Remember all the happy talk about how there were not that many subprime mortgage loans anyway, and that the problem would be contained, whatever that meant?) But it has taken until now for there to be clear signs that the problems were spreading beyond mortgage lending and real estate.

Why has it moved so slowly?

One reason is that the excesses of the lending spree both ensured that the crisis would come and delayed its arrival until it could be worse.

It now appears that the vintage 2006 and early 2007 mortgages were very risky not just because home prices were high and lending standards low. Many homeowners who bought in 2004 and 2005 refinanced their mortgages in later years, often taking out large amounts of cash. Those refinancings prevented problems from appearing earlier, and made the later problems larger for those who had the misfortune to have invested in securities backed by the post-2005 loans.

Similarly, the leveraged loan market in 2006 and the first half of 2007 featured banks competing with each other to make foolish loans. There was a flood of "covenant-lite" and "toggle-PIK" loans. The first feature stopped the bank from stepping in until the borrower actually missed a payment, rather than when it violated a financial covenant related to assets or profits. The second feature made it almost impossible for a borrower to miss a payment. If it did not have the cash to pay interest, it could "pay in kind" by taking out more loans.