The severity of the 2008-2009 international financial crisis was the result of two storms meeting. A global recession (or North Atlantic recession as it was referred to in China, which escaped it) and a financial markets crash whose catalyst was the implosion of investment portfolios over-exposed to subprime mortgages.
Recessions are, it is generally accepted, an unavoidable part of the cycle of long term economic growth. They can be tough but are generally not disastrous. Unless they double up with a financial markets crash, creating a perfect storm.
Many analysts believe that, give or take a couple of years, we are now approaching another international economic growth downturn and recession. However, there has been a belief that the tightening of controls on capital buffers and lending put in place following the crash almost 11 years ago now would mean that the next recession will prove more manageable, avoiding the kind of double-whammy that brought first Wall Street and then much of the rest of the developed world to its knees last time around.
But in recent months, concerns have been raised that a new kind of debt-based beast has evolved and is not stalking the stability of global financial markets – leveraged loans. But what are leveraged loans, why are they so risky, are financial institutions overexposed to them in a way comparable to the lead up to the subprime mortgage disaster or is the systemic risk posed being exaggerated in some quarters? Should those investing online be running for the hills or have defences protecting the health of financial markets been reinforced enough that they can withstand the next onslaught?
What Are Leveraged Loans?
A leveraged loan is credit extended to company defined as ‘risky’. That’s typically because the company taking out the loan already has a significant amount of debt or has a poor credit history. The ‘leveraged’ part of a leveraged loan refers to the fact that its paper value is a multiple of the liquid assets on the borrower’s books. The lender is relying on future cash flow allowing the company the loan has been extended to servicing it. The heightened risk leveraged loan creditors accept mean that the interest rates charged are also much higher than standard.
That has made them attractive to investors chasing returns in the ultra-low interest rate environment of the last decade. Banks make leveraged loans to companies but then usually sell them on to investors. They can be packaged up so lots of leveraged loans, or exposure to them, come as one financial derivative. Sound familiar? In recent years, investors have favoured leveraged loans over high coupon ‘junk’ bonds, which have traditionally been the most popular way for riskier companies to raise finance. That’s because if a debtor runs into difficulties, the repayment of loans takes first priority, with bond holders near the bottom of the pile if assets are sold to pay off creditors in the case of bankruptcy.
A high profile example of a leveraged loan would be that taken out by the Glazers to fund their 2005 takeover of Manchester United. It was secured against club assets such as the Old Trafford stadium and Carrington training complex. The significant cash flow generated by the club, which has the third highest turnover in the world behind only Real Madrid and Barcelona, means the Glazers and club have had no serious issues in servicing the debt. However, it is thought that doing so has taken somewhere in the region of £1 billion out of the club.
Why Are Leveraged Loans So Risky?
The attraction and risk of leverage loans are two sides to the same coin. Unlike bonds, leveraged loans do not pay creditors a fixed return but one that varies with interest rates. The Federal Reserve’s move to start incrementally hiking interest rates from their post-crisis historic lows, something which has been followed, albeit more tentatively, by much of the rest of the developed world, has made buying leveraged loans from banks more attractive. As interest rates rise, so do their returns.
With more investors ready to take leveraged loan risk off banks’ balance sheets, handing them out has also become more attractive for them. Qualification requirements for companies being able to take out large leverage loans have subsequently relaxed further. The market has boomed.
The flip side of the coin is that when interest rates rise, making leveraged loans more profitable for lenders and investors, they also become more expensive for debtors to service. That’s sustainable while the economy is in good health. But if a recession also takes hold and the revenues of debtors dip, the situation could change quickly. The more vulnerable could start to struggle to service their loan repayments. If default rates increase significantly, that could have a knock-on effect on the liquidity of investors over-exposed to leveraged loans.
A further danger is that as banks have relaxed their lending criteria on leveraged loans to meet investor appetite for them, the loose terms and conditions have seen investor protection drop. Intangible assets such as popular Instagram accounts have formed part of the ‘collateral’ allowed to back loans. As have assets whose value has been based on future revenue forecasts, which are often highly ambitious and dependent on a myriad of uncontrollable factors.
Most concerning is that the Ts and Cs of many big leveraged loans allow debtors to subsequently transfer collateralised assets to other company structures within a group in a way that would make it difficult, if not impossible, for investors to reach if the debtor falls into bankruptcy. It’s particularly easy in the USA for a group of companies to bankrupt one entity, sacrificing it while keeping other related companies and owners protected from its creditors. A wave of companies that are leveraged loan debtors taking that approach, particularly if collateralised assets have been moved out of the reach of creditors could quite easily, say some analysts, bring a house of cards crashing down. Combined with a recession, which that would be expected to deepen, it could be 2008 all over again with subprime mortgages swapped out for leveraged loans.
How Likely Is A Leveraged Loans-Catalysed Market Crash?
For now at least, it doesn’t look like an implosion of the leveraged loans market is imminent. Default rates in the USA are particularly low at just 1.6% against an historic average of 3.1%. Economic growth is slowing internationally but it’s still pretty healthy in North America.
There is also an argument that while the laissez-faire contractual structure (referred to as cov(enant)-lite) of many leveraged loans means that investors have limited protection if things go wrong, they are make it easier for companies to maintain repayments. Strict conditions can push companies that are not actually badly placed financially into default by limiting the tools at their disposal to manage liquidity by moving things around.
There is also hope that financial markets and investors have learned at least some kind of lesson from the last crash. November 2018 to January this year has seen a significant market sell-off, reflecting growing underlying risks. In December, loan prices dropped more than 3%, the market’s worst performance since the USA lost its triple A credit rating in 2011. Market analysts think that December sell-off included many ‘weak hand’ investors reducing their exposure to leveraged loans, leaving the market healthier.
With investors now warier than they were a few months ago, banks are being forced to offer loans to investors at better terms. That means they are increasing interest rates to levels that will scare off many potential debtors that might have gone to the market under the conditions of a year ago. Tighter terms sheets that better protect investors and lower leverage are also being demanded.
Terms are still considered to favourable to borrowers in some quarters. However, the market may just have started to self-police by deleveraging on leveraged loans before critical levels of exposure were reached. Perhaps some lessons have been learned after all. But that doesn’t mean the danger has blown over entirely or that the winds might not change and see leverage pushed back up again. The leveraged loans market is one canary in the mine investors should keep a close eye on.