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Sinking Feeling for Citi, JPMorgan

Liz Rappaport

The latest buyout debt debacle has left investors in Citi (C) and JPMorgan (JPM) with an unsettling feeling.

The banks failed Wednesday to sell billions of dollars worth of loans to finance Cerberus' buyout of Chrysler Group and Kohlberg Kravis Roberts' buyout of Alliance Boots. The setback stands to load down Citi's and JPMorgan's balance sheets with more risky, unwanted debt securities -- a fact not lost on stock investors who sent the banks' shares down more than 1% Wednesday afternoon.

The black eye comes as the banks and their Wall Street rivals have belatedly sought to rein in their exposure to risky debt. According to sources in the markets, banks have cut back funding to collateralized debt obligations that buy mortgage debt, and increased their collateral requirements for lending to hedge funds.

But it grows clearer by the day that there is not much the investment banks can do to undo the hits they may have to take based on over $200 billion of commitments to finance the leveraged buyouts already announced.

Citi and JPMorgan didn't comment.

The underwriters of the $20 billion of Chrysler debt -- JPMorgan, Citi, Goldman Sachs(GS), Bear Stearns(BSC) and Morgan Stanley(MS) -- could not sell the $12 billion portion of the deal tied directly to the Chrysler auto business, according to a report in The Wall Street Journal.

The banks have agreed to take on $10 billion of the $12 billion portion of the loans, while Cerberus and DaimlerChrysler(DCX) will lend Chrysler $2 billion to complete the financing, according to the report, which cites sources familiar with the matter.

In Europe, Deutsche Bank (DB) is the lead arranger of the loan deal to finance KKR's buyout of U.K.-based drugstore chain Alliance Boots. According to a Bloomberg report, it and other banks involved were unable to sell $10 billion of loans out of a total $12 billion to finance the buyout.

Shares of JPMorgan were recently down 1%, while the rest of the investment banking group was mixed. Goldman Sachs has bounced after closing below $200 Tuesday, and remains up 1.5%. Deustche Bank and Citigroup are down 1.2% and 0.7%, respectively.

"The panic has already happened" regarding the potential for these deals to fail, says Christian Stracke, senior strategist at CreditSights. He also notes that the banks have likely hedged much of their exposure to the loans in the derivatives markets.

Indeed, the risk premiums on the U.S. automakers in the credit derivatives market have risen dramatically. Stracke says the same is true for the derivatives connected to Boots, and to the overall derivatives index tied to the leveraged loan market, which continues to fall and make new lows.

But, hedged or not, "banks are working with their working capital," says Stracke. "They can't be buy-and-hold investors."

Last week, the brokerage sector suffered losses amid news of the true losses incurred by two Bear Stearns hedge funds. Punk Ziegel analyst Richard Bove said the debt market has grown too fast, exposing firms to risks that are both huge and difficult to calculate.

So, for the private-equity sponsors and the sellers involved in Chrysler and Boots, the deal is done, and they can get back to business. For the banks taking on the debt, they now have $20 billion of speculative-grade debt on their balance sheets. And for the leveraged loan market, which has already seen deals postponed and banks hanging on to extra paper, it means those securities will one day get dropped onto the market, most likely at a huge discount to the price at which the banks originally bought them.

"There is a sense that there is a forced seller out there," says Stracke.

So, if and when the banks sell all the loans they're collecting, the discount will surely drag down prices in the rest of the loan market, too.

Chrysler and Boots aren't the first and they're unlikely to be the last loans to get stuck at the banks, either. Citigroup and JPMorgan made a point on their recent earnings conference calls to note that they expect their revenues will be somewhat stifled in the third quarter from being stuck with these loan commitments.

Likewise, the stalling out of these deals means that private equity isn't budging from its end of the bargaining table.

"For the banks to get stuck with Chrysler and Boots, it means that the private-equity firms aren't willing to give up the borrower-friendly terms they've become accustomed to," says one fund manager who speaks only on the condition of anonymity. These are the very terms that loan investors have recently stuck out against. These include weak covenants, meaning very little protection for the lender in the case of events that suggest deterioration in the borrower's ability to cover their liabilities.

So, with the buyers demanding more yield and covenant protection on one side, and private equity unwilling to amend the agreements they've made with the banks, these firms are stuck in limbo.

The banks' only recourse is to eat through the pipeline as best they can, and unload the loans when the market seems at its best. But with all this looming supply coming from the banks, not the debt issuers themselves, the credit markets are poised for further declines.

The prevailing sentiment among bank loan investors is, Why would anyone buy a comparable new deal, when they know the banks will be having a virtual closeout sale on all their piled-up loans sometime down the road? The game of chicken just further stalls the market for leveraged buyouts, and particularly those for the riskiest companies.