The default crisis that never happened.
When most of us think about the credit bubble that burst in 2008, we think about the lax terms of mortgage loans. But many corporations, particularly those that were bought out by private equity firms, also got debt on lax terms. This debt was known as "covenant-lite," because the normal terms of corporate credit—such as a requirement that a company, say, maintain a certain level of profits—were waived by deal-hungry lenders.
After it all went pop, banks regretted the cov-lite loans almost as much as mortgage originators regretted their "no documentation" loans to home buyers. Cov-lite loans plunged in price. At his retirement dinner in May 2007, Anthony Bolton, Fidelity's investment guru, said, "Covenant-lite borrowing … will come back at some stage to haunt the banks." Indeed, Goldman Sachs and other big firms took massive losses when they sold or marked down the price of the bonds they were stuck holding. One person involved in negotiating these deals says his banking clients swore, "Never again."
But less than three years later, cov-lite loans are back. "With a vengeance," my friend David Pesikoff, a Texas-based hedge-fund manager, assures me. Has the world of finance gone insane? Not necessarily. The return of cov-lite loans makes a certain sense in the current financial environment. But I find myself wondering what that says about the current financial environment.
For most of financial history, a cov-lite loan, especially one made to a corporation with a lot of existing debt, would have made zero sense. Lenders wanted their money to be as safe as possible. That meant they wanted the borrower to pay a high interest rate, but it also meant that they wanted other protections, such as promises that the borrower wouldn't exceed a certain level of debt or would maintain certain ratios of debt to income. If the borrower broke those promises, then the lender could restructure the debt. Such covenants served as a surveillance system, a warning of problems on the horizon. They also represented control. They gave the lenders power, thereby allowing them to salvage more from a situation that was going bad.
This calculus shifted in 2006, because the financial world was awash in credit. Yields on debt were so low that investors were searching for something, anything, that paid just a little bit more. Subprime mortgages were one answer, but so were cov-lite loans made to highly indebted takeover targets, which paid just a wee bit more in interest (and at the peak of the mania, it really was just a wee bit) than super-safe debt. A big market for these loans existed in so-called "collateralized loan obligations," or CLOs, which were a sister of the "collateralized debt obligations," or CDOs, that snapped up subprime mortgages. Investors such as insurance companies bought slices of the CLOs, which were assigned varying levels of risk by the rating agencies, just as they bought slices of the CDOs.
Another reason for the rise in cov-lite loans was the relationship of mutual convenience between private equity firms and Wall Street banks. Private equity firms wanted cheap money on easy terms to finance all those big buyouts. Because private equity firms made such great clients—all those fees generated by buyouts!—Wall Street banks vied to give them what they wanted. Cov-lite loans were used to finance some of the biggest, best-known deals of the era, like KKR's buyout of Alliance Boots and Thomas H. Lee and Bain Capital's buyout of Clear Channel. According to the credit rating agency Standard & Poor's, $32 billion in cov-lite loans were issued between 1997 and 2006. Most of that came in 2006. In the first six months of 2007, cov-lite volume hit a stunning $97 billion, according to an S & P piece called "The Leveraging of America: Covenant-Lite Loan Structures Diminish Recovery Prospects."
As the title of that piece, written in mid-2007, implies, Armageddon seemed near. Banks got stuck holding the debt from both the Alliance Boots and Clear Channel deals as buyers of any and all risky debt went on strike. There were fears that cov-lite loans would default en masse. By the spring of 2009, prices for risky corporate debt hit all-time lows.
But the market for corporate debt differed from the market for mortgages in one crucial respect: Armageddon never arrived. The Federal Reserve slashed interest rates, helping to spark a huge rebound in the price of risky debt. According to S&P, during the past five years cov-lite debt returned a total of 33 percent, versus 31 percent for standard loans with covenants. Companies that were running into trouble were able to raise more money in the markets. Corporate default rates stayed very low. And it all happened so quickly that the protection afforded by the covenants, or the lack thereof, never seriously got tested.
Bethany McLean is a contributing editor at Vanity Fair and the co-author of All the Devils Are Here: The Hidden History of the Financial Crisis.
Bethany McLean writes a weekly business column for Slate and is a contributing editor to Vanity Fair. She is the author (with Joe Nocera) of All the Devils Are Here: The Hidden History of the Financial Crisis and (with Peter Elkind) "The Smartest Guys In The Room."