The power of Collateralized Loan Obligations.
By Don Quijones, Spain, UK, & Mexico, editor at WOLF STREET.
“The global leveraged loan market is larger than – and growing as quickly as – the US subprime mortgage market was in 2006,” said the Bank of England’s Financial Policy Committee in the statement from its latest meeting. And the committee is “concerned by the rapid growth of leveraged lending.”
In terms of magnitude, the US and EU “leveraged loan” market combined now exceeds $1.3 trillion, up from $50 billion at the turn of the century.
A “leveraged loan” is a loan that is extended to junk-rated (BB+ or lower), over-indebted companies. These loans are considered too risky for banks to keep on their books. Instead, banks sell them to loan funds, or they package them into highly rated Collateralized Loan Obligations (CLOs) and sell them to CLO funds and other institutional investors. In the UK, over £38 billion ($50 billion) of these loans were issued in 2017 — more double the amount in 2016 — and a further £30 billion ($39 billion) has already been issued in 2018.
Leveraged loans are popular among investors because of the slightly higher interest rates they offer, and because they’re often based on floating rates, a positive in an environment where interest rates are rising. Investors earn a set amount of interest — the so-called margin — on top of the prevailing Libor benchmark rate. As the Libor rises, so too does the interest. The loans’ floating interest rates offer investors some degree of protection from rising rates, until, of course, the borrower defaults.
While banks benefit from issuing leveraged loans via hefty fees for arrangement, structuring and portfolio management, since these loans are typically sliced, diced and sold in global financial markets in classic sub-prime fashion. Among the biggest buyers are CLO funds.
One of the myriad problems with this practice, warns the Bank of England, is the acute lack of certainty about investors’ “ability to sustain losses without materially impacting financing conditions.” But if things do go south, the resulting pain may nevertheless end up boomerang back to the banks.
“The borrowing they [the risk-chasing investors] do is usually from a bank,” Douglas Diamond, a finance professor at the University of Chicago Booth School of Business, recently told Bloomberg. “They buy a loan from a bank, they borrow money from the bank to buy the loan from the bank — not necessarily the same bank. So the risk would ultimately get back to the bank balance sheets.”
Taking junk bonds and leveraged loans together, the estimated stock of debt outstanding in UK non-investment grade firms is estimated to account for around one-fifth of total UK corporate sector debt. There have been similar increases across Europe and in the US, the Bank of England’s Financial Policy Committee pointed out. Since 2012, the leveraged loan market in the U.S has doubled in size to $1.1 trillion.
It’s perhaps no surprise that the riskiest corporate loans are surging on both sides of the Atlantic at a time that the number of so-called “zombie companies” is also exploding, in large part due to the central banks’ low interest rate policies, which have allowed moribund firms to stay alive much longer than they would have under normal conditions.
The Bank of England is not the only financial regulator sounding the alarm bells about leveraged lending. The IMF voiced its reservations about the loan market in its global financial stability report in April. “Signs of late credit cycle dynamics are already emerging in the leveraged loan market and, in some cases, are reminiscent of past episodes of investor excesses,” it warned.
Then, a couple of weeks ago, the Bank of International Settlements (BIS) added its voice, cautioning that rising interest rates around the globe could cause distress among the heavily indebted borrowers that depend on leveraged loans. According to the BIS, the total value of leveraged loans and high-yield bonds outstanding in Europe and the U.S. has doubled to around $2.6 trillion since the global financial crisis.
As the market has grown, the lending terms have loosened. Maintenance covenants require a borrower to meet certain financial tests every reporting period, usually quarterly. This provides lenders with basic protection against default by allowing them to exercise some degree of control over a borrower’s behavior. But such covenants entail additional costs for investors and many investors would rather forego those costs in order to maximize their returns.
In the UK the proportion of leveraged loans with maintenance covenants has plunged from close to 100% in 2010 to around 20% currently. These are the infamous “covenant lite” or “cov lite” loans — in other words, about 80% of the leveraged loans are cov lite. A similar scenario is playing out in the US.
As criticism of this trend rises, banks have begun hitting back. Credit Suisse, one of the largest players in the $1.3 trillion market for leveraged loans, sent a confidential letter to clients in September attempting to dampen their fears. The letter was duly passed on to The Financial Times, which a few days ago shared its content with its readers.
While the bank acknowledged the mounting concern about the recent explosion of leveraged loans, it claimed the fears were overdone. It also stressed that forecasts for loan defaults are still below long-term averages and that one of the largest buyers of the securities were CLOs, vehicles that “do not become forced sellers and actually provide consistent, stabilizing demand for loans”. The growth in the size of the leveraged loan market has also slowed since the years before the Financial Crisis and is “hardly an indication of excess,” it wrote. As the third-largest US manager of CLOs, Credit Suisse has every incentive to downplay the risks arising in the leveraged loan market. By Don Quijones.
This deal is “reminiscent of the kind of deal I would have seen in 2006 and 2007.” Read… Just How Wildly Exuberant is the Junk-Credit Market?
