The FT's special report on derivatives yesterday (in FTfm) had some interesting points to make. Paul J Davies's article about CDOs in particular:
As one London-based banker quips: "What's going on in the loan market makes ordinary junk bonds look like the quality end of the leveraged finance market."
Lots of people are indeed beginning to compare the two markets, particularly since the subprime mortgage crisis. There are easy parallels to draw between lax mortgage lending and loosening loan-covenants. The Bank of England made the
comparison a few weeks ago - although many in the market
dismissed it as trite.
Cov-lites and subprime mortgages are very different kettles of fish - so far, cov-lites deals have been struck only where the vendor is sure about the underlying credit quality of the sponsor - quite the opposite has been the case with subprime mortgages. The comparison is useful, however, in showing the way things may run. Both subprime mortgages and cov-lite loans are being driven by a burgeoning secondary market, which as Davies writes, is hungry for paper with high yields.
Take a look at this graph:
In the last quarter, demand for sub-investment grade loans has soared in the secondary market. It's all because spreads are getting tighter and tighter. With demand this high, there is a sense the market could diversify further. There clearly is a demand for more risk which isn't yet being met, and certainly isnt being reflected in spreads. I guess two things could happen. Firstly, the market could suffer a correction, in which case, liquidity will dry up and spreads on risky loans will widen. Secondly, if the bull run continues, I wouldnt be suprised to see new, higher risk loan products syndicated by banks. Cov-lites already carry slightly higher yields, and with CDOs diversifying and spreading risk so much, I think the loan market has a way to go before it finds it subprime mortgage equivalent.
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