The Wrongologist

What’s
Wrong Today:

We
remember all too well the real estate bubble that culminated in the Great
Recession. We are still paying a huge price for letting the real estate mortgage
market and the associated risk lay-off mechanisms, Collateralized Mortgage Obligations (CMOs) and
Credit Default Swaps (CDS) turn into a financial bubble.

The
price was the loss of middle class net worth, the loss of middle class jobs and
the massive run-up in debt to support the banks that caused the problem,
because otherwise, they might have failed.

But
we learned not to let that happen again, didn’t we?

Maybe
not. Things are starting to get bubbly in the high yield corporate debt market. Corporations issue debt routinely.
The loans can be for short durations (6 months) to 20+ years. The high yield market
describes companies that have a higher risk of repayment of the borrowed funds.
These loans are sometimes called “leveraged loans” when the risk is high. Investopedia
defines leveraged loans as follows:   

Demand for corporate leveraged loans has
been growing and continues to stay unusually strong. These loans are more risky
than high yield loans. Senior loan closed-end funds, Business Development
Companies (BDCs),
Collateralized Loan Obligations (CLOs),
hedge funds and even insurance firms are clamoring for senior loans of
sub-investment-grade companies. The chart below shows the growth in leveraged
loans:

Source:
Deutsche Bank

The most alarming
element in this trend is the sharp relaxation of lending terms. These deals
have detailed terms and conditions called “covenants”, which typically restrict actions by the company that could impact its
creditworthiness. Failure by a borrower to continually meet the requirements of
its covenants can give lenders early warning of a possible default.

Most investment
advisors would say that strong covenants make these loans a safer risk than
other high risk forms of debt like Junk Bonds, (a colloquial term for a high-yield or
non-investment grade bonds).

But covenants are no
longer a big part of new leveraged loan volume. Now many leveraged loans are called
“cov-lite”
(covenant-light). Over 70% of
recent deals have been structured as covenant-light. The chart below
shows the rapid growth of covenant-light loans as a percentage of total
corporate debt:

Doesn’t this sound familiar? Banks
relax credit standards to build loan volume. They use sophisticated financial
instruments to move the credit risk off their balance sheets to other
investors, mostly funds and insurance companies. Bankers make big fees for
arranging the deals. They make their budgets and thus get their bonuses. The
last guy in the game of musical chairs winds up holding the loan, and is
screwed.

Welcome to the son of the mortgage
debacle.

Today’s
investors are poorly compensated
for the risks they are taking compared to the recent past. In
2007, a three-month certificate of deposit yielded more than junk bonds do
today. Average yields on investment-grade debt have dropped to 2.45%
from 3.4% a year ago, according to Bank of America Merrill Lynch’s Global
Corporate Index.

Wilbur
L. Ross Jr., chairman and CEO of WL
Ross & Co. has noted that 1/3 of first-time issuers in the leveraged
loan market have credit ratings of CCC or lower (ratings go from AAA
downwards). In the past year, more than 60% of high-yield bonds were
refinancings. None of that capital was to be used for expansion or working
capital, just refinancing balance sheets.

Some
might say that it is good that there is no new leveraging, but it is really much
worse. This means that many companies
had no cash on hand to pay off old debt and had to refinance.

Bloomberg
reports that regulators are taking an interest in the possible leverage loan bubble.
The Federal Reserve and the Office of
the Comptroller of the Currency sent letters to some of the largest US banks
asking them to avoid arranging debt that may be classified by regulators as
having a deficiency that may result in a loss. In March, they had issued guidelines
for junk-rated loans, citing deteriorating underwriting conditions. The guidance update was the first since 2001.
Regulators are seeking to cut down on excessive risk taking as typical lender
protections have been stripped from credit agreements at a record pace. From
Bloomberg:

Unsurprisingly, the Loan
Syndications and Trading Association LSTA, with 350 members
consisting of banks, investors and law firms, said the regulators’ request will
hurt the least-creditworthy companies. Bloomberg quotes Meredith Coffey, EVP of the
association:

Remember
that these leveraged loans are rated by Moody’s, who according to Bloomberg, is
forecasting that the speculative-grade
default rate will rise to 3% percent for this year, from 2.8% in September,
2013. The measure peaked at 13.73% in November 2009. Many argue that weak loan covenants
and high risk don’t matter much when corporate default rates are as low as they
are.

Didn’t
we hear similar arguments in 2006 with a different asset class?

This doesn’t
rise to same level of risk that the $Trillions of credit default swaps and
collateralized debt obligations that traded on top of the $14.6
Trillion of mortgage debt that was outstanding in 2008. But in October
2013, junk bonds outstanding are more than $2.2
Trillion, while leveraged loans are $1.3
Trillion. More and more retail-oriented funds are including leveraged loans
in their Exchange-Traded Funds (ETFs), held by
many average American investors.

A possible
financial bubble could be waiting, particularly since NOTHING has been done to change
the behavior or incentives of the banks that arrange these loans.

US financial
bubbles are frequent. In the 1970s, gold went from $35 to $850 before crashing.
The NASDAQ experienced the dot-com bubble and stocks went from 440 to 5,000
before crashing spectacularly in 2000. The NASDAQ lost 80% percent of its value
in less than two years.

The US stock
market has crashed in: 1929, 1962, 1987, 1998, 2000, and 2008. Every time, the
bubble was driven by different sectors. In 1929, radio stocks were the Internet
stocks of their day. In 1962, the electronic sector crashed. The previous year,
most electronic stocks had risen 27%, with leading technology stocks like Texas
Instruments and Polaroid trading at up to 115 times earnings. In 1987, the
S&P had risen more than 40% in less than a year and over 60% in less than
two years. In 2000, it was the Internet bubble.

Eventually,
all bubbles burst. Fundamental values re-assert themselves and markets crash.

Do
yourself a favor, stay away from this game of musical chairs.