Dogs Getting More Attractive Financing Than Houses

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I guess if you read the jobs numbers today you'd say "huh, the economy is getting a little better," though there are other avenues you could go down. But if you read that Petco Animal Supplies, where the pets go for their animal supplies,1 sold $550 million of Caa1/CCC+ holding-company covenant-lite PIK-toggle notes at an 8.62% yield2 yesterday to fund a dividend recap, you'd be all "HOLY CRAP I LOVE 2006!"

The Journal article on the latter point takes the view of "some managers are sort of skeptical of holdco PIK-toggle notes to pay dividends to the private-equity owners of pet supply stores," and, I mean, you can't blame them (the managers or the Journal), but of course the real story is not "some people didn't buy some terrible bonds," which is always and everywhere true, but rather "other people did," which is less common.

Part of the purpose of the Fed bidding everything government-guaranteed and <=5 years down to a zero yield is to convince / force the investors of the world to start making reckless investment decisions, er, "move further out the risk curve," because people making reckless investment decisions like "I want to fund a chain of big-box kibble stores" is how we create new productive ventures and Put Our Economy Back To Work™. That and juicing aggregate demand by handing people money, which in America takes the somewhat unintuitive form of (1) lending them money to buy houses and/or (2) convincing them that they have more money because their house price went up.

The Petco part of the strategy is working like a charm. First of all, buying these bonds is just a classically reckless investment decision. Really the recklessness decision checklist for fixed-income investments consists pretty much of:

  • holdco?
  • unsecured?
  • PIK-toggle?
  • use of proceeds is dividend recap?
  • do you sell pet supplies?

So, success. Not only that, though, it's a virtuous cycle. In some sense you're an idiot to give money to a risky company, charge them 8.5% interest, and then let them not pay you that interest if things get tough. But in a broader sense, it's a great idea: if things get tough, Petco is more likely to survive, because (1) their interest rate is relatively low versus historical CCC levels and (2) they don't have to pay it. Similar things can be said about the continued weakening of covenants: if you don't have covenants that throw you into bankruptcy when you run into financial trouble, you can run into financial trouble while still avoiding bankruptcy. Part of why high-yield investors are stretching to buy these bonds is that recent and expected default rates are low; easy terms - and expected easy refinancing with low rates forever - are part of why you can expect default rates to remain low.

Meanwhile the other half of the mechanism - cheap mortgages and juiced home prices - is only sort of working. Ryan McCarthy has a nice rundown of the disconnect between (1) the Fed has lowered MBS rates to, like, zero and (2) you still can't get a mortgage, for a very very metaphorical "you."3 Basically the answer comes down to a lowering of rates not translating into a lowering of underwriting standards, which in some unexpressed sense is what you want: you want people moving further out the risk curve to capture more yield.

Some of the theory here is frankly mysterious to me. For instance, the Fed directly lowers yields by buying conforming agency RMBS, while those agencies are actually tightening underwriting standards - via stepped-up putback enforcement - in a way that reduces the supply of conforming mortgages. So in some ways that works at cross-purposes, but in another sense both of those things should have the effect of pushing banks (investors) out the risk spectrum in the form of making more non-conforming mortgages (buying non-agency RMBS) to capture higher yields. But in fact while subprime RMBS is booming, pricewise, it is actually contracting, sizewise. Similarly the big Journal piece on putbacks contains this assertion:

Fannie officials also say put-backs aren't as responsible for tighter standards as lenders suggest. Underwriting criteria for jumbo mortgages are every bit as stringent, and those loans are too large, by definition, for purchase by Fannie and Freddie.

I'm assuming this is just a temporary friction. Who will be brave enough to toss aside Fannie and Freddie and just start making reckless jumbo and subprime loans? Those can't be that far behind Petco, can they?

But they're not here yet. And that provides one reason not to get too excited about the Petco deal. Yes it is people recklessly flinging money at Petco, which is great. But they're not flinging that money at Petco to open Petcos, which is less great, because we need more Petcos for reasons both economic and PUPPIES. They're flinging the money at Petco to give it back to its private equity investors, who are at a loss for what to do with it.

Investors Jump Off the 'Junk' Pile [WSJ]
Counterparties: What’s holding back mortgage lending? [Reuters / Ryan McCarthy]

1. They really do! It is totally adorable. Guys, I cannot lie: I love Petco. BUY PETCO.

2. Bloomberg tells me 8.5% cash-pay or 9.25% PIK, sold at 99.5, which it also tells me is 8.624% YTW (for the cash-pay I mean). Maturity is 5 years, seems to be a free call after 1 year, which is itself quite a bet on rates.

3. Not you, you. You're still cool. Plus you want a jumbo.