Someone asked me the other day “Where are the bond vigilantes?” The person who asked was referring to the treasury market in relation to the rising CPI. Before proceeding, let’s discuss the term bond vigilantes.

Richard Russell in Dow Theory Letters offers this viewpoint: “These are the bond people who are like bloodhounds when it comes to inflation. When the bond vigilantes smell even a hint of inflation, they head for the exits, meaning they unload their bonds.

That is one kind of bond vigilante. A second kind of bond vigilante is concerned with receiving adequate yields when risks of defaults rise.

In regards to treasury yields, with the economy heading in to a recession, consumer spending declining in real terms, unemployment rising and the ISM contracting, yields on treasuries should be dropping. And they have been as the following yield curve shows.

Yield Curve For January 5 2008

Chart courtesy of Bloomberg. Click on chart for sharper image.

How To Find Bond Vigilantes

If you want to find the bond vigilantes, you have to look in the right places. Treasuries are the wrong place. I suspect we see the 30 year long bond below 4% sometime in 2008.

After a long hiatus, bond vigilantes are starting to show up in commercial real estate. For proof I offer Leveraged Loans Lose $28 Billion; Carlyle Is Punished.

For investors stung by $28 billion of losses on high-yield, high-risk loans, it’s payback time.

Creditors are making borrowers from Carlyle Group’s LifeCare Holdings Inc. to casino owner Tropicana Entertainment LLC increase the interest on their debt by an average 0.83 percentage point to change the terms of their loans, the highest price since at least 1997, according to data compiled by Standard & Poor’s in New York. The penalties are four times higher than six months ago, S&P; said.

A total of 179 North American companies have a high risk of default or may need to change details of their debt agreements, Moody’s Investors Service said. Lenders are taking advantage of the distress to recoup losses after the collapse of the subprime mortgage market caused $551 billion of so-called leveraged loans tracked by S&P; to fall below 95 cents on the dollar, from 100 cents before June.

“There’s been a dramatic shift in negotiating leverage from borrowers to debt holders,” said Scott D’Orsi, who helps manage $1.4 billion in loans as a partner at Boston-based Feingold O’Keeffe Capital. “We will see more of this with companies that are susceptible to a slower economy.”

Creditors are also demanding fees of as much as 0.35 percentage point of the value of loans to relax terms, or covenants, such as the minimum ratio of earnings to debt they require or deadlines for reporting quarterly financial results, S&P; said. Before June, lenders charged 0.125 percentage point.

Carlyle, the Washington-based private-equity firm led by David Rubenstein, bought LifeCare, the third-largest long-term health-care operator in the U.S., for $555 million in August 2005. In November the Plano, Texas-based company broke a covenant limiting debt to less than 8.5 times earnings before interest, tax, depreciation and amortization, or Ebitda.

LifeCare asked banks to change the loan terms to allow Carlyle to invest more money in November. They [the bond vigilantes] demanded a $2 million payment and raised the interest rate on $250 million of loans by 1 percentage point to 4.25 percentage points more than the London interbank offered rate. The increased interest will cost LifeCare an extra $2.5 million a year.

Tropicana borrowed $3.1 billion a year ago to help fund the takeover of its parent Aztar Corp. by closely held Fort Mitchell, Kentucky-based hotel owner Columbia Sussex Corp. Chief Executive Officer William Yung promised lenders the company would retain its casino licenses.

The New Jersey Casino Control Commission revoked Tropicana’s gaming permit last month, citing “lack of business ability, a lack of financial responsibility and a lack of good character, honesty and integrity.”

Tropicana’s lenders agreed on Dec. 21 to delay a declaration of default on $1.34 billion of loans in return for a $7 million payment and a 3.6 percentage point increase in the interest rate to 10.5 percent, costing about $48 million more a year, regulatory filings show. The company also pledged to sell the Tropicana in New Jersey and casinos in Indiana and Mississippi to repay the debt.

“It was a bad time” to be seeking a waiver, said Derek Haught, vice president of finance at Columbia Sussex. “There was pushback from lenders.”

“Anytime you need to go a bank it’s a problem right now,” said Jonathan Rather, general partner and chief financial officer of Welsh, Carson in New York. “Banks are going to extract some flesh. They have to.”

Commercial Real Estate Dominoes

Here is a snip of what I said on December 26, 2007 in Commercial Real Estate Dominoes Collapse.

This is the final nail in the coffin for jobs prospects in 2008. Store expansion has been one of the key drivers for job creation. Look for unemployment to soar. Look for rising unemployment to trigger still more delinquencies in credit card debt and housing foreclosures. One by one, collapsing dominoes are picking up speed, and from multiple directions as well.

Well that was fast: Unemployment Soars as Private Sector Jobs Contract. Those expecting a “soft landing” or “shallow recession” are badly mistaken.

Implications of the Return of the Vigilantes

  • The number and size of commercial real estate deals in 2008 will collapse.
  • Deals that do go through will be closely scrutinized.
  • Covenant-lite deals and Toggle Bonds will be a thing of the past. See Toggle Bonds – Yet Another High Wire Act for a prediction that is now coming home to roost.
  • Banks are going to be unsympathetic to problems of any kind.
  • Borrowing costs will increase for all but the very best of customers.
  • The commercial real estate implosion will be refreshingly simple compared to housing.
  • Some mega-deals are going to blow up spectacularly. One possibility that many are watching is the empire of Harry Macklowe, a famed New York real estate buccaneer. The New York Times has more on Harry Macklowe’s $6.4 Billion Bill.

By now it should be clear to everyone that commercial real estate will not be the savior most thought it would be. At best, commercial real estate is going to be a huge drag on lending capability of banks as the number and size of defaults soar.

If you are looking for love (or vigilantes) then don’t look in all the wrong places. If you are looking for love from the vigilantes, then you are in trouble.

Mike “Mish” Shedlock
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