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If you're like me, this hootin' hollerin' market rally has you wondering when the next shoe will drop and bring the party to a halt. On that note, I'd say the financial sector continues to have the many shoes of a millipede, and the laces of low-grade corporate debt appear to be loosening.
Shareholders of banks and life insurers: Look out above
Stop, pop, and roll your debt. That's what many highly leveraged or otherwise speculative companies often did in previous years: As the principal on loans and junk-rated bonds came due, management would pop up into the fanciful, floaty world of the credit markets, open their arms to eager lenders, and refinance to their hearts' content. The risk-mellowing miracle of loan collateralization allowed banks to offer attractive rates on these leveraged loans -- so named because of the high debt levels of borrowers -- and collect fat fees.
Writing in a recent New York Times article, Floyd Norris describes the whole process as the corporate version of subprime mortgage machinations. He goes on to tell how the founder of private equity firm The Carlyle Group now publicizes the fact that JPMorgan Chase (NYSE: JPM ) and Citigroup (NYSE: C ) used to compete to lend money to the firm. But as with housing, when you play in this arena, sooner or later, the lions come sauntering in.
According to a Moody's representative, the default rate on leveraged loans and speculative grade bonds could approach 14% by year end, compared to the 10%-12% range during the 1991 and 2001 recessions. Others look at the higher percentage of low-grade bonds in today's market and conclude that the bond default rate could reach as high as 24%.
While it appears that banks may be the group that's mostly on the hook for leveraged loans gone bad, insurers, which collectively own roughly 18% of all outstanding corporate bonds, may be the ones to take it in the gut on much of the projected bond losses. Standard & Poor's recently noted that the group's bond and commercial mortgage holdings will cause "unprecedented stress" in the next 18 months. It's well known that insurance companies Prudential Financial (NYSE: PRU ) , Hartford (NYSE: HIG ) , and Lincoln National (NYSE: LNC ) have all applied for TARP funds. How much they will ultimately receive, and whether it will be enough to offset future losses on asset writedowns, is the premium-grade question.
Insure your portfolio
The coming release of stress test results may provide some clarity on the actual dollar amount of leveraged loan losses that banks face in the next couple years. As for the insurers, I'm not holding my breath on getting details anytime soon. What I do know is that the recent let's-get-happy run-up in the sector seems to be based more on hope than fundamentals. Investors who are attracted to the banks and insurers may want to consider doing what these companies should have done all along -- manage risk. That means taking a pass on their shares until hard facts emerge.
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