"They just dont know when to stop"

In the midst of a serious bout of indigestion in the credit markets, the private equity masters of the universe have announced another mega-deal. Like a child at a party, they are loading up with chocolate, sweets and fizzy drinks without working out how they are going to carry it all, let alone digest it.

The announcement by KKR of another mega (US$24bn) offer to acquire Macy's Inc is just one of many large private equity deals this year including Chrysler, Alliance Boots and TXU. Most of these deals involve a significant amount of debt finance in the form of loans and bonds. Since March, the leveraged loan and high yield markets have been struggling to get the debt financed. How things have changed since the heady days of the first quarter when the loan issuers were able to get away with less covenant restrictions and record low spreads. Then, as the deals began to grow in size and frequency the sub-prime mortgage meltdown filtered through to affect sentiment in the broader credit markets. As a result there was a general 'push back' by investors. Bond and loan deals have been adjusted, and even pulled as a result. This may be good news if it wasn't for the fact that they remain on the banks books in the form of a bridging finance (currently around US$11bn). However, this is only a temporary fix and these deals will come back to the market as soon as there is sign of stabilisation. Meanwhile, the future pipeline continues to fill up as new private equity takeovers are announced.

The problems facing the credit markets can be defined into three related groups:

The first is the demise of the US housing market, which is affecting credit-backed by mortgages. It started with the sub-prime sector and is currently moving on to Alt-A issues. As investors lose money in these securities they may be less inclined to take on risks elsewhere. The two Bear Stearns hedge funds that ran into difficulty last month have been valued at nothing and next to nothing (they had been investing in AAA and AA rated tranches but leveraged at least 10 times). In their letter to hedge fund clients, they described the planned winding up of the funds as a 'difficult development for investors in these funds' - no kidding. Bear Stearns did try and stabilise things by propping them up with a US$1.6bn collateralised repo line, which they say should be covered by the remaining assets in the fund - oh that's ok then. There must be other similar funds out there that are experiencing problems with leverage bets on AAA bond spreads. We should not assume, however, that all hedge funds were positioned this way. Indeed, over the last 12 months a number of funds have been set up to short the US housing market. Furthermore, some of the moves we are seeing in the credit indices are hedging strategies, and therefore reducing exposure.

The second category is over-supply. This is the problem described at the beginning of this piece. Eventually there will be a level at which the backlog of deals gets done. We started with incredibly low borrowing costs and relatively low levels of company leverage. The modest increase in borrowing costs, together with less accommodative covenants, does not make the economics of private equity deals go away. The Chrysler deal, for example, includes a possible US$20bn of loan financing, which at current market levels will now cost the company an extra 1%. Instead of paying 8.4% each year, they will have to pay 9.4%. That's an extra US$200m a year.

The third is economics. So far the global economy has soldiered on, corporate profits have remained strong, the US consumer has continued to spend etc.. However, eventually this strong growth story will fade as the central bankers are determined to bring inflation under control, and to continue to stave off this threat.

The equity markets have been in denial about the implications of problems in the credit markets. Normally a robust equity market would lend support to credit, but the fact that equity volatility has remained high has undermined many credit models. We have said in previous notes that we will get increasingly worried about the economic consequences when we start to see problems with the Alt-A type of lending - this now appears to be occurring. We have also warned about the drag effect coming from rising rates, as ARMs (adjustable rate mortgages) are re-fixed.

The European high yield market has reacted to these three factors by pushing spreads from 188 at the end of May, to 317 yesterday. This has occurred with equities (usually a support) reaching new highs and with strong economic growth. Any sign of weakness in either will not be taken well by the credit markets.

There is little economic reason to suggest that the so-called 'carry-trade' will reverse. Growth in Japan is still modest and short rates are unlikely to rise significantly, meanwhile rates in the target markets continue to trend higher. However, there is a related concern; what if there are hedge funds that are using the carry trade to fund their CDO investments? Closing down these positions could start a new decompression trend in this area as well.

The summer months will continue to be difficult for credit markets, and investors should stay underweight. We are still not ready to signal 'the big one', but the evidence is mounting.