Low interest rates in the U.S. enabled the 2013 bull market but have also created the conditions for another credit bubble. Covenant-lite loans, the latest financial innovation, could spell trouble.
With multiple alarm bells ringing with the slightest suggestion of Fed tapering, it might be time for the interest rate of the world’s largest economy to abandon its historically low figures and edge upwards . Yield-chasing investors are seeking some sort of return, but given the artificially low rate secured by three rounds of quantitative easing , return is elusive and often rather risky.
Case in point, the Fed issued a warning to a number of large banks, guilty of lax leveraged loan underwriting. Sounds familiar? It should. The credit bubble caused by a tremendous boom in subprime mortgages and the quick spread of Collateralized Debt Obligations (CDOs) and various other instruments were one of the key triggers of the 2008 financial meltdown.
Barclays, Citigroup, Deutsche Bank, Goldman Sachs, JP Morgan Chase, Morgan Stanley and UBS have received a warning from the Fed, the same authority which is distorting the market. Irony aside, this could spell trouble. The U.S. economy might be overheating, and the monetary base is more bloated than ever.
More specifically, the mentioned banks have engaged in a certain type of high yield, high risk corporate loans. It tends to be professional investors, who borrow cheaply from banks and then invest in stocks or financial instruments such as derivatives. For this particular group of loans, growth was so rapid in 2013 that it brings back memories from the run-up to the Credit Crunch.
Supposedly, this is what has triggered the efforts of the Fed, the Office of the Comptroller and FDIC to make big banks limit their exposure to such risk. This is the first time several entities have ‘ganged up’ to raise a fist of warning in the face of the big banks.
It is hard to point just a single finger when looking to place the blame. There is a sense in which the Fed’s policy of low interest rates and continuous QE has pushed investors into taking on cheap credit and chasing yields. The development is evident from margin debt figures, reflecting investor sentiment.
Marginal debt rises when investors are bullish about the prospects of the stock markets, and the levels of marginal debt have peaked simultaneously with market indices in the past. Investors are more willing to take out debt against investments when shares are rising, and they have more value in their portfolios to borrow against.
The Investor Intelligence data reveals that bullish sentiment among investors is at a 27-year high (see chart 1). Such extremes usually precede an important trend reversal. The danger emerges when markets decline fast, and large numbers of margin calls come due, adding to the already intense selling pressure. In November 2013, margin debt stood at $424 billion and was up for the sixth straight month. The record in 2007 was $381 billion.
With the S&P 500 posting its largest annual jump in 16 years and the Dow its biggest gain in 18 years, it seems as if it is either going exceptionally well in the U.S. or another bubble is heating up.
Jeremy Stein, one of the more outspoken Fed governors, leans towards the latter, as he states in a remark delivered at a symposium in honour of Raghuram Rajan. Rajan, incidentally, featured in the well-known documentary “Inside Job” as one of the few to see the 2008 financial crisis looming, which he argued in his controversial paper titled “Has Financial Development Made the World Riskier?”
To make matters worse, it is not only corporate high risk, high yield loans that are booming. So are covenant-lite-loans. Covenant is Wall Street jargon for the conditions under which banks are willing to grant loans.
Cov-lite-loans are a type of loan, where financing is granted with limited restrictions on the debt-service capabilities (collateral, payment terms, level of income, etc.) of the borrower. In May 2013, Moody’s wrote that signs indicated a ‘cov-lite-bubble’ building. Since then, that bubble has more than doubled. More than half of 2013’s leveraged loans have been of the cov-lite variety, and they quite possibly spell trouble (see chart 2).
Seeing as cov-lite refers to loans with lax lending conditions, the echo from the subprime bubble resonates and ought to cause concern for bubble-averse (or simply risk-averse) investors. As highlighted by the FT:
“Intuitively, such loans appear to swing the balance of power to corporate borrowers at the expense of lenders. Lenders have often argued that covenants act as an early warning sign to problems further down the road. With cov-lite, the worry is that the first time a borrower sits down with its lenders is after it’s already defaulted.”
Apart from acting as a warning sign of trouble for loan investors, cov-lites are also a potential indicator of overheating in credit markets. Thanks to dovish incoming Fed chairwoman Janet Yellen (propagating outgoing chairman Ben Bernanke’s near-zero interest policy), low interest rates are most likely going to stick for quite a bit longer, waiting for the U.S. economy to gain traction – and likely to only making the asset bubble worse.
 The real reason why the interest rate remains so low is likely more pragmatic than policy-oriented. If Americans were to pay an average interest rate on debt of 5.7 percent, rather than the 2.4 percent they pay today, in 2020 the debt service cost will be about $930 billion. In comparison, in 2012 the total tax revenue (from which interest on the debt is to be paid), was $1.1 trillion, meaning that at 5.7 percent – the historical average rate over the past 20 years – 85 percent of all tax collected would go to just servicing the debt.