There is too much money sloshing around out there and history could be ready to repeat itself. From the Wall Street Journal:
In a world awash in investable funds, even many of the most troubled companies are finding lenders willing to offer them big money. This rescue financing, as it's sometimes called, can give companies time to clean up their balance sheets and avoid a trip to bankruptcy court. U.S. filings for bankruptcy reorganization -- a painful experience for employees, creditors and shareholders alike -- are at a 10-year low. Also at historic lows are U.S. corporations' debt defaults.
But some worry that all the money flowing to troubled companies deters them from solving their problems. At times it just lets them "kick the can down the road," . . . .
It also can be risky to have so much debt sloshing around the economy's shakier regions. When rescue lending fails, the extra debt can make a bust just more spectacular. Among lenders that risk taking it on the chin are some hedge funds, which have largely replaced banks as lenders in this kind of finance. . . .
Rescue money can come in the form of bonds or even equity infusions, but many of the recent deals involve credits known as leveraged loans -- those carrying interest rates of at least 1¼ or 1½ percentage points above the London interbank offered rate, or Libor. . . .
The question that should be asked (and answered) is why would someone lend a troubled comapny money at Libor + 1.5% (about 6.86% at current rates). Currently one can purchase a number of medium term Treasury securities with no risk of default at yields just over 5% . Going to the mutual fund market one can easily obtain yields of 5% to just over 7% with almost no risk of default. If money is "so cheap" individuals lending in high risk situations are not being properly being compensated for their risk. In this case buy no default government or low default corporate debt instruments, relax, go sip a mint julep on the veranda, and stop trying to squeeze an extra 0.5% out of a company by taking on a much higher level of risk.
The Federal Reserve is watching the leveraged-loan market as an "area of possible financial risk," a Fed governor, Randall S. Kroszner, said in a recent speech. He said the Fed was "mindful that high levels of leverage can lead to credit problems relatively quickly for both borrowers and lenders when conditions turn.". . . .
This has happened before.
. . . . late-1980s era of high-yield "junk" bonds gave way in the early 1990s to a recession, the collapse of savings-and-loans and the downfall of the main junk-bond underwriter, Drexel Burnham Lambert Inc. A severe credit crunch ensued, with all but blue-chip companies having trouble securing debt funding.
In 1998, a crisis at hedge fund Long Term Capital Management, amid turmoil in global debt markets, brought on a milder credit squeeze. Three years later the combination of the dot-com meltdown, another recession and the Sept. 11, 2001, terrorist attacks led to a wave of bond defaults. The default rate on high-yield bonds soared to nearly 13% in 2002, according to data compiled by New York University.
Today, the default rate on leveraged loans, which are somewhat akin to high-yield bonds, is running below 1%. Credit-rating agencies expect it to move higher. Standard & Poor's Corp. foresees a 2.7% default rate by next April. That still would be below the 3.3% long-term average.
Meanwhile, last year saw only 30 corporate bankruptcy filings with liabilities over $100 million in the U.S. There were more than 100 a year from 1999 through 2002.
In the past, banks were the main source of leveraged loans. But now hedge funds -- investment partnerships for institutions and the rich -- and other nonbank institutions make up about 75% of investors in this market. Many rescue loans are secured or are fairly senior. In some cases, if they go sour, the lender may be able to turn its loan into equity or control of the borrower. Hedge funds are generally more open to doing that than banks are.
Past experience in banking has shown me that companies that lend money for a living do poorly at running companies such as pipelines, mining companies, shopping malls, etc. that they took over because the borrower could not repay the loan.