Buyout Loans: Who’s Holding the Bag?

August 7, 2007, 11:11 am

Just a few weeks ago, selling the debt used to fund leveraged buyouts was a piece of cake. Now, it borders on the impossible. As a result, many of the investment banks that agreed to finance these deals are on the hook to make the loans themselves — at least until buyers and sellers can settle on a price and the debt can be resold.

By some estimates, more than $200 billion in high-yield debt is stuck in the pipeline. Which banks are shouldering the biggest burden? Glenn Schorr, an analyst at UBS, ran the numbers.

Goldman Sachs tops his list, both in absolute and relative terms. Goldman was committed to $71.5 billion in leveraged loans, mostly to fund buyouts, at the end of the second quarter, representing about 8 percent of the firm’s total assets.

Merrill Lynch had an estimated $49 billion in leveraged loan commitments, or 5 percent of its assets. Lehman Brothers was committed to $43.9 billion in leveraged loans, representing 7 percent of its assets.

Rounding out the list was Morgan Stanley, with $34.8 billion in commitments (or 3 percent of assets) and Bear Stearns with $19.6 billion (5 percent).

What’s so bad about holding these loans rather than farming them out, as the banks originally intended? For one thing, it represents a concentrated risk in a large, relatively illiquid asset. For another, these particular loans are generally underpriced, at least by today’s market standards. That means they generally do not provide enough interest to compensate the lender for the risk involved — and so may need to be sold at a discount.

What’s the worst that could happen? At the extreme, Mr. Schorr estimates that the banks involved could take a 10 percent hit on these loans, although he expects the actual haircut to be much smaller. (Some banks may have hedged some of their exposure or pre-syndicated part of the loans.) At the high end, such a loss would equate to about 25 percent of 2007 earnings, he calculated.

Even so, Mr. Schorr thinks most banks are positioned to ride out the storm, especially Goldman, because of its diverse range of businesses and its heavy presence outside of the United States. He also likes Merrill Lynch, whose stock he upgraded to “buy.”