Banks trying to restructure European leveraged loans to sell them and cut their exposure are creating a new class of risky "toxic" junior debt, which could leave them more exposed in an economic downturn, bankers say.
Banks are creating new junior debt - lower-ranking junior mezzanine and payment-in-kind or PIK loans - to allow them to reduce exposure by selling most of the leveraged loans that have been stranded on balance sheet by the credit crisis.
But banks may be replacing one problem with another: the toxic junior debt cannot be sold and will have to be held by the arranging banks at below-market rates for high risk and limited rights in the event of default.
"Yes, you can free up the rest of the capital structure to be distributed, but you're left with an unsaleable rump. It's a risky strategy," a leading leveraged loan arranger said.
European banks have made little inroads into the 75 to 80 billion euro pipeline of hung leveraged loans, as they are reluctant to sell the debt at deep discounts. Instead, they are focusing on restructuring deals that are being offered with relatively small discounts.
The end result is banks taking more credit risk. They end up holding highly-leveraged debt for a longer time in an environment where defaults are expected to rise as the credit turmoil starts to hit the real economy.
"This is the highest risk debt in the capital structure and it's uneconomic. Banks are not being paid an appropriate return for where they are in the capital structure," a senior leveraged loan banker said.
The approach is being favoured by some European commercial banks, which are not under the same pressure to mark positions to market as investment banks, which prefer to discount the paper and take losses to retain seniority in highly leveraged deal structures, bankers say. ( Gulf )