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Europe's New Wave of Toxic Debt

More toxic debt soon could come crashing through the global financial system. The surprising source: Europe Inc. Once-stodgy Old World companies, from cement makers to phone operators to chemical companies, went on an unprecedented borrowing spree over the past decade that has left them up to their necks in debt. Corporate debt in the euro zone stands at more than $11 trillion, equaling some 95% of the region's economy, vs. only 50% in the U.S.

Hundreds of billions in payments are coming due just as sales are slumping in the global economic crisis. In better times, companies might have gone to the bank to refinance. No more. Bank lending to euro zone companies plunged 40% last fall as the credit squeeze tightened.

That helps explain why Europeans in January issued $159 billion in bonds, the highest level in two years. But the price is steep. Average yields on investment-grade European corporate bonds have almost tripled during the past year, even for relatively healthy companies such as Nokia (NOK) and German utility group E.ON (EONGN.DE). The higher cost of servicing debt "will entail a restriction in hiring, wage growth, and investment," says Gilles Moëc, a London economist with Bank of America (BAC). "The amount of debt to roll over is huge."

Credit-Rating Downgrades

Many businesses are struggling already. Moody's Investor Services (MCO) says 249 Western European companies were hit with credit-rating downgrades in 2008, the highest number since 1990. Thomson (TMS.PA), a $7.2 billion-a-year French provider of video equipment and services, acknowledged on Jan. 29 that it was about to breach agreements with lenders on some of its $2.7 billion debt. Thomson is scrambling to raise cash by selling off businesses such as Grass Valley, a California-based maker of video production equipment it bought in hopes of becoming a key supplier to Hollywood. Although the situation is painful, "We had to tell the truth to our company, our investors, and our employees," says Chief Executive FrÉdÉric Rose.

How did Europe get into this mess? Conservative bank regulations barred most risky mortgage lending, so banks had plenty of money to offer businesses. Private equity funds, smelling opportunity in undervalued Old World companies, poured in hundreds of billions more. With interest rates low and the euro strengthening, companies were eager to borrow to finance acquisitions.

Take Paris-based Lafarge (LAFP.PA), the world's largest cement maker. It shelled out $11 billion last year to buy the cement business of Egypt's Orascom Construction Industries. Lafarge now has $22 billion in debt, with payments of more than $3.4 billion due this year. A Lafarge spokeswoman says lenders have agreed to let the company delay all but about $500 million in payments until 2010. But that may only postpone the day of reckoning, as Lafarge sales are forecast to drop 2.7% this year on a sharp downturn in construction worldwide.

LBOs Get Slammed

The outlook is even scarier for companies that were grabbed by private equity funds. Standard & Poor's estimated last June that 58% of European companies that underwent leveraged buyouts were saddled with higher debt than originally projected, while 56% were running behind forecasts on operating earnings. Things have gotten a lot worse since then. London-based 3i (III.L), one of the region's biggest private equity groups, on Jan. 28 reported a $942 million, or 21%, decline in the value of its biggest holdings.

Some LBO targets have already succumbed. Edscha, a $1.4 billion German auto-parts maker acquired by U.S. private equity outfit Carlyle Group in 2003, declared bankruptcy on Feb. 2.

Rising defaults could send shock waves through global markets. Just as with subprime mortgages in the U.S., corporate bonds and loans were packaged and resold to investors in vehicles called CDOs and CLOs, or collateralized debt obligations and collateralized loan obligations. "There was a flood of cheap debt, lower and lower terms," says Jon Moulton, head of London private equity group Alchemy Partners, "and with less and less due diligence."

Matlack is BusinessWeek's Paris bureau chief. With research assistance from Andrea Zammert in Frankfurt

Matlack is a Paris correspondent for Bloomberg Businessweek.

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