Covenant-lite: The default crisis that never happened. Will it now?

Commentary about business and finance.
Feb. 22 2011 5:35 PM

Corporate Subprime

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."

Bethany  McLean Bethany McLean

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."

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.

Some cov-lite boosters like Tony James, the president of private equity giant Blackstone, argue that that covenant-lite loans have proven to be less risky than regular loans. In a Feb. 3 call with investors, James said that the cov-lite structure "helps preserve enterprise value. It helps preserve jobs. It's good for the economy. It is good for the sponsors, but it's also good for the creditors, and it is also good for the employees of these companies." The argument is that without covenants, trigger-happy lenders can't step in and dismantle a company at the first sign of problems. Instead, they have to work with management, often extending the terms of the debt, for the benefit of all. In effect, James's argument is that borrowers are smarter, better managers than lenders are. 

The Fed's stunning largesse means that the jury is still out on James's argument. It also means that in some key ways, we're right back where we were in 2006 and 2007.  Interest rates are very low, meaning that yield-hungry investors are reaching for risk. According to an index of high yield bonds tracked by Credit Suisse, the yield on risky debt is a record low 6.86 percent, down from more than 20 percent at the height of the panic in March of 2009. Retail investors are pouring money into high yield bond funds—$6.7 billion so far this year, according to the Wall Street Journal. That's half the inflow for all of 2010.

There are other similarities between the credit bubble and the current credit market. Banks still want to please their biggest clients, the private equity firms. And CLOs are once again a brisk market for whatever higher-yielding debt that can be found. That's because CLO managers aren't paid to have cash on hand, and all that refinancing of risky debt has resulted in an inflow of cash. They have to invest the money somewhere—and in order to justify the existence of the CLO in the first place, it has to be somewhere that offers a decent yield.

So is it surprising that, according to S&P, more than 25 percent of first-lien loans (those that have the first call on a company's assets) issued in 2011 have cov-lite structures? The $8.8 billion in such issuance so far this year already tops the total for all of last year, and it isn't even March. Among the private equity deals that used cov-lite loans are the buyouts of Del Monte and J. Crew, according to market participants. "Investors want yield any way they can get it and are willing to take less and less protection to get it," says one hedge-fund manager.

There's some reason to be sanguine about this. If, indeed, we're having an economic recovery, then it's in the early stages, meaning that debt issued now has a better chance of being paid off than debt issued later in the cycle. The prices on private equity deals aren't crazy, so the debt levels might be manageable. And the Fed is showing no signs of raising interest rates, meaning that risky assets should continue to perform well.

Then again, if you're a pessimist—or a rationalist—this might give you some pause. As Pesikoff, a fellow Williams College math major, reminds me, and as any statistician will tell you, a good outcome for a bad risk doesn't mean the risk wasn't bad; it just means you happened to get lucky. The fact that the Fed rode to the rescue doesn't necessarily mean that cov-lite loans were a good risk to begin with. You also might see in the desperate hunt for yield some uncomfortable parallels to the bubble years. Weren't we all supposed to have learned that too much debt is bad for us? Whether the cov-lite deals getting done right now will face a day of reckoning is anyone's guess. But at the very least, these deals strike me as a sign that some kind of reckoning is in store. I hope I'm wrong about that.

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