Distressed debt returns to the spotlight

Much of the time, when people are running around screaming “we’re all going to die!”, it’s time to curl your lip and be the optimistic contrarian.

You buy the assets they’re dumping and keep your eye on the fundamentals. Sometimes, though, they are right, and this is looking more like one of those times.

The fundamentals, among which is a lot of cash in developing world central banks and high corporate profits in the developed world, now also include a loss of confidence measured in shrinking dealer-provided liquidity and waves of margin calls.

I was a tad early in thinking the US leveraged loan market index, the LCDX, would soon rally off the lows of early last week. The LCDX didn’t get hit as badly as junk bonds and their indices, and rallied the day after my column, but it still lost about a point over the balance of the week.

More liquidation could be coming in the next several weeks, even though aggressive hedging has tailed off.

“Dust off the playbooks for ’98,” as a credit strategist for a major dealer told me. That means that if you are going to be a liquidity provider for sellers of the LCDX, you have to be prepared to take a mark.

Jeffrey Rosenberg, a credit strategist with Banc of America Securities, says: “The events in the credit markets have important implications.

“This is not a one-off event because this is the beginning of a significant change in the volatility environment, and that has a direct relation to liquidity. The virtuous cycle of low vol and higher liquidity is broken.”

Last week, it was hard to see any heavily traded leveraged assets for which mark-to-market traders and investors were willing to provide liquidity. Those are the circumstances in which it is the function of central banks to step up and take the other side of a selling wave. But the Fed doesn’t seem to be inclined to do anything.

Bernard Connolly, the global strategist for AIG Financial Products, and a prominent monetary economist, says: “If Greenspan were still chairman, I would have put the odds of an easing in the next month at better than 50 per cent. Though it has to come, the odds of an easing in the next month are, unfortunately, low.”

What market people don’t understand is that, while that is important, yes, it’s not as important as winning an academic argument. This environment is exactly the sort for which Mr Greenspan’s improvisational “risk management” approach was best adapted. Oh well.

Soon, though, political pressures, if not econometric models, will force a reliquification, and the Day of the Credit Vultures will return.

I spent time this month discussing one such strategy with Michael Sheehan. He incurred the wrath of the Africa-centric NGO community and the UK Treasury, and wrung up a lot of legal bills in the course of suing Zambia in London to pay a settlement agreed for some bilateral debt he had bought from Romania.

While the sum – $15.4m plus some costs were awarded – was not huge, Mr Sheehan and his investors attracted the vilification suitable for mid-level Bond villains, so to speak.

“If you Google ‘Sheehan’ and ‘vulture’, he says, “you’ll get 36,000 web pages.” Actually, “Sheehan” and “vulture” are now up to more than 62,000 web pages.

Mr Sheehan, whose Washington DC area firm, DAI, manages Donegal, the entity that bought the Zambian debt, has not been the hardest-core vulture investor on the emerging market street.

He specialised in debt conversion deals, under which debts denominated in richer world currencies are exchanged for local currency that can be used for investment in local enterprises or securities.

In the the 1980s or 1990s, that was seen as soft-core vulturing, not like the confrontational litigation approach for which the Dart family and Elliott Associates have become known.

Mr Sheehan’s debt, which he bought for 11 cents on the dollar from Romania, had been incurred to pay for tractors. Socialist-era Romanian tractors, yes, but that’s a better use of borrowing capacity than the consultants and travel costs that inflate a lot of World Bank loans. He tried to convert it to local currency to invest in either local enterprises or the Zambian treasury’s term notes, but was brushed off and evaded by government officials.

Finally, he settled for a cash pay-out, on which, he says – and a London court agrees – they defaulted. Then he took them to court in the UK to enforce the settlement agreement. In late April he won but is still waiting for his money as procedural matters spin out.

The cancel-the-debt NGOs and Africa campaigners may not be aware that the Zambians are using their debt relief “room” to lever up again, this time with local currency issuance as well as new international borrowings. Throughout Africa, written-off developed world debts are being replaced by loans from China. The Chinese don’t seem to worry about being considered vultures.