Posted on October 15, 2008
While most economists and the Fed discount the control of monetary growth as a tool for managing the economy, money does matter. Monetary growth in excess of growth in the economy’s productive capacity contributes to inflation. Similarly a sharp decline in the money supply would likely lead to economic contraction and ultimately to deflation, as was experienced during the 1930’s.
In my world, mergers and acquisitions and corporate finance, we witnessed a unique phenomenon during the 2005-2007 period as many new sources of financing became available to support the rapidly growing Private Equity community. Loans were syndicated at a furious pace and specialized finance entities, many supported by hedge funds, aggressively provided capital with a speed and at risk levels not seen with traditional bank lenders. Second lien and tranche B paper became the norm.
Much of this paper was ultimately securitized through issuance of collateralized loan obligations and similar instruments. Some have estimated that this resulted in an increase in credit availability of at least 25% above levels that would have been possible if the market had been restricted to traditional sources such as banks and asset based lenders. The net impact was a dramatic decrease in the cost of capital, with loan spreads contracting by several hundred basis points and a sharp relaxation of underwriting standards. Lenders routinely provided senior debt at five times cash flow to companies and deals that would have only supported two and a half to three times cash flow a few years earlier.
As a result purchase multiples increased dramatically and companies that might have been worth six times cash flow earlier in the decade were suddenly worth eight times cash flow or even more. The worm has now turned and deal loans, if available at all, are being underwritten at more traditional levels and more traditional … read the rest