Snap! Cov-lites and subprime mortgages

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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The buck stops where?

Some of the hysteria around the current mergers boom is making headway in the national press. Since Anthony Bolton's speech a couple of weeks ago, there's suddenly been a lot of interest in covenant-lite loans.

But I think a lot of the coverage has done them a disservice. For a start, it won't be the banks that suffer if a default occurs, contrary to what the business pages are saying. Most covenant-lite loans are syndicated - sold on - by the banks in lucrative deals that allow for arbitrage. "We don’t hold onto any of ours. Of the deals done so far? 100%, they’re all syndicated,” I was told by the head of loan syndication at one of the big US banks.
The buyers of this loan debt aren't exactly unaware of the risks, however. They're hedge funds, CDOs, pensions funds and the like, who actively seek out risks to make money from the high-yields. As yield spreads go down, they're looking for new areas to invest in.

Covenant-lite loans are senior debt anyway, which means in relative terms they're less risky that a lot of the debt products out there that have been available for a long time. From senior debt you can expect an average 78% return of your investment in the event of a bankruptcy. If you'd invested in second-lien loans, bonds, mezzanine debt or equity, you could expect between 0-30%.

Sure covenant-lite loans are risky, but I don't think they're the "iconic catchphase for the peak, or near-peak, of an over-exuberant buy-out boom" the FT says they are.

The real problem with all of this, is that the banks' own desks are getting too involved in the secondary market themselves. Through their hedge-funds, they're making a lot of money, but they're also exposing themselves to the risks they're supposed to have diced up and safely resold on their syndication desks. It's all got the ring of systemic failure to it. Like the reinsurance crisis that brought down Lloyds, I wonder whether the banks are being a little too naive about the state of risk in the market at the moment. Someone has to be holding it.

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