“It’s as if the financial crisis never happened and the lessons from it are ancient history,” Jonathan Rochford of Narrow Road Capital told The Daily Telegraph. In the 2000s, toxic subprime mortgages were bundled together in collateralised debt obligations (CDOs) and sold to buyers who didn’t realise how much junk the packages actually contained. Ten years later, the surge of covenant-lite loans in the leveraged-loan market could prove to be another “ticking time bomb”, says The Daily Telegraph’s Tom Rees.
Covenants require a borrower to pass financial tests. However, “cov-lite loans”, which have been stripped of these conditions, have proliferated amid the desperate global search for yield. In the US, cov-lite loans now account for nearly 77% of the estimated $1trn corporate-loan market. And some of these loans are packaged up and resold as CLOs – collateralised loan obligations. In the UK, the leveraged loan market hit a record £38bn in 2017 and could grow by 4% this year, according to the Bank of England. Meanwhile the quality of covenants has sunk to a record low, says credit-rating agency Moody’s.
It may not be too late to head off the danger, says William Cohan in The New York Times. Banks could tighten their underwriting standards and “demand more covenants”, while regulators could be more vigilant. But don’t hold your breath. We may have to “inure ourselves to the inevitable”.