They Never Learn: Cov-Lite And Leveraged Borrowing Frenzy From The 2007 Top Is Back---With Even More Madness

In the excellent post below, Wolf Richter cites the most recent stats on the renewed explosion of leveraged lending----and especially in its most reckless form called "Cov-Lite" loans. These are essentially faux credits which parade as senior loans to LBOs and other highly leveraged companies, but they are missing the age-old ingredient that has always defined a senior credit. Namely, strong covenant protections to prevent borrowers from massively loading up on additional debt and interest service costs that could jeopardize the solvency and viability of the enterprise; and most especially to protect senior lenders from equity owners who pile on more debt to pay themselves a dividend.

One of the more noxious consequences of the Fed's massive money printing campaign is that it has so distorted financial prices and repressed the benchmark treasury interest rates that it has unleashed a veritable stampede for higher yields among money managers and institutional investors. Hence, we once again have a boom in the so-called CLO (Collaterized Loan Obligations), which are a Wall Street invention whereby the big loan syndicating banks like JPMorgan off-load new LBO debt to conduits which in turn off-load a new piece of junk paper to money managers thirsting for yield.

So great is the demand that it becomes a sellers market. As the bubble cycle matures, senior loan covenant protections are stripped off to the point that what passes for senior loans have become more or less naked credits. When the bubble eventually bursts, of course, large losses will be incurred; the CLO shops will close-down waiting for the default storm to end; and then position to start-up again once the Fed gives the all clear signal and begins a renewed cycle of money printing. At least this is what happened last time, but even that game may now have become a road too far.

As shown in Richter's graph below, Cov-Lite issuance in 2013 of $50 billion substantially exceeded the 2007 peak of $35 billion, and the current issuance run rate (annualized) of upwards of $200 billion is at an even steamier level. This is guaranteed not to end well, and, as Richter notes, even the Keynesian gummers at the IMF have taken note. The remarkable thing, however, is that this is a virtual "instant replay" of the pattern which occurred in 2005-2007 before the last credit market bust.

That was only 80 months ago. So in what is a pretty vivid display of "why don't they ever learn" we present below Wolf Richter's post on the current Cov-Lite mania followed by an excerpt from the "Great Deformation: The Corruption of Capitalism In America", that documents the same pattern last time around.

By Wolf Richter

Hidden in the IMF’s just released 188-page Global Financial and Stability Report is a doozie of a chart that screams not only “credit bubble” but also flashes a red warning sign: “seek cover, implosion in sight.” It depicts US issuance of covenant-lite loans and second-lien loans since 2001, including their phenomenal bubble that so spectacularly collapsed in 2008, and the even greater bubble currently underway – with an equally spectacular future.

Covenant-lite loans, which eliminate many of the protections that lenders normally require, allow over-leveraged junk-rated companies to pile on even more debt when they would normally no longer be able to do so. A key benefit for the Private Equity firms that own them: PE firms make a big part of their profit by having their portfolio companies borrow money, but not for expansion purposes or other productive uses. Instead, PE firms suck that cash out the back door through special dividends, fees, and other devices. When the portfolio company pops, the PE firm conveniently has the cash, and the lenders eat the loss.

To protect themselves, lenders normally force borrowers into covenants that prevent these and other shenanigans. But not anymore. Lenders, driven to near insanity by the Fed’s interest rate repression, are caught up in an all-out chase for yield and don’t look at anything else, and to get that minuscule extra yield, they take on risks, any risks, no questions asked, and to heck with future losses, and they hold their noses and close their eyes and pick up the worst crap, and then find ways of stuffing those risks into your mutual fund.

It’s a feeding frenzy out there.

The longer it goes on, and the more of this reeking debt with a high probability of default is piling up on the books of banks and other lenders, the more damaging the implosion will be. And so covenant-lite debt has become a flashing red light of a credit bubble in its final throes. A record $238 billion were issued in 2013, according to Thomson Reuters. Over 50% of the market, another hair-raising record.

The IMF chart shows the prior bubble as expressed in covenant-lite loans (green line, right scale) and second-lien loans (red line, left scale) and where it all ended so spectacularly – namely in the financial crisis. It also shows the current bubble through 2013. Covenant-lite loans started setting new records last year, but second-lien loans, a particularly nasty contraption for banks, haven’t quite caught up yet. Up to us to figure out where it ends:

This year, it’s even worse.

Through March, about $68 billion in covenant-lite loans have been issued, according to Thomson Reuters. Banks are making even more concessions and relax loan terms further, giving over-leveraged companies enormous flexibility in how they deal with their debt if they run into trouble and allow them to pile on yet more debt. These new loosey-goosey loans have lovingly been dubbed, “covenant-lite 2.0.”

