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The Risk Of Junk Upends Leverage

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Lenders are supposed to call the shots in the midst of a credit drought. But a few junk-rated borrowers have been flexing their muscles lately. Using the specter of about $460 billion of high-yield loans that mature from 2011 through 2014, they’ve gotten creditors to agree to change terms in ways that indicate that leverage has swung to the borrowers from the banks.

Lenders have good reason to worry. Unless the so-called shadow banking system, mainly securitized investment vehicles like collateralized loan obligations, which absorbed about 70 percent of leveraged, or below investment-grade, loans during the boom years comes roaring back to life, this tidal wave of supply could easily overwhelm demand. That’s especially a risk in the peak year of 2014, when a staggering $219 billion of debt comes due, according to Standard & Poor’s Leveraged Commentary and Data.

Even allowing for a partial recovery in credit markets by then, that could shut a lot of borrowers out of the market and cause a spike in defaults among those companies that binged on debt during the leveraged buyout craze.

Lenders are eager to avoid that risk. And anything that reduces the probability that a borrower will eventually default should make its loans more valuable, a boon for banks and investors that hold the debt.

Some borrowers are taking advantage of this, as well as the improved loan market conditions, and average junk-rated loan prices have increased to about 85 cents on the dollar, from about 63 cents in December. They are negotiating extensions of the maturities of some of their loans to avoid the rush.

Companies like SunGard Data Systems, Smurfit Kappa and VNU have done so-called amend-to-extend deals in the last few months, paying in most cases a small fee as well as a higher interest rate. For example, SunGard extended $2.5 billion of a $4.2 billion loan by three years, paying lenders an additional 1.9 percentage points in interest and a one-time quarter-point fee, according to Leveraged Commentary and Data.

That sounds good for lenders — they get paid more and don’t have to worry as much about the refinancing squeeze down the line. And in a number of cases, the revised loans have traded higher than the residual nonmodified debt in the secondary market. But borrowers seem to have gotten the better deal from some of these modifications.

Consider a borrower’s alternative, which is to refinance an entire loan. Then, it would have to abide by the stricter covenants and otherwise less-forgiving terms now demanded by creditors. It would also have to offer them an upfront price discount. By instead just modifying an existing loan written during the borrower-friendly credit glut of several years ago, it can avoid the full extent of market changes since then. And a loan modification requires only the consent of 50.1 percent of lenders, so borrowers may find it easier to get controversial terms approved.

Some borrowers have actually managed to use the process to loosen covenants. SunGard, for example, eased some of the borrowing and debt limits written into its loan. Such changes would probably have been impossible to secure had the company been forced to completely refinance its loan. But by modifying only part of it, SunGard, a financial technology company, needed to persuade just half of its banks to play along.

Of course, the nonmodified parts of these loans still have the original covenants. But if the borrower later modifies the remainder of its loan, as many are expected to do, it may be able to wriggle free.

Granted, tweaking a loan to reduce the probability of default can be valuable for a lender, especially at a time when creditors’ recoveries from bankrupt borrowers are running below their long-term average of about 40 percent. So borrowers are right to take a strong stand when negotiating a modification. But the prospect of making concessions during a credit drought must nonetheless stick in lenders’ craws.

It just gets better, there are huge ticking bombs in the system.

Surely it's in the lenders interest to get there money back as fast as they can, why increase the interest charges surely increasing the repayment rate would be more beneficial to reduce the risk?

And still the debt mountain isn't tackled.

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