Covenant-lite (cov-lite, for short) loans have come to dominate the leveraged loan market since the end of the Great Recession, an economic catastrophe the financial world has seemed to have learned nothing from.
To recap the Great Recession in extremely cursory fashion, recall that in the early- to mid-2000s, banks began to issue subprime loans to people with limited or poor credit and then packaged those subprime mortgages into collateralized debt obligations. In conjunction with increased housing speculation, this massive spike in subprime lending led the housing market to crash as Americans defaulted on their adjustable-rate mortgages in droves, and it was ultimately revealed that CDOs had been given credit ratings that sorely failed to reflect their high risk.
In short, banks oversold the value and stability of their investments to the detriment of the public. And they’re doing so again.
Leverage loans, which package debt from companies with lower credit ratings, have historically been protected by covenants, a protection for lenders that borrowers won’t engage in certain risky financial behaviors. Cov-lite loans, which eviscerate most of those standards, now comprise 77 percent of the corporate loan market, which in turn is valued at $1 trillion. That’s more than 5 percent of our GDP.
Like many of the subprime mortgages of the 2000s, these leveraged loans have floating interest rates. Investors, from university endowments to hedge funds, keen to to put their money anywhere with higher interest rates, have poured billions into this risky market.
The leveraged loan market risks falling in the same game of musical chairs that tanked the financial industry in 2007. As banks try to sell cov-lite loans to other investors, a bust in the market would leave banks stuck with debts that can never be repaid. While the specific financial structures of CDOs aren’t perfectly parallel to cov-lite loans and collateralized loan obligations, the risks and circumstances are uncanny enough to draw suspicion.
Former Federal Reserve Chair Janet Yellen wisely warned that leveraged loans carry “systemic risk” due to deteriorating standards and covenants.
Moody’s Investors Service ranks investor protections on a five-point scale, where 1.0 means a loan features the strongest protections and 5.0 features the worst. They issued a 4.09 rating for American and Canadian leveraged loans.
It’s not too late for banks to correct course on their own. Increased government regulations should be avoided whenever possible, and hopefully the financial industry can reinstate more covenants before the companies default en masse a la 2008.
But given the scope of the market and potential for profit margins, I wouldn’t hold my breath.
The last time banks screwed over the public with financial malpractice, we gifted them with a $700 billion bailout. If leveraged lending guidance doesn’t crack down or the banks refuse to learn from their mistakes and another bubble of their own making pops yet again, they might not be so lucky.
