This is how things can get out of control.
Wall Street firms that want to loan money to companies are increasingly allowing those companies to adjust their earnings so that they look credit-worthy enough for loans, says Bloomberg.
Think of it as putting a little lipstick and rouge on a pig — but these pigs are made-up with tricky accounting.
Beth MacLean, who manages $14 billion in loans at PIMCO told Bloomberg that its time for everyone to keep an eye out for “what is real versus what is accounting” gimmicks.
It's no secret that, since the Federal Reserve lowered rates after the financial crisis, investors have turned to increasingly risky loans in their search for some kind of yield. Junk bonds (as no one on Wall Street likes to call them) have returned 145% since 2008, are up 45% this year, and yield an average of about 6%.
The Fed, for its part, has been eyeing this specific corporate debt junk bond issue since last summer. That's when it sent letters to a bunch of Wall Street banks warning them not to finance big corporate takeover deals with a 6 times debt-to-EBITDA (earnings before interest, tax, depreciation and amortization) ratio.
Back in 2013, 27% of deals passed that threshold. During the deal boom of 2007 it was 52%.
What makes 2014 especially worriesome to regulators, though, is that this flurry of deals we've seen recently is the clearing of a back log in dealmaking since the financial crisis, and the word is that it's not close to over. That means money for banks when they desperately need it. Trading, as we know, is not doing so hot, so these deals are hard to pass up.
In December Morgan Stanley, Credit Suisse Group AG and Goldman Sachs Group Inc helped KKR finance a $1.6 billion LBO that was over the Fed's threshold (at a ratio of 6.8). Now, however, three banks have opted out of doing another similarly leveraged deal with KKR to buy landscaper ValleyCrest Companies LLC because of pressure from the Fed, says Reuters.
But that doesn't mean the deal won't get done. It means that someone else will do it. In this case, that someone Jefferies, a smaller less regulated boutique firm.
So maybe these risky loans won't end up on a systemically important bank's balance sheet, but they'll still be out there. And that means companies still have an incentive to pull off some accounting shenanigans in order to meet loan standards.
And when everyone's making money people want to keep the party going — especially when there's not a lot of parties going on anywhere else anyway. For banks and private equity firms making these loans, that means making credit agreements with junk bond borrowers that allow them to make accounting tweaks.
One Fed associate director, Todd Vermilyea, said earlier this month that standards “have continued to deteriorate in 2014” and that we may need “stronger supervisory action.”
Be careful out there.
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