And then the loans just float away... with the rest of the garbage

Creativity is generally viewed as a positive trait. But at this moment in time and in the world of finance, creative financing solutions have become synonymous with shell games. Its unfortunate, because creativity in finance has brought us so many important innovations, most I'm sure were derided in their early stages. But anyway, I digress.

The top banks who underwrote bridge loans to finance recent LBO transactions find themselves in a tough position. A prison of their own creation, to be sure, but it may require a little creativity to find their way out.

So let's look at where they stand and make a few not-so-bold assumptions:

1. Banks like J.P. Morgan, Citigroup, Bank of America and others made large loans to private equity in order to facility LBO transactions. The assumption was that these loans would be paid off quickly from proceeds of either a permanent loan package or a public bond offering. The terms of the bridge loan, therefore, were borrower friendly.
2. Now that the high-yield market has sold off tremendously, the borrowers may choose (or be forced to) keep the bridge loan outstanding for considerably longer than first assumed.
3. The banks would certainly not agree to the terms of the bridge loan if negotiating a permanent loan today. Considering the rate alone, the Lehman High Yield Index OAS has risen 207bps off its recent low in May. So its likely that the banks would want something on the order of 150-200bps in additional yield if negotiating these loans today.
4. The spread duration of a 10-year loan is about 7. So that implies that the theoretical market value of a 10-year loan declines by around 10% if market spreads increase by 150bps. Obviously the loans were made with various terms and at various levels, but its safe to say that loans agreed upon between January and May 2007 have probably decreased in market value by at least 5-10%.
5. The banks are willing to take some amount of the credit risk in these companies, but would like very much to reduce the concentrations. With the CDO market basically shut down for the moment, they will have to find some other buyer.

So if we accept all of above, all of which is either simple fact or a easy assumption, what are the bank's options.

Well, first they could offer to pay the break up fee. Usually in a LBO, either the buyer or the seller can walk away from the deal, but must pay a 1% or so fee to the other party. If the private equity buyer was game, the bank could offer to pay the break up fee. Its a good deal for the bank, because the banks probably know that the real value of the loans has declined by considerably more than 1%. We know that banks involved with TXU have offered to do just this.

I'm skeptical that this will actually happen, because I think the private equity firm can get a better deal by negotiating down the price of the acquisition, as discussed here.

Now here is a creative solution, which I've got to say is absolutely brilliant. I'm sure the odds of this actually happening are incredibly low, but its brilliant none-the-less. OK here is the idea.

Banks know they can't get away from the economic loss taken on these poorly negotiated loans. But they still want to mitigate the concentration risk of having such large loans to a small number of borrowers. Why not just solve each other's problems? Create a new company with all these various banks contributing equity capital. Then the new company buys the loans from the bank. The banks, as a group, have exactly the same economic risk as before, but individually they have spread out their credit risk. As Deal Journal points out, this is very similar to a CDO transaction in most respects.

The downside is that the banks basically eat the market loss on the loans up front. But not only do they wind up with more diversification, its also possible that they'd be able to someday sell some or all of this new company they created. At the very least, they wind up retaining some of the upside should the loans eventually be sellable to a 3rd party.

Now, I'm sure the comment section is going to light up with complaints that this is some kind of accounting shenanigans. That's a legitimate concern. But this wouldn't seem to excuse the banks from taking a FMV loss, nor would it ultimately be much different than a normal loan syndication, other than the huge size of the thing.

Creative? Yes. Shell game? Maybe on the books, but not in real economics. Good idea? Absolutely.