Recovery rates on leveraged loans (often used to fund leveraged buyouts) have been less than 25 percent, compared to historical average recovery rates greater than 80 percent (see WSJ article).

Source: WSJ article image, Moody's Investor Service data

Given the recession and recent credit problems in the market, increased defaults are to be expected from companies with high debt and falling revenues, yet there appears to be more to the story. As is typically the case when a company defaults, those at the bottom of the debt food-chain, such as those holding senior unsecured bonds and subordinated debt, are the first to lose everything, compared to leveraged loans and senior secured bonds. What is unique in the current market is that a large majority of recent leveraged financing for acquisitions was done with loans, rather than unsecured bonds. As a result, the debt food-chain has contracted, such that the normal buffer of junk bond subordinated debt that is usually in place to absorb the initial losses is smaller than normal, or in some cases non-existent. Recent data from Moody's finds that 60 percent of all issuers in the US that have rated loans, along with over 30 percent with speculative-grade issuers, have a loan-only capital structure. With such a flat structure, losses go straight to the top of the debt food-chain, thereby explaining the lower recovery rates for leveraged loans. This is certainly not good for the large bank lenders of leveraged loans, but may be even worse for the junior lenders that hold subordinated second-lien and mezzanine loans (see Reuters article). A recent Fitch report finds that the recovery rates of such subordinated holdings are expected to remain in the 0 to 10 percent range. It appears we can expect more shakeout in the credit markets, which will continue to put pressure on the banks.