Banks are lapping it up. Classic covenant-lite debt, of the type that helped blow up the banks in 2008, have maintenance covenants to give lenders at least a modicum of protection in case of default. But one of the many newfangled features – increasing the “restricted payments baskets” – permits companies to channel more borrowed money via dividends and other devices back to the PE firms that own them. The cash is gone. The debt is still there. The loan-to-value ratio deteriorates and wreaks havoc on recovery in case of default.

Covenants are supposed to protect banks from those shenanigans – but aren’t anymore. Leverage ratios have been rising for a couple of years and now exceed those of the white-hot bubble market of 2007. But these hyper-leveraged companies won’t pop right away, not as long as new covenant lite loans allow them to borrow even more, and not as long as they can bamboozle desperate banks into lending more. Yet piling on more debt to deal with old debt merely pushes the day of reckoning into the future and increases the loss for the banks.

Even the Fed, which never sees signs of a bubble, and denies the very existence of bubbles until long after they have imploded, is seeing the ballooning covenant-lite loans as a risk to the very banks it had so heroically bailed out during the financial crisis, and Fed heads have mentioned them as an item on their worry list, and as a reason for eliminating QE.

In the IMF chart, second-lien loans (red line, left scale) also bubbled and collapsed beautifully. These loans are secured by a second lien over assets that have already been pledged as lien for other loans. In case of default, holders of first-lien loans have first claim to the assets. Holders of second-lien loans get whatever is left, which is mostly nothing. These second-lien loans, a particularly nasty contraption for banks, are jumping again. The skyward angle of the slope continues beyond the IMF chart: in January and February, $7.4 billion in second-lien loans were issued, up from $4.5 billion during the same period in 2013.

Defaults are unlikely as long as the Fed shoves nearly free money out the front door into the hands of even over-leveraged junk-rated companies that would otherwise have trouble servicing their existing debt. But the Fed is cutting back on QE and is generating a deafening cacophony about raising interest rates. Watch out for falling debris.

Giant PE firms and REITs have become the largest landlords in the country over the last two years because “there was a moment in time where it made sense,” but now home prices are too high, the business model has collapsed, and buyers evaporate. Read..... Hot Air Hisses Out Of Housing Bubble 2.0: Even Two Middle-Class Incomes Aren’t Enough

This is a syndicated repost, which originally appeared at Testosterone Pit. View original post.

{adinserter 1}The following excerpt is from chapter 24 of the Great Deformation entitled, "When Giant LBO's Stripped Mined The Land".


The wherewithal for financial engineering came from the leveraged loan market that had been on death’s door after “risk” went into hiding during the dot-com bust. But when the Fed caused interest rates to tumble to lows not seen for generations, the market for leveraged finance literally exploded.

Issuance of highly leveraged bank loans plus junk bonds leapt higher by $1 trillion annually, rising from $350 billion in 2002 to $1.35 trillion by 2007. Funding available for LBOs and leveraged recaps thus quadrupled. Altogether, a total of $4.5 trillion of so-called high-yielding debt was issued dur- ing this six-year interval. This astounding number exceeded all of the high-yield debt ever issued in all previous history.

Moreover, the surging quantity of available high-risk debt was only part of the story. The deterioration in quality was even more spectacular. The riskiness of leveraged loans is usually measured by the interest rate spread over LIBOR; the more risk the larger the spread. This LIBOR spread on leveraged bank loans, for example, dropped from 375 basis points to 175 basis points, meaning that compensation to lenders for the risk of loss posed by highly leveraged borrowers virtually disappeared.

Likewise, under a euphemism called “covenant lite” traditional borrower restrictions were essentially eliminated from junk bonds, transforming them into financial mutants. Under standard bond covenants, company cash could not be paid out to common equity holders who stood at the bottom of the capital structure unless bonds were well covered. But under “covenant lite,” private equity sponsors could suck huge self-dealing cash dividends out of a company, bondholders be damned.

Implied default risk also increased sharply as measured by average deal multiples, which rose from 7X cash flow to nearly 11X. Moreover, near the end of this leveraged lending spree an increasing share of junk bonds were of the “toggle” variety. This meant that if the borrower came up short of cash it could just send the lender some more IOUs (bonds); that is, it could borrow to pay interest just like under “neg am” home mortgages.

The ultimate indicator of the drastic deterioration of loan quality during this period, however, was the eruption of leveraged “dividend recaps.” LBO companies were able to issue new debt on top of the prodigious amounts they already owed, yet not one penny of these new borrowings went to fund company operations or capital expenditures.

Instead, the newly borrowed cash drained right out of the bottom of the capital structure and was paid as a dividend to the LBO’s private equity sponsors. This sometimes permitted sponsors to recoup all of their initial capital or even book a profit within a few months of the initial buyout transaction, and long before any of the initial debt was paid down.

