Lessons from the financial crisis have not been learned

When interest rates are so low and tolerance for debt so high, the chances are that someone somewhere is borrowing too much – and you only have to look back a decade to see the potential consequences



Juan Torres Rodriguez
Fund Manager, Equity Value

Even if you have only been dipping into the financial pages this month, it probably has not escaped your attention that Saturday was the 10th anniversary of the collapse of Lehman Brothers.

This is generally seen  as the moment the global financial crisis kicked in in earnest and much of the recent commentary has focused on the lessons that have been learned in the decade since 15 September 2008 – or indeed not learned.

On that note, our recent article on the growing popularity of so-called ‘covenant-lite loans’ sparked some real feelings of déjà vu.

Search The Economist’s database around 2007, for example, and a number of pieces on the subject will come up – including You only give me your funny paper, which was published the week after one of the key harbingers of the financial crisis: the demise of two Bear Stearns hedge funds

Global debt levels 

That was a time when people were still coming to terms with global debt levels and what they might mean for markets. And the first of a trio of what we tend to call “red flags” but The Economist piece characterised as “habits that in more sober times would have had lenders reaching for the Alka-Seltzer”: 'covenant-lite loans'.

Specifically, the article referred to this type of borrowing being used by private equity firms to finance leveraged buy-outs (using a signifcant amount of borrowed money to buy a company) and highlighted how one such business had sought the previous month to raise a record $16bn (£12.2bn) of covenant-lite loans ahead of a single deal.

“Covenant-lite loans now account for almost 35% of all loan issuance in America,” the piece observed.

Fast-forward to July 2018 and a Barron’s cover story, headlined Wall Street rushes into a new asset class, which focuses on the rise in direct lending stemming from a reluctance on the part of banks to lend to certain types of business.

In their place, the piece notes, “investors have been pouring into direct-lending funds in waves, eager to share the profits of lending to companies either too small or too risky to be bank clients”.

As Barron’s points out, the risk here is the same as ever – “that companies struggle to make interest payments and default, and that investors’ money will evaporate”. And it continues: “Another worry is that, in the fever of competition [for the honour of being able to make the loan], investors aren’t demanding the kinds of yields and protections that would help cushion losses.”

 Covenants. Back again?

Another word for “protections” in that context is “covenants”, which the article describes as “the emergency alarms triggered by credit-negative signs”.

Covenant-lite deals, it adds, have “re-emerged and spread across the syndicated loan market. Now, 77.6% of all outstanding loans are ‘cov-lite’, according to S&P Global. While protections are tighter in the private loan market, it’s moving in step.”

Since such loans are not registered or reported publicly, says Barron’s, the health of the private lending market can be very difficult to assess.

Its size, however, is more easily quantifiable – in the month of May 2018 alone, some $105bn in new high-yield loans were made, compared with $91bn in January 2017 and a pre-crisis high of $82bn in November 2007.

The Wall Street Journal has also been expressing concern in recent months, with articles such as Shorting loans: A hedge against financial trouble.

Rising interest rates

This piece highlights a number of risks it suggests may not be wholly appreciated by non-specialist investors, the first of which is the rising interest rates that are broadly anticipated in the US “are great for investors in floating-rate loans – until they aren’t”.

That is because there comes a point when higher interest payments start eating up too much of a company’s cashflow, which heightens the chances of a default.

Among other risks the piece notes is there are more lowly-rated borrowers than ever before. “Today almost two-thirds of leveraged loan issuers are rated B2 or lower by Moody’s, or single-B in other agencies’ scales,” it says. “That compares with less than half in 2006.”

A few months earlier, the same paper had warned “rising rates will bite eventually”, concluding: “Right now, companies with leveraged loans have plenty of earnings before interest, tax, depreciation and amortisation relative to their interest costs. According to UBS , this interest cover is more than three times. But borrowers can only withstand three more rate rises before interest costs start to become more painful – and UBS expects six increases by 2019.”

What do we think?

Here on The Value Perspective, in pieces on topics ranging from car financing to obscure financial instruments such as PIK toggle and Schuldschein bonds, we have often argued that mistakes are being made in financial markets.

It may not be possible to know for sure where this is happening but, when interest rates are so low and the tolerance for debt is so high, you do know someone somewhere is borrowing too much.

And you do not have to look back all that far in time to see the potential consequences …


Juan Torres Rodriguez
Fund Manager, Equity Value


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