Will Leveraged Loans go the way of Sub Prime Loans

In my effort to asses how far and wide the credit problems will reach, I started to looking at the possibility of a parallel situation in the corporate borrowings to what happened in the house mortgage markets. The housing sub prime market has been hit with a wave of defaults and repricing that has caused severe losses in banks and hedge funds. The sequence of events, although extremely condensed, is as follows:

1. Low interest rates and abundant liquidity in the economy encouraged borrowing and real estate investment.
2. The increased activity in real estate reached a mania level and a bubble in the housing market has manifested.
3. As soon as interest rates began to creep up, housing prices began to decline and real estate activity slowed down.
   
4. The housing bubble bursts leading to high level of mortgage defaults and house foreclosures
   
5. As defaults began to increase, Collateralized Debt Obligations (CDOs), a pool of home mortgages that issue debt and pays interest to their holders, began to decrease in prices and their investment grade credit quality has been questioned.
   
6. As CDOs began to reprice, SIVs and Hedge Funds started to show losses and difficulty to finance and borrow against these deflating assets.
7. The combination of slower borrowings, increase defaults and foreclosure and crash in CDO values lead to massive bank write downs, so far to the tune of $50 Billion, see here.
   
8. Capital ratios, which allows bank to extend and originate loans, began to suffer and as a result banks began to tighten credit across all lending activities.

The situation is similar to housing crises in the corporate borrowing market, where, again, cheap credit has fueled another bubble as well. Home owners were not the only one who were buying assets on cheap credit. Private equity funds were on a tear for the past few years. Those funds bought every thing and any thing at huge premiums to their market prices. You can argue that the stock market record highs earlier this year was a direct result of the private equity LBO activity. The game plan was simple, take private a company that generates good cash flows and leverage it to the tilt. Banks then sell these loans, junk loans as they are highly leveraged and covenant lite, to hedge funds, SIVs and in the form of Collateralized Loan Obligations CLOs, see chart below the level of issuance of these loans.

Both situations saw feverish activity predicated on cheap credit. In the situation of highly leveraged homeowners, they buckled under high interest rates and declining home prices and the ensuing mess began. My question is will highly leveraged companies from private equity activity in the past few years get affected by higher interest cost and tight credit?

The leveraged companies bought by private equity has no room for error due to the maximum debt they took on. Banks now are tightening their lending practices and more realistically they have shut down any lending to sub par borrowers, ie., highly leveraged balance sheets, as evidenced by high LIBOR rates (lending rate between banks) see chart below.

The matter gets worse by the added complexity of slowing economy and possible rescission. In slower economy junk bond issues and highly leveraged companies experience high level of defaults, (see chart for corporate default rates from 1985- 2007). Defaults in corporate loans can hurt holder of CLOs and junk bonds, which may be found in the hands of hedge funds and on the books of banks. Banks have held the bag for over $300 billion of leveraged loans from private equity transactions that was completed through the year (source wall street journal) and could not get sell them due to lack of interest from investors, as evidenced by the failed sale of $4 billion Chrysler debt earlier this month, see article here.

If leveraged loan issuers began to default with slowing economy, bank will have another crises of write downs on their hands.