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What could go wrong with these loans!!! What an absolute mess.
When a bank says there’s no reason to worry about the risks they are taking – worry.
It’s a bit late for the BoE and the rest of these Keynesian fraudsters to start fretting over the consequences of ten years of “No Billionaire Left Behind” monetary policies and resultant orgy of speculative excesses.
Partial solution is to require that bank’s keep at least 50% of EACH loan on their books.
The other part of the problem (not lending to fund purchase of CLO) is easily fiddled & avoided. Maybe require that CLOs only be sold as full recourse – nobody except the originating bank stands a chance of understanding or believing in the underwriting standards.
It’s ironic that this alarm was sounded by one of the prime culprits in this mess: the BoE. Just was did these highly educated PhDs think would happen when they kept interest rates at zero for ten years. Looks like today the markets have got the memo, at long last.
The ICE BofAML Euro High Yield Index Effective Yield (note the last two words) is still in historically low range, but has risen steadily all throughout 2018 and now stands at 3.49%, up 72% year on year. This happened while the QE party is still ongoing and interest rates remain ferociously repressed. The same index for US dollar denominated bonds now stands at 6.48%: again low by historical standards, but high by recent standards.
Theoretically speaking this is good news for holders of junk bonds and leveraged loans, because it means their fixed yield keeps on going up.
However, most of these bond issuers are completely dependent on repressed interest rates to stay in business and keep on servicing their obligations: higher yields on their bonds will disrupt their business models. This will not lead to a flood of defaults, but to a steady and growing trickle of companies either reneging on their obligations or seeking court protection from creditors. The kind of thing that sends yields steadily higher, as potential bondholders rediscover risk never really went away. He was just on vacation.
It remains to be seen how central banks and especially governments will react, as this whole situation is their handywork: it took a loud sneeze from US equity markets (dip and panic buyers will be on the case shortly I am sure) to whip politicians into a “forever easing” frenzy and the whole world is watching the standoff between Italy and the European Commission as the former refuses to accept the taps are about to be finally closed. Every excuse on the book is being used, but it all boils down to Italy’s “legions of undead”, the huge number of zombie companies active especially in the construction, real estate and retail sectors which are benefiting from financial repression.
It would be interesting to see if the bookmakers in Las Vegas are taking bets on which govenment and/or central bank will blink first: I may even break my decades long absence from the betting scene for such a thing.
Why is the lender not held accountable for all loans they issue? Why is the debtor always the one who shoulders the burden?
Just pass a law saying that in a default, the lender sucks up a minimum of 30-40% of the loss. That’ll hold them to a higher standard.
Re: “Why is the lender not held accountable for all loans they issue? Why is the debtor always the one who shoulders the burden?”
1) The Lender is accountable – if the debtor can’t repay, the lender takes the loss. Which is why there is collateral in most cases, covenants in some cases, and so on. You maybe were asking why the originator/facilitator isn’t accountable, why they are allowed to set up a loan and then sell it to a CLO or other entity?
2) Only the debtor has the true picture of the debtor’s financial condition. 3) If the debtor is not on the hook for their own poor performance, that creates perverse incentives not to repay the loan.
4) If a bank doesn’t want to keep a loan on its books, but is willing to lend you money at a lower rate for you to take it off their hands… that tells you everything you need to know that you should run away from the deal. If the deal was good, the bank would rather have the higher rate than give it to you!
I remember reading an article some time back about the creators of the modern leveraged loan industry. It was about GSO Capital Partners, a subsidiary of Blackstone which is the biggest player in leveraged loans controlling over $100 billion in assets. What stuck with me was this remarkable quote about the leveraged loan industry:
“The firm follows in the footsteps of Drexel and Michael Milken, who in the 1980s invented the junk bond market for non-investment-grade companies. In the 1990s, GSO’s three founders, then working for Hamilton (Tony) James at DLJ, took up where Drexel left off, building that firm into the No. 1 leveraged-finance player, lending to blemished companies that were in some of the fastest-growing sectors of the U.S. economy, including energy exploration and homebuilding. If Drexel came up with the junk bond and DLJ created the institutional leveraged-finance market, GSO is again reinventing the concept of providing capital to non-investment-grade companies — this time as an asset manager.”
Australia can no longer borrow from international sources –
Because they have nothing to offer up as security –
Lucky Australia does not have a cashless economy –
Luckily, Australia can still prints its own currency & therefore it has a tangible means of exchange & business can still go on.
But what Australia needs is a vast forest, a gushing oil well, or some such thing to be eligible to borrow the vast sums of money they are used to borrowing from international sources.
What to do ??
What to do ??
Is it possible borrow money by offering up the nations people as collateral ??
And how would such a thing work ??
By voting for Labor (sar)
Love the article. I am relatively new to the macro data and the effects that the data has on markets. However, looking at the ICE BofAML Euro High Yield Index Effective Yield, the yield was at 6.24% in Jan of 2016. I know that the recent run up in yield should be alarming, but it is nearly 300 bps below the high. So no reason to panic yet?