Leveraged dividend recaps during the second Greenspan bubble (2003– 2007) were off the charts relative to all prior experience. Thus, more than $100 billion was paid out during this period, compared to generally less than $1 billion annually in the late 1990s. Since private equity sponsors normally are entitled to a 20 percent share of profits, a couple of dozen buyout kings and their lesser principals pocketed $20 billion from these payouts.

The real trouble, however, was not so much the greed of it as it was the sheer recklessness of it. Most of these leveraged recaps were done by freshly minted LBOs, some of them so fresh, in fact, that they had hardly gotten to their first semiannual coupon payment.

So the feverishly overheated leveraged loan market was the real culprit. Investors were indiscriminately devouring any high-yield paper offered, and for the worst possible reason. As the 2003–2007 Greenspan bubble steadily inflated, fund managers became convinced that the monetary central planners at the Fed had truly achieved the Great Moderation; that is, recessions had more or less been banished.

While implausible it nevertheless caused a drastic mispricing of junk bonds. They carry a high yield owing to their embedded equity-type risks, the most important of which historically had been the sharp impairment of cash flows and rise of default rates triggered by business cycle downturns.

Now that the risk was attenuated or even eliminated entirely, high-yield bond managers started acting as though they owned a Treasury bond with a big fat bonus yield and commenced buying junk bonds hand over fist. The demand for new paper became so frenetic that Wall Street underwrit- ers virtually begged private equity sponsors to undertake “dividend recaps” so they would have product to sell to their customers.

This was another sign of the reckless speculation induced by the Fed’s bubble finance. During seventeen years in the private equity business, I never observed these firms reluctant to scalp a profit when, where, and as they could. But most firms believed the prudent strategy was to get a new LBO out of harm’s way as soon as possible by paying off debt and ratchet- ing down the initial leverage ratio. Rarely did sponsors think about piling on more debt in the initial stages, and certainly not to pay themselves a dividend. Even during the final red-hot years of the first Greenspan bubble (1997–2000), dividend recaps were rare, with volume averaging only $1.7 billion per year.

During the second Greenspan bubble, by contrast, annual volume soared to $25 billion. Junk bonds and leveraged loans were so cheap and plentiful and the overall financial euphoria so intense that even the great LBO houses succumbed to violating their own investing rules. In fact, $100 billion of dividend recaps on the backs of dozens of companies already groaning under huge debt loads was not just a violation of time-tested rules—it bordered on a derangement and madness of the crowds.

This eruption of leveraged dividend payouts dramatically exposed one channel by which cash from CEW was recycled to the top 1 percent. More importantly, however, it also laid bare the whole self-feeding web of bubble finance that the Fed’s monetary central planners unleashed while attempt-ing to levitate asset prices.

In this instance, the stock market bust of 2000–2001 and the modest eco- nomic slump which followed brought the excesses of leveraged finance to a screeching halt. Accordingly, the secondary market for high-yield debt cratered, new loan issuance slumped badly, and LBO activity stalled out at low ebb.

The financial market was attempting to heal itself for good reason. De- fault rates on leveraged loans soared from an average of 2 percent of out- standings during 1997–1999 to 10 percent during 2001–2002. These high default rates, in turn, sharply curtailed the investor appetites for junk bonds, causing new issues to drop by two-thirds between 1998 and 2000.

In effect, the free market was attempting to close down the LBO business as it had been practiced during the late 1990s boom years when the cash flows of buyout companies had been drastically overleveraged.

Not for the last time, however, the Fed refused to permit the financial markets to complete their therapeutic work. When the federal funds rate was slashed to 1 percent by June 2003, the collateral effects on the junk bond market were electrifying, precisely the opposite of what the doctor ordered.

During the twenty-four-month period between mid-2002 and mid-2004, junk bond interest rates plunged from 10 percent to under 6 percent. Since bond prices move opposite to yield, the value of junk bonds soared and speculators made a killing on what had been deeply “distressed” debt. In- deed, in a matter of months, a class of securities that had been a default- plagued pariah became a red-hot performance leader.

This massive windfall to speculators was not the result of prescient in- sights about the future course of the US economy. Nor was it owing to any evident “bond picking” skill with respect to the performance prospects of the several hundred midsized companies which constituted the junk bond issuer universe at the time. Instead, junk bond speculators made billions during the miraculous recovery of leveraged debt markets during 2003– 2004 simply by placing a bet on the maestro’s plainly evident fear of disap- pointing Wall Street.

Wall Street underwriters, in turn, had no trouble peddling new issues of an asset class that was knocking the lights out. These gains were not all they were cracked up to be, of course, because junk bonds had not become one bit less risky (or more valuable) on an over-the-cycle basis. But the Fed’s interest rate repression campaign made these gains appear to be the real thing, demonstrating once again the terrible cost of disabling free market price signals.

