You may think the subprime mortgage mess is huge. Well just around the corner a larger elephant is looming and its impact may be even more devastating than the current credit crisis.

While it sounded like good news when banks sold $30 billion of loans for leveraged buyouts last week -- $26.4 billion of that was for the First Data buyout. That sale came with a big price tag -- banks agreed to sell the debt at 96 cents on the dollar, which means they locked in losses after their fees.

And then there was the problem of what to do with the other 90% of LBO loans in the pipeline.

The Wall Street Journal (subscription required) reported today that Citigroup Inc. (NYSE: C), Credit Suisse Group and J.P. Morgan Chase & Co. (NYSE: JPM) hold $400 billion in debt they promised for financing purchases private equity firms have in the works globally. If they can't sell the debt, they're left holding the bag, which means a lot less money for other loans. If the economy slows as expected and corporate profits weaken, the only way the banks will be able to unload the debt they're holding will be a fire sale on that debt at even deeper discounts then the First Data deal.

According to the WSJ article, hedge funds, which usually buy a lot of LBO, debt sat out the First Data sale because they expect to be able to pick up the debt even cheaper in the future. Just like when you want to buy a house, if prices are dropping, you sit on the sidelines and let the market fall to get the best bargain. Someone caught up with a house that won't sell may end up in foreclosure. While the banks aren't anywhere near foreclosure, if they are forced to take deeper and deeper discounts to get rid of the debt, what will happen to their bottom line and the investors who hold their stocks?

Lita Epstein is the author of more than 20 books including "Trading for Dummies" and "Reading Financial Reports for Dummies."

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On its prior conference call, The Blackstone Group LP (NYSE: BX) said it's planning to scoop up distressed buyout bonds. With its cash hoard, it seems like a good bet. Besides, there are signs that the debt markets are picking up, especially in light of the financing of the First Data deal.

According to news reports, some other firms now are seeing dollar signs from the same strategy. Take Onex, which is a top private equity firm in Canada.

But there's a hitch: Onex does not have the right staff to pull it off. Just like many other private equity firms, Onex focused on putting deals together. Onex said it is talking to a two-person group to help out. Hmmm....does seem kind of flimsy, huh?

Basically, this is yet another indication of why big firms, like KKR, TPG, and Blackstone, have big advantages. With their scale and resources, they certainly are nicely positioned when markets have sudden changes.

But, the distressed debt opportunity might be big enough for many firms. After all, as Onex's CEO, Gerald Schwartz, said: "there are opportunities that are just staggering."

Tom Taulli is the author of various books, including The Complete M&A Handbook and The Edgar Online Guide to Decoding Financial Statements. He also operates DealProfiles.com.

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KKR is known as a tough negotiator. After all, the firm walked from its $8 billion deal for Harman International (NYSE: HAR), which crushed the stock by 24% on Friday.

But, as for the First Data Corp. (NYSE: FDC) transaction, KKR is certainly jazzed. Despite talk that financing had dried up, it now looks like the debt offering is oversubscribed -- at least for a $5 billion tranche (this is according to a story in Bloomberg.com). Although, to generate more demand, there was a 4% discount on the notes.

But for the most part, it looks like things should pan out and based on the stock price of First Data, Wall Street also agrees.

Does this mean things will get easier for other deals? To some degree, I think the answer is yes. Liquidity is coming back into the system and fear is dissipating.

However, I think there will still be some carnage, especially for those deals that may not have the strong fundamentals of First Data or that were aggressively priced and structured.

Tom Taulli is the author of various books, including The Complete M&A Handbook and The Edgar Online Guide to Decoding Financial Statements. He also operates DealProfiles.com.

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At mid-summer, it would have been hard to imagine any of the large private equity deals like First Data Corp. (NYSE: FDC) and Harman International (NYSE: HAR). Harman is hardly an unknown entity. It was started more than 50 years ago. It built the first car radio in 1948. The company has a large customer base that includes most of the major car companies.

In the fiscal year ending June 30, Harman's revenue rose 9% to $3.55 billion. Net income was up 23% to $314 million. Not bad. But, in the fourth quarter of the fiscal, operating income was down, as cost of sales and expenses both rose.

Yesterday. KKR and Goldman Sachs (NYSE: GS) said that they were pulling the plug on the $8 billion deal to take Harman private. The said that Harman had breached the "material adverse effect" clause of the buyout agreement. In other words, Harman's business had gotten much worse.

Maybe. What the court will ask, and this is almost certainly going to court, is whether Harman's financial situation took a significant turn for the worse. Or, did they buyers simply believe that the credit markets had turned against them by making capital unusually expensive. Better to face,and perhaps lose a lawsuit than to default on billions of dollars worth of bonds.

As the Wall Street Journal points out, the unraveling of the deal "raises some broader questions for the pipeline of deals outstanding: whether the pullback shows that buyout firms are becoming comfortable with the risks associated with scuttling a deal." Lawsuits against the costs of defaults. Years of litigation. Shareholders in public companies who believed that they would get a 25% or 30% premium for their shares, only to watch them crash as a deal dissolves.

The company may have legal recourse against the private equity firms. Shareholders are likely to want to get the likes of KKR to the docket as well.

Douglas A. McIntyre is a partner at 24/7 Wall St.

