When hedge fund managers from FrontPoint Partners drove through a Florida suburb in the run-up to the financial crisis, they quickly realised the US housing market was built on sand. Anyone could grab a 2,000 sq ft slice of the American dream in the Sunshine State.
These toxic subprime mortgages were then bundled together in collateralised debt obligations (CDOs), given top ratings from credit agencies, and sold on in a neat, explosive package to buyers unaware that the US housing bubble was about to burst.
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The famed hedge fund depicted in Hollywood blockbuster The Big Short would cash in on the market's over-exuberance.
"The buyers of so-called triple A, double A, triple B, double B tranches in these collateralised loan obligations (CLOs) are making an investment off data that is dubious at best," says Robin Doumar, founder of credit manager Park Square Capital.
Doumar is not casting his eye back to the housing bubble but calling out a new one that could be emerging in the risky leveraged loan market, which fuels private equity buyouts and bankrolls companies with poor credit ratings.
"With the stack of securities being sold to investors in a CLO, I don't think anyone is doing their homework on what is the underlying pool of collateral, and in that regard I think it is very similar to The Big Short."
With the 10-year anniversary of the Lehman Brothers collapse this month offering a ghostly reminder of past excess, some believe that the surge of covenant-lite loans in the leveraged loan market could be another ticking time bomb.
"It's as if the financial crisis never happened and the lessons from it are ancient history," says Jonathan Rochford, portfolio manager at credit manager Narrow Road Capital.
Amid fervent demand from lenders, these below investment grade loans have been stripped of their basic investor protections, like covenants, in recent years. Investors have piled into these risky but lucrative high-yield loans to obtain higher returns.
Rochford explains that companies are "emboldened to seek ever weaker covenants and are taking advantage of the current conditions to borrow more at lower margins".
"The US high-yield market has grown larger and riskier since the financial crisis. Issuers of debt have the whip hand as buyers compete to gain an allocation in the face of surging demand from CLOs and retail funds."
Covenants require a borrower to pass financial tests, usually on a quarterly basis. These tests can stipulate how much debt a company can have or the earnings it needs to generate.
But cov-lite loans now make up around 80 per cent of new issuance in the booming leveraged loan market, which surged past the US$1 trillion (NZ$1.5 trillon) milestone in the US earlier this year. In the UK, the leveraged loan market hit a record £38bn in 2017 and will have grown by a further 4 per cent this year if the current rate is sustained, according to the Bank of England's latest financial stability report.
A concerning emergence of exchange-traded funds worth just under US$8bn now allows retail investors to spin the wheel, according to data from ETF.com. Corporate titans have been gorging on debt in the leveraged loan market.
Taxi ride service Uber tapped the market in March, French telecoms giant Altice has built an eye-watering mountain of debt from junk bonds and loans, while Blackstone will reportedly market the US$8bn in risky loans it needs to fund its acquisition of a 55 per cent stake in Reuters's financial and risk division next week.
American Airlines, Four Seasons and Dell are other household brands to rely on leveraged loans. Doumar is far from being alone in fearing the explosive growth of this market. The credit ratings agencies, accused of being asleep at the wheel in the run-up to the crisis, are now among the first to sound the alarm.
The quality of covenants has sunk to a record low, according to Moody's. The ratings agency believes that leveraged loan investors "face significant future risks".
Its Loan Covenant Quality Indicator in the first quarter of 2018 climbed to a record 4.12 on a scale of one to five, with a higher score indicating weaker protections for investors. It argued that there has been "shift of power to borrowers" who have taken advantage of "favourable market conditions" and left investors with an "unprecedented" lack of protection.
The International Monetary Fund also conjured up the ghosts of the last crisis when warning investors on leveraged loans. Lower-quality companies are enjoying "ample" access to credit and the market is "reminiscent of past episodes of investor excesses", the lender of last resort said in its global financial stability report in April.
The two organisations agree that the widespread abandonment of these protections will likely lead to more defaults in the next downturn. Cov-lite loans being of a lower quality will "exacerbate the next default cycle" and a surge in defaults would send shock waves that would reach the real economy, the IMF predicted.
