LBO Debt: Another Banking Debacle

Banks thought they would make money on everything in 2007. Instead, they made money on nothing. That winning streak appears to be extending into 2008.

One of the most sure-fire schemes at banks was lending money to LBO firms so they could take big public companies private. The LBO analysts were smarter than most investors and people on Wall St. They would find companies which were badly and inefficiently run. Once these firms were bought, they could cut costs and drive up the value of the assets.

Banks figured this kind of LBO debt was safe. The guys doing the deals, like KKR and Blackstone (NYSE: BX), had been around for decades and almost always made their investors huge returns. That was due to their impeccable judgment. They only picked winners to take private.

All of this seemed to work until no on wanted the LBO debt. The banks could not sell it to institutions, so they had to hang on to it themselves, or sell it at a discount. Tribune Co., which was taken private in April by investor Sam Zell for $8.2 billion, issued loans now trading a 26% discount, according to The Wall Street Journal.

Big money center banks are between Schylla and Charybdis. They risk losing money by selling loans at a discount. The risk write-downs on loans that go unsold.

There are about $150 billion of LBO loans sitting with banks. That mean a haircut of $15 billion at current discounts. If the bank balance sheets were not weakened by subprime write-offs, that might be OK. But, that isn’t the case.

Douglas A. McIntyre