First Cracks (And Losses) In The Insane LBO Craze

It could be an aberration. Or it could be the first visible crack in the insane leveraged buyout craze that has spread across the country: JPMorgan, Bank of America, and Goldman Sachs could get hit with a combined loss of up to $156 million on the $780 million in junk debt they pledged to sell to fund the buyout of teen-fashion retailer rue21. With consequences for investors.

Private Equity firm Apax Partners, which already owned 30% of rue21, had offered to buy the remaining shares for $1.1 billion, a 23% premium of where the shares traded before the announcement. It was in May, when the hot air had just started to hiss out of the junk bond bubble – and more ominously, out of the greatest debt bubble in history – after the Fed had begun to contemplate out loud the revolutionary concept that it might actually dare to taper what Wall Street had considered a taper-less “QE Infinity.”

The 23% premium was a great deal for shareholders. They couldn’t believe their eyes, and 99.7% of them approved the deal last week. But since May, the world has changed. Retailers, particularly teen retailers, have run into trouble as the excitement of a hot back-to-school season turned into a dud. Same-store sales at rue21 dropped 5.9%, earnings dropped too, and the bane of all retailers, inventories piled up. Meanwhile, the company continued at breakneck pace to open new stores around the country, now numbering 971, as it is trying to get to the magic 1,000 by the end of the year.

The Fed’s policies have accomplished a magnificent feat: turning conservative but desperate investors into “high-yield” investors – in quotes because the Fed at its peak performance managed to push yields on even risky junk bonds below 5%, a level that FDIC insured one-year CDs were paying during the halcyon days of the old normal, before QE, when “high yield” meant something in the double digits. And these conservative but desperate investors, hunting down yield in reasonable places without finding any, closed their eyes and held their noses and picked up this stuff and gorged on it, and drove down yields even further.

But since May, investors have begun to open their eyes just a teeny bit, and some let go of their noses, and yield on junk debt has been rising since. This rue21 debt was the first that actually turned investors off. Suddenly, they’d smelled junk.

JPMorgan, BofA, and Goldman had tried to sell $530 million of that stuff last month but failed. So now they’re trying again, “according to people familiar with that matter,” the Wall Street Journal reported. To rid their books of the $780 million in debt, the banks are offering it at a discount of $0.80 to $0.85 on the dollar – and will have to eat the difference.

If they dump it at the low end, they’d receive $624 million, for a loss of $156 million. That the banks are even contemplating such a loss, rather than keeping that crap hidden in their basements, while waiting for sunnier days, exposes their thinking:

One, new banking regulations require that banks maintain higher capital reserves against risky paper of this type, raising the costs of holding it, and giving the banks an incentive to unload it.

Two, the banks estimate that the value of the debt will continue to go south, as rue21, teetering under its load of debt, will run into rough waters, given the dreary retail environment in the US.

And three, the banks are seeing that more hot air, despite the current reprieve, will hiss out of the junk debt market, and more generally out of the greatest debt bubble in history, and that dumping that debt now might produce a smaller loss for the banks  than dumping it at a later date. This vision would be another signal for investors around the world to buckle their seatbelts.

The LBO and junk-debt craze was ignited by the nearly $3 trillion the Fed printed since the financial crisis. Recipients include JPMorgan, now negotiating to settle various mortgage scams for $11 billion; it made $53.2 billion in profits over the last three years. But American consumers weren’t so lucky.

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