The $13.5 billion worth of debt backing the tech mogul’s adventures in social media added to more than $40 billion of similar loans and bonds that banks already had stuck on their balance sheets after a collapse in investor appetite in 2022. Starting in the summer, the big US and European banks that underwrite the financing for highly leveraged private takeovers began writing down the value of debt they were stuck with, booking more than $2 billion of losses on the debt they had been unable to sell. More losses, including large hits from the Twitter debt, are to come.
As 2023 gets going, keep watching this loan market: It will be one of the clearest indicators for the health and profitability of investment banks.
Leveraged finance relies on banks being able to distribute loans they have underwritten quickly when a deal gets closed: That frees up space on their balance sheets to pledge funding for the next deal and keep the advisory fees rolling in. The current backlog means investment bankers likely enter 2023 with one arm tied behind their backs, while still facing markets that aren’t going to quickly get any less volatile or worrisome.
Bankers spent the last weeks of 2022 trying unorthodox routes to shifting loans. For Musk’s monster deal, lenders led by Morgan Stanley have tried to persuade the billionaire to replace some of the Twitter debt with personal loans that would be backed by more of his stake in Tesla Inc., according to Bloomberg News. That would make the loans less onerous for Twitter and both safer and cheaper for the banks to own because the debt would be secured against easily sellable Tesla shares.
It would free up capacity in leveraged finance divisions to write new deals and offer an escape from the steep losses banks would likely have to realize if they end up having to sell all the Twitter debt at discounts of 30% to 40% of face value, which is where early discussions with investors indicated the prices might be. It would also reduce Twitter’s crushing debt service costs by a significant amount.
Barclays PLC, Citigroup Inc., Morgan Stanley and others among a group of 30 lenders have also been slowly offloading bits of one of the other financing monster from this year: the $15 billion in debt backing a private equity buyout of Cytrix Systems. The banks used a pooled sell-down arrangement to sell another $750 million of loans in mid-December at just 87 cents on the dollar, chipping away at a deal that cost banks more than $600 million in losses on the first $8.6 billion of debt they managed to sell earlier in 2022.
The seizing up of leveraged finance is the stickiest problem left by the widespread collapse in dealmaking and company fund raising in 2022, wrought by war, inflation and growing fears of recessions in many economies. Wall Street executives have been left fretting about business in 2023 with several using speeches at a Goldman Sachs Group Inc. conference in December to sound alarms about the US economy, corporate earnings and the prospects for financial markets. Their messages are geared strongly towards their own staff as the annual fights over bonus payments gets going and staff cuts get underway.
Bonus budgets are being cut heavily for bankers who work on takeovers, stock listings and bond sales — up to 50% in some areas. Even traders of stocks and bonds are set for disappointment. Executives are trying to preserve capital ahead of bumpy times, while also ensuring that highly valued people who haven’t had the best year are still paid well enough to stick around.
But don’t get your violins out just yet. What sounds like a heavy comedown for bankers is really just a change of pace from two blowout years in 2020 and especially 2021. Investment banking and trading revenues aren’t far out of line with what banks made in 2018 and 2019 — investment banking fees will likely be down 20% or so in 2022 compared with those two years, but trading revenue was already well ahead after just nine months of 2022.
So how tough is 2023 likely to be? Leveraged loans are a great market to watch as the year unfolds to judge how things are going. Investment bankers typically see an order to how troubled markets stumble and recover: The riskiest assets stop selling first and make their comebacks last. Investment grade bond issuance has already settled down significantly and found a comfortable zone of pricing where companies are happy to borrow and investors happy to lend. Leveraged loans, the riskiest junk bonds and new share sales are normally the last things to find a market again, more or less in that order.
Loan prices in the main US and European indexes run by Morningstar have been trading in the low 90s cents on the dollar since late spring, while the share of loans in the US index that trade below 90 cents on the dollar has risen sharply to more than 20%, according to analysts at Jefferies. When these numbers start to improve, a recovery in dealmaking and other kinds of fundraising won’t be far away.
Banks are still prepared to underwrite leveraged loan deals now, but the terms are much tougher for prospective borrowers than in the early months of 2022. Banks want more freedom to change the interest rates on loans to attract investors and to be able to sell at steeper discounts with the borrower bearing the cost instead of the bank. That is making it harder to make deals: It mainly underlines the gap between the returns that worried debt investors need to be enticed into a new loan and the cost of finance a private owner can afford to pay while still having a chance of making a decent return on their equity.
Before this gap can start to close, central bank interest rates need to approach their peaks and markets must settle down. The longer it takes, the worse 2023 will be for investment banking fees and the deeper the job cuts will run. If banks can get the new or potential owners behind the biggest borrowers to take on more financing risk themselves — as they are trying to do with Musk — they’ll have more of a chance of rebooting takeover activity and everything else.
More From Bloomberg Opinion:
It’s the $65 Trillion in Debt You Can’t Find That’ll Get You: Paul J. Davies
DeFi Discovers New Market Manipulations: Matt Levine
The Temptation to Call the End of Inflation: John Authers
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Paul J. Davies is a Bloomberg Opinion columnist covering banking and finance. Previously, he was a reporter for the Wall Street Journal and the Financial Times.
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