The intense demand in the leveraged loan market has fuelled the deterioration in the covenants. The balance of supply and demand leans heavily towards the latter. A borrowers' market exists in which companies can issue loans without these basic red lines in the knowledge they will still be gobbled up by investors.
Moody's warned last month that investors are "under pressure to keep buying" and continue to "cede control" of loan terms. These loans track interest rates higher and therefore, hunger for them is increasing as they shield investors from Federal Reserve rate hikes in the US.
The IMF warned that this "reach" by investors for stronger returns had driven the decline in loan quality. Derek Gluckman, a vice president and senior covenant officer at Moody's, believes it is a trend that is likely to continue.
"Until it becomes a big enough issue that people stop voting with their dollars we continue to see investment in the asset and there continues to be deterioration in these covenant protections." The market has become "comfortable with covenant-lite" loans, he says. "It's difficult to put the genie back in the bottle."
Taron Wade, director at LCD, S&P Global Market Intelligence, explains that an "evolution" in the investor base, first in the US and more recently in Europe, has also underpinned this shift. Institutional investors and CLO managers are now the main lenders rather than banks, which typically demanded a more active role.
She adds that the loan market has become more like the bond market, which has few financial covenants and is also institutional investor-driven. Doumar believes the surge in cov-lite loans is just the tip of the iceberg.
"The bigger problem is the overall erosion of documentation, which has become almost a joke. It has crept into the documentation that more and more cash from the company can be dividended out to the private equity firm when the lenders have not been repaid."
Furthermore, the US appeals court ruled in February that CLO managers, the biggest buyers of these risky corporate loans, will no longer be required to have "skin in the game".
CLO managers are now exempt from the post-crisis rules that stipulated that they have to hold some of the loans that they were packaging up to sell on.
Cov-lite loans were once only given to the sturdiest companies that could be trusted to be handed more lax loan terms. Companies were lured by cov-lite loans in the aftermath of the crisis by their flexibility. While covenants offer investors protection, companies, in particular those vulnerable to economic cycles, such as the car industry, can struggle to meet the rigid terms of the loans in a downturn. Staving off default by meeting covenants led to companies self-harming.
In the crisis, companies "were trying to do anything and everything" to meet the covenants and avoid default, John Puchalla, a senior vice president at Moody's, explains. But a search for flexibility quickly morphed into an opportunity to ditch safeguards.
"It might have started innocently but as the market has evolved in the last 10 years we've seen it transition to a much more aggressive structure with fewer covenants and it has also led to a deterioration in debt structure," Puchalla says.
A common defence of the leveraged loan market is the current default rate is stubbornly low and is set to sink further.
But Patrick Marshall, head of private debt at Hermes Investment Management, describes this as a "skewed argument". "The reasons defaults are low is that there are not any covenants to trigger a default and when a company does finally default in a cov-lite situation you can be sure that your recovery will be far lower."
He explains that covenants act as flashing amber warning signs for lenders, allowing them to step in to discuss and rectify an issue early on. Rochford argues that the cov-lite loan boom will "flatten and lengthen the default cycle" as zombie companies "struggle on for longer" without covenants to trigger a much-needed intervention from lenders.
Moody's has also warned investors to brace for far lower recoveries – the amount clawed back from defaulted loans. It forecasts that recoveries on first-lien loans – the first to be repaid in the event of a default – will be 60 per cent, well below the long-term average of 85 per cent.
The collapse of Toys R Us offers a grisly reminder of how a company can buckle under a pile of risky debt. Prior to the retailer's collapse Moody's deemed that it had been "hamstrung" by its "significant levels" of buyout debt.
Doumar says: "I think that CLOs are relying on historical default data to sell the securities to the market and I think you can throw that empirical data out of the window because it has absolutely no relevance today.
"The default statistics and the recovery rates will be far worse than what CLO issuers have been touting." Wall Street legend Sir John Templeton famously said "this time it's different" are the four most dangerous words in investing.
As investors ditch protections in a desperate hunt for stronger returns, they could have made the same mistakes all over again.
- The Telegraph
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