3 Scenarios for the End of Cheap Debt

From a risk perspective - what should you do today if these are the 3 possibilities of how the cheap debt period will end (Wall Street Journal). Also when do you this the era of cheap credit will end because this will effect your decisions as well.

The waves of debt feeding today's buyout deluge will eventually recede. Now's the time to figure out what will make that happen.

This has become the essential question on Wall Street, where even the cocksure ranks of banks, hedge funds, and private-equity firms have begun to doubt lenient standards for lending and deal-making. . . . .

The markets have changed dramatically since 1989. . . . At the core of the change is the term "liquidity," a catch-all meaning there's lots of money in the markets for anyone who needs it.

Behind the liquidity is something grander: The culmination of decades of advances in the architecture of financial markets and information technology. The result is a global, instantaneous network of hyperinformed investors, moving money from Dubai, Geneva, or Greenwich into ever-more specialized investments.

Will this global liquidity actually minimize the impact of the inevitable credit downturn? Or is it, in fact, only feeding a bubble?

We won't know until it happens. But theories have begun to form around three different scenarios.

Scenario #1

The Big One: This is the realm of the capital letter, meant to express outsize effect: The Asian Currency Crisis or The Russian Financial Crisis. As this theory goes, some big event flips investor confidence in an instant, drying up capital as investors flee to safe havens. These are by their very nature unpredictable and devastating.

Right now, credit markets are at the other end of this spectrum. Bond investors demand next to nothing to own corporate debt. The difference in yield between a risky B-rated junk bond and an ultrasafe Treasury is just 2.4 percentage points, the lowest spread on record. It's a sign of investors' high tolerance for risk. The big event causes them to quickly reassess this tolerance, dumping corporate bonds and pushing out spreads in an instant.

Scenario #2

Death by Drowning: In this scenario, the pullback doesn't come from one outsize event. Instead, lenders and borrowers slowly choke on their own largess. Lenders prop up many companies in a series of refinancings, heaping new debt on old. Eventually, lenders would be compelled to tighten their standards. That's what's happened in the housing market today.

Scenario #3

The Slow Leak: The Slow Leak theory is the most benign of the scenarios. It's based around the idea that annual private-equity returns will gradually decline, slowly ending today's ferocious buyout binge, which comprises a third of today's record mergers volume. As private equity firms adapt, they'll pull back the reins on their borrowing, ending the debt boom before it gets too messy.
Investing has already gotten harder for the private-equity groups, which face hostile shareholders and boards of directors demanding more at the negotiating table. . . .

"The issue is not a meltdown but that they may not get the returns," says Morgan Stanley vice chairman Robert Kindler. Private-equity firms are targeting "high-teens returns, versus mid-20s three to five years ago."

The risk is they borrow even more as they try to make up for faltering performance ... which will bring them right back to scenarios one and two.