Two Reasons to Worry About Corporate Credit

As far as big banks are concerned, private equity ('PE') has overstayed its welcome...

PE firms are eager to keep making deals. However, these firms are having trouble securing their usual debt capital from large bank loans.

The issue stems from past transactions. Banks still hold debt from prior PE deals on their balance sheets.

Take Citrix Systems, a software company that went private last year in a deal worth $16.5 billion. This was done with help from PE firms Elliott Management and Vista Equity Partners.

Bank of America (BAC), Credit Suisse, and Goldman Sachs (GS) were all involved in the process. They incurred collective losses exceeding $500 million from the debt supporting the transaction.

Other banks, like Barclays (BCS) and Morgan Stanley (MS), still owe money from when Elon Musk bought Twitter.

As a result, many banks are hesitant to lend any more money to PE. These firms are forced to explore alternative financing sources like private capital... which often come with higher interest rates.

And even if they're willing to pay high rates, finding such alternative financing can be a challenge... there just aren't that many other options out there.

This is a classic example of what happens in a credit crunch. Today, we'll examine two metrics that point to a worrying setup in the current economy...

Banks have good reason to be concerned these days...

We can see this via the Senior Loan Officer Opinion Survey ("SLOOS"). It's one of our favorite ways to track credit standards.

The SLOOS is a quarterly survey from the Federal Reserve. In short, it gathers information about lending practices in the U.S... by asking loan officers if their lending rules have tightened, eased, or remained unchanged in the past three months.

In the most recent SLOOS report, 51% of banks indicated they've made their lending standards stricter. That's about as high as it gets before we hit recession levels...

During the first quarter of 2008 – when the U.S. was on the brink of a recession – 32% of banks reported tightening standards. Within a year, that number surpassed 75%.

And in early 2001, 51% of banks were tightening standards... right as the dot-com bubble was bursting.

A similar story is shaping up today. When times get tough, banks can't just assume they'll make their money back on loans.

Instead, they look at the recovery rate – the value of a company’s assets compared to its debts. It gives the bank an idea of how much money it would recover in bankruptcy.

And right now, recovery rates look horrible.

Take a look at the following chart. It shows the aggregate recovery rate for the 1,000 largest U.S. companies.

If it holds where it is today, companies will have their lowest recovery rate in 30 years...

This is a huge cause of concern for banks today. There are fewer valuable assets to help protect the value of their loans.

No wonder they're tightening standards so fast.

When the SLOOS indicates a tightening of credit availability, it reflects the financial sector's growing caution in lending money. This caution is typically triggered by perceived economic risks like high interest rates and inflation.

And that's what we're seeing from banks today.

They're still deep in the red from past transactions... And with tighter credit conditions, they're hesitant to lend any more money to PE firms. In an economic downturn, PE-backed companies may struggle to generate the returns needed to repay their loans.

In essence, banks are the 'canary in the coal mine'...

When they tighten their purse strings, it means they're bracing for economic headwinds. That's what we're seeing today.

As longtime readers know, credit availability drives the economy. So if banks are unwilling to lend, we know what comes next... Companies that need to borrow will be starved for capital to the point of bankruptcy.

The SLOOS is right around levels where we see recessions kick off. Plenty of companies are already struggling with refinancing.

Keep an eye out for third-quarter SLOOS data. If tightening gets any higher, it will be yet another sign that the credit market is in bad shape.

Regards,

Joel Litman
October 23, 2023