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That the credit market climate has changed from a quarter ago is not news. That the new environment is imposing changes on even the most-preferred deals is, perhaps.

There's word that Kohlberg Kravis Roberts & Co. will most likely make concessions to banks in order to facilitate the $24 billion in debt needed to purchase First Data Corp (NYSE: FDC). FDC traded up 17 cents to $33.46 Tuesday at mid-day. KKR is buying credit card processor First Data for $34 per share. KKR's bid to take FDC private for that price is considered high because the bid is 14 times FDC's cash flow.

According to people familiar with the deal negotiations, KKR agreed to maintain a certain level of earnings before interest payments, depreciation, tax and amortization in relation to senior debt, The Wall Street Journal reported (subscription required).

KKR's concessions became necessary due to the tighter credit market conditions following a wave of subprime and subprime-related asset-backed defaults in August. Jolted back to reality by the sting of those bond losses, the market is pricing risk back into deals at more typical levels, and investors, including the major investment banks, are adding conditions to lending terms -- even for the most-preferred, large capital deals, such as KKR's purchase of First Data.

Further, neither the deal's size nor the import of the blue chip names involved could get the banks to compromise regarding the new requirements. The investment banks argue they would incur billion-dollar-level losses if KKR hadn't changed its terms.

Prior to Sunday's changes, KKR had said it was unwilling to make concessions that would deny it flexibility in the way it manages First Data.

That suggests, analysts say, a credit market where lenders/investors are dictating a majority of the terms. Moreover, analysts, in general, argue that the more-stringent requirements for KKR are warranted in a decidedly tighter credit market -- one where it's difficult for any debt/loan to be sold at 100 cents on the dollar, regardless of the offering company's health, due the re-pricing in of risk and investors' concerns about the ripple-effect on the credit markets of potential additional subprime debt defaults.

Fly Analysis: The KKR deal terms are significant not just because of the deal's size but also because they represent the first chance to gauge investor sentiment toward the credit markets following the August credit crunch -- sentiment that could serve as a reference point for the more than $400 billion global docket of financing deals expected to price and close in the months ahead.

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MAJOR PAPERS:

• Barron's Online's (subscription required) "Weekday Trader Extra" reported that Wall Street is eyeing the negotiations of the First Data Corp (NYSE: FDC) buyout, as there has been talk that Kravis Roberts might be willing to make some concessions to a bank group arranging financing for the purchase.
• The Wall Street Journal (subscription required) reported that General Motors Corp (NYSE: GM) has sent the UAW two proposals as their negotiations are nearing the deadline.
• With near record high oil prices, there are signs that OPEC may increase crude output 2%, or 500,000 barrels a day, as a gesture to comfort oil markets, according to the Wall Street Journal.

• The Associated Press reported that EPR, a leftist guerrilla group, said they caused a number of explosions yesterday aimed at about six Mexican oil and gas pipelines, resulting in millions of dollars in lost production and unsettling financial markets.
• Countrywide Financial Corporation (NYSE: CFC) is reportedly working with Goldman Sachs Group (NYSE: GS) and a law firm to put together another multi-billion dollar bailout plan for Countrywide, the nation's largest home lender, reported the New York Post.
• Sir Martin Sorrell believes that WPP Group (NASDAQ: WPPGY), the company he has built and is currently the CEO of, is likely to appoint his successor from within the company, reported the Telegraph.

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The Wall Street Journal [subscription required] reports that Kohlberg, Kravis and Roberts (KKR) is negotiating with banks to lend it $24 billion for its $26.4 billion deal to buy payment processor, First Data Corp. (NYSE: FDC). What's at stake here is whether last month's pause in the private equity fueled takeover market is temporarily on hold or dead for a decade.

There is a $400 billion backlog of such debt deals in the pipeline. Prior to the August pause, banks had no trouble selling the debt to hedge funds and others. But the terms -- or covenants -- of that debt were so loose that the banks were creating loans that demanded very little in the way of performance.

These so-called covenant-lite loans may soon become a thing of the past. If the Journal's reporting is correct, KKR may agree to a covenant requiring it to maintain a minimum level of earnings before interest taxes depreciation and amortization (EBITDA). Such terms used to be common in debt offerings, but the fact that there is even any debate about it, indicates how much covenant-lite debt risk is currently out in the market for which debt buyers have no protection at all.

The fees at stake for this deal are absolutely outrageous. If KKR completes this takeover, it stands to pocket $300 million in fees from First Data for getting the deal done. At the same time, KKR is paying the banks $500 million to $600 million in fees to finance the deal.

So if KKR can put enough covenants into its First Data financing to get its deal done and enable the banks to sell the debt to investors, then perhaps the private equity boom can continue. Unfortunately for KKR and its peers, the investment banks have already given up and are shuttering the prime brokerage units that arrange hedge funds' borrowing lines. Without the borrowing facilities, investor's demand is likely to fall far short of supply.

The same dynamic is true for managers of what are known as collateralized loan obligations (CLOs). These managers buy up pieces of loans that come along, combine them and then sell slices that have higher credit ratings. This market, which depends on the extensive use of borrowed money, has slowed markedly. With little leverage now available, it's not clear where the money will come from to absorb all that debt.

The market for buyout debt is already fragile, if KKR cannot agree on terms with its banks, the impact on investors could be devastating.

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter.

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