Moreover, when the rebounding demand for risky credits enabled the issuance of nearly $3 trillion of highly leveraged bank loans and bonds dur- ing the three years ending in 2007, the result was a “dilution illusion.” The junk debt default ratio fell mainly due to arithmetic; that is, the swelling of the denominator (bonds) rather than shrinkage of the numerator (de- faults).

Thus, by the end of the second Greenspan-Bernanke bubble the total volume of leveraged debt outstanding was nearly three times higher than in 2001–2002. At the same time, the temporary credit-fueled expansion of the US economy caused new junk bond issues to perform reasonably well. Due to this happy arithmetic combination, the measured default rate plummeted sharply, dropping all the way down to 0.6 percent by 2007.

Yet this was a preposterously misleading and unsustainable measure of junk bond risk, since it implied that the Fed could prop up the stock market and extend debt-fueled GDP growth in perpetuity. Nevertheless, having quashed the free market’s attempt to cleanse the junk bond sector in 2001– 2002, the Fed had now enabled the leveraged financing cycle to come full circle.


2007, the junk bond yield stood at about 7 percent and was juxtaposed against what appeared to be negligible default rates. Not surprisingly, this generated a vast inflow of yield-hungry money into the junk bond market, and a blistering expansion of the market for securitized bank loans.

The latter were called CLOs, for collateralized loan obligations, and were another wonder of bubble finance emanating from the same financial meth labs that produced mortgage-based CDOs. In this instance, however, Wall Street dealers sold debt to yield-hungry Main Street investors that had been issued by what amounts to financial “storefronts.” These shell com- panies were stuffed with LBO junk loans rather than subprime mortgages.

The daisy chain of financial engineering was thus extended one more notch: leveraged buyouts were now financed from the proceeds of bank debt which, in turn, was funded with the proceeds of CLO debt. Nor was that the end of the leverage chain. Not infrequently, these CLO “store- fronts” also employed leverage to enhance their own returns. Thus did the true equity in the system retreat ever deeper into the financial shadows.

By the top of the cycle in 2006–2007, the CLO market of debt upon debt upon debt was expanding at a $100 billion annual rate, compared to less than $5 billion at the prior peak seven years earlier. In its headlong pursuit of asset inflation, therefore, the Fed was spring-loading the financial sys- tem with a fantastic coil of debt.

As it happened, however, the miniscule 2007 default rate for junk loans was no more sustainable than had been the initially low default rates for subprime mortgages. By 2009 defaults were actually back above 10 percent, signaling the third junk market crash since 1990.

Accordingly, investors and traders fled the leveraged loan markets even faster than they had stormed into them. Junk debt issuance plunged by 85 percent from peak levels. The CLO market disappeared entirely.

This cliff-diving denouement should have come as no surprise. Near the end of the boom, many issuers were simply borrowing to pay debt service and few had sufficient excess cash flow to withstand a sharp economic downturn. The massive coil of LBO debt fostered by the Fed’s financial re- pression policies had thus been an accident waiting to happen.

Yet the leveraged finance boom went on right until the eve of the 2008 Wall Street meltdown because risk asset markets had been sedated by the myth of the Great Moderation. If the Fed had indeed abolished the risk of steep and unexpected business cycle downturns, as Bernanke claimed, the corollary was that deal makers were free to push leverage ratios to new ex- tremes. This was a matter of spreadsheet math: the banishment of reces- sions obviously meant that the cash flows of leveraged business wouldn’t plunge in a downturn.

It also meant that the junk bond interest rate spread over risk-free treas- uries would stay narrow, owing to reduced expectation of recession- induced defaults. So the junk market’s read on the Great Moderation was that it meant a floor under cash flow and a cap on default risk. Better still, since many junk bonds now had the “toggle” feature, they couldn’t default; they could just add the coupon to what they owed.
If defaults were thus minimized or eliminated, the hefty yield on junk bonds would be pure gravy. Not surprisingly, the leveraged loan market be- came fearless, happily assuming that the Fed had infinite capacity to prop up the economy and peg the price of risk. Nearly two-thirds of all the junk bonds issued in 2007 were of the so-called covenant lite variety, and that was another canary in the coal mine.

The purpose of covenants is to trap an LBO’s cash flows inside a com- pany’s balance sheet for the benefit of the bondholders. So when these pro- tections were permitted to fall away, it meant that high-yield investors were no longer looking to the borrower’s cash to keep themselves whole. In- stead, they assumed that borrowers who didn’t have the cash to redeem their debts at maturity would simply refinance; that is, investors would get their money back not from original issuers but from the next punter in the Ponzi.

Likewise, purchase prices for larger LBOs soared to more than 10X cash flow, compared to 6.5X when Mr. Market was endeavoring to heal the ex- cesses of the previous leveraged finance bubble back in 2001–2002. Indeed, the light was flashing green for issuance of every manner of risky credit. These included second-lien loans, which effectively meant hocking an LBO company’s receivables and inventory twice.

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