Sir--

As always, I enjoyed your leaders section, in particular, [link|http://www.economist.com/opinion/displaystory.cfm?story_id=8888776|"The trouble with the housing market"]. I was particularly struck by the theory that if you had replaced the word "subprime" with the phrase "leveraged finance" your analysis would have worked equally well with the institutional debt markets, particularly in Europe.

Both aim at borrowers with often poor credit records (at least on average) with worries of defaults increasing as introductory "teaser" rates expire. In leveraged finace these teasers are the back-loading of debt structures, for example through the use of payment-in-kind notes, that mean the interest is rolled up to be paid at the end of the debt's term or where there is no repayment (amortisation) of the principal at all.

As you say, "any structural surveyor would spot tightening credit and a glut of...supply". The leverage finance market was up 27% to $253bn last year in Europe, Middle East and Africa, according to Deutsche bank, but even now bankers say there is massive overdemand for paper. Private equity is responsible for most of this - 90% of it, according to ratings agency Standard & Poor's.

And, as with mortgage self-certification, or US liar loans, private equity firms soothe concerns by pointing to pro forma earnings - ie what they hope the company borrowing the money will make this year. These earnings are also colloquially known as 'earnings before the bad stuff' or Ebitda. This means it is not free cashflow that is used to repay debt but earnings before interest, tax, depreciation and amortisation - Ebitda.

This overdemand is caused by investors, primarily pension and insurance funds, trying to finding areas promising relatively higher yield than in other areas in order to meet their obligations. But, late this this party as they were to 1990s technology stocks, they are buying assets at the low point in the default cycle from people whose interest is only aligned to selling them the paper - the arranging banks keep very little, if any, through the use of syndicated markets and derivatives.

Worse, the intermediary funds, the hedge and collateralised loan obligation funds, that the pension funds buy also encourage the party but might not be there to help clean up. CLOs and hedge funds make up 80% of the US and more than half of the European leverage finance markets and are incentivised to buy any asset as quickly as possible, securitise it into chunks, or tranches of riskiness, and hope the assets last a few years before any default (hence the weak covenants) so the fees can be collected.

As always, it is hard to grasp the size of the problems being stored up. Houses are seen, but the fruits from this harvest will be stressed and troubled companies with overleveraged balance sheets, probably job cuts and pensions whose promises might not be met. But as these loans are being stashed in more places, ie diversified away from the banks, it is likely that the problems will be shared among many but also, provided some market remains as expected, will be less severe as the debt will be refinanced through a change of ownership (debt for equity swap).

James Mawson

London