Con­cern grows over new breed of sub-prime loan

So-called lever­aged debts are ring­ing alarm bells in the City, writes Ka­ly­eena Mako­rtoff

The Observer - - Business -

When an ex­pert in fi­nan­cial risk at one of the world’s most pow­er­ful pri­vate eq­uity out­fits tells in­vestors to scale down their ex­po­sure to a spe­cific cor­ner of the debt mar­ket, it is worth tak­ing no­tice.

Henry McVey, who sits on the risk com­mit­tee at KKR, said last week that the lever­aged loan mar­ket – a $1.3tn (£1tn) pile of risky cor­po­rate loans – had been on a “great run in re­cent years” but the firm was now cut­ting its ex­po­sure to the as­set class to zero.

McVey is not alone. A grow­ing cho­rus of global lead­ers spent 2018 warn­ing that the lever­aged loan moun­tain was get­ting dan­ger­ously large and invit­ing com­par­isons with the fi­nan­cial cri­sis a decade ago.

The Bank of Eng­land, Aus­tralia’s cen­tral bank, the In­ter­na­tional Mon­e­tary Fund and mem­bers of the US Fed­eral Re­serve have raised red flags over so-called lever­aged loans, which are of­fered to com­pa­nies al­ready in debt but of­ten come with few strings at­tached.

In Oc­to­ber last year the Bank’s fi­nan­cial pol­icy com­mit­tee, which mon­i­tors the health of the fi­nan­cial sys­tem, point­edly raised the spec­tre of the 2007-08 credit crunch. It said the “global lever­aged loan mar­ket was larger than – and was grow­ing as quickly as – the US sub-prime mort­gage mar­ket had been in 2006”.

As with the sub-prime cri­sis, the bank added, un­der­writ­ing stan­dards had slipped – in other words, risky cor­po­rate debt was too easy to get right now. “Given the de­cline in un­der­writ­ing stan­dards, in­vestors in lever­aged loans are at in­creas­ing risk of loss,” said the Bank.

The key ques­tion now is whether a bub­ble in a dif­fer­ent cor­ner of the debt mar­ket could trig­ger a mar­ket panic. “A quote wrongly at­trib­uted to Mark Twain fits here: his­tory rarely re­peats, but it does rhyme,” said Rasheed Saleud­din, a re­search as­so­ciate at the Uni­ver­sity of Cam­bridge’s Judge Busi­ness School.

While he said it was hard to see the next fi­nan­cial crash com­ing di­rectly from a fail­ure in the lever­aged loan mar­ket, Saleud­din added that there was a chance that “small changes in de­fault rates in the loans or even in ex­pec­ta­tions of same could cause a melt­down”.

In the lead-up to the 2008 fi­nan­cial cri­sis, banks were so keen to lend that they lib­er­ally handed out mort­gages to cus­tomers with weak or no credit his­to­ries who ended up de­fault­ing when times got tough. Those mort­gages had been bun­dled to­gether and turned into in­vestable prod­ucts, caus­ing a chain re­ac­tion of losses that spread like wild­fire through­out the fi­nan­cial sys­tem and caused a global down­turn.

A decade later, rather than dol­ing out risky loans to home­own­ers, banks are hand­ing out lever­aged loans to in­debted com­pa­nies. Many are also “covenant-lite”, mean­ing they come with fewer strings at­tached for bor­row­ers, and as a re­sult, present greater risk for lenders.

But since most loans are sold on and pack­aged as col­lat­er­alised loan obli­ga­tions, or CLOs, there are fewer in­cen­tives to im­pose strict terms. Lever­aged loans also come with float­ing rates, mak­ing them more at­trac­tive for in­vestors, who re­ceive higher in­ter­est pay­ments when rates rise.

Amir Amel-Zadeh, an as­so­ciate pro­fes­sor at the Uni­ver­sity of Ox­ford’s Saïd Busi­ness School, ex­plained that in­vestors in lever­aged loans, loan mu­tual funds and CLOs could face higher losses than in­vestors in the same prod­ucts dur­ing the 2008 cri­sis due to lower lend­ing stan­dards, an in­crease in covenant-lite loans and higher lev­els of cor­po­rate in­debt­ed­ness than 10 years ago.

But while the trends in the CLO

‘Small changes in de­fault rates, or even the ex­pec­ta­tion of this, could cause a melt­down’

Rasheed Saleud­din, an­a­lyst

mar­ket were sim­i­lar, he said the scale was nowhere near the mort­gage se­cu­ri­ti­sa­tion mar­ket in 2008 – at about a tenth of the size. “So at first sight it is not as wor­ry­ing from a sys­temic risk point of view. How­ever, if eco­nomic con­di­tions worsen, it can lead to losses for many in­vestors and lead to a sim­i­lar dry-up in liq­uid­ity in these in­stru­ments as we have wit­nessed with sub-prime mort­gage se­cu­ri­ti­sa­tions dur­ing the 2008 cri­sis.”

Re­ports have al­ready emerged that the mar­ket for CLOs may be cool­ing, as uncer­tainty grips mar­kets. With fewer in­vestors lin­ing up to take a slice of the lever­aged loan mar­ket, prices have dropped, and banks have been post­pon­ing sales of lever­aged loans. “If banks have to keep the loans on their books they will be ex­posed to the price risk,” Amel-Zadeh said.

With­out a hun­gry mar­ket to sell lever­aged loans to, banks may be less will­ing to lend so lib­er­ally to in­debted com­pa­nies. And with­out fur­ther loans to feed their debt habits, com­pa­nies could be at risk of de­fault. This par­tic­u­lar debt mar­ket will be one to watch in 2019.

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