The Great Debate

Lessons from the credit crisis debacle

January 14, 2010

- Steven Miller is managing director of Standard & Poor’s LCD, a unit not part of Standard & Poor’s ratings business. The opinions are his own and not those of S&P.-

As the worst credit crisis since the 1930s recedes, investors are starting to boil down the lessons of the past two and a half years.

With time, we’ll get smarter about how to interpret the recent upheaval but for now, it comes down to these: (1) financial covenants, which test the financial health of a borrower each quarter, can be used to reset loan spreads when times are tough, (2) collateral is indeed resilient, (3) bubbles work in both directions, (4) models are better at predicting the past than the future and (5) “black swans” –- those big unexpected events and their consequences — take many forms.

This first item is hardly a surprise. Lenders knew going in that by foregoing covenants, which would have allowed them to re-price loans to struggling issuers, they were giving up the power to force borrowers to pay more as their financial profile deteriorated. The extent of that omission is now clear: By the end of 2009, loans with covenant tests paid an average spread over LIBOR of 3.20 percent compared to 2.33 percent for loans that lacked such tests -– the so-called “covenant-lite” loans that proliferated during the height of the boom.

Collateral is resilient
From time immemorial, security has been a principal calling card for the loan asset class because it limits an investor’s downside. Despite some high-profile default wipe-outs in the early 2000s from large blue-print telecom issuers, loan recoveries –- the amount a lender gets back when a loan defaults -– have consistently been significant. Between 1997 and 2006, the average initial recovery, or price-at-default, of first lien loans was 66 cents on the dollar. By comparison, unsecured bond recoveries have averaged 45 cents over time, according to New York University professor and credit-markets guru Ed Altman.

In the first half of last year, however, the floor fell in. With default rates soaring and credit prohibitively expensive, the average price-at-default fell to just 37 cents on the dollar, an all-time low. In the second half, however, the worm turned. With economic conditions improving, default volume dropping and liquidity seeping back into the markets, the average climbed to 63 cents in the second half of last year. Still, the average price-at-default in 2008 and 2009 was 53 cents, about 10 percent lower than the average of 59 cents from the 2001/2002 default spike. Then, like now, the average is below-trend during periods of distress when there is a flood of defaulted supply and the economy is weak.

Given the recent trends, however, that gap seems likely to close in the year ahead. In fact, the prospects for recoveries are getting better and better. Just look at the average price of loans exiting bankruptcy as seen on the S&P/LSTA Leverage Loan Index. In the fourth quarter, 10 S&P/LSTA loans exited bankruptcy at an average final pre-emergence price of 68 cents. Those numbers are just inside the historical average recovery of 71 cents on the dollar, according to Standard & Poor’s Global Fixed Income Research Group. And the story appears to be improving: Five others in the final stages of exiting – LyondellBassell and Smurfit-Stone, for instance – are trading at an average of 96.

Bubbles work in both directions
In financial markets we tend to focus on bubbles of excess. Clearly, though, markets overreact in both directions. Since 1900, for instance, the S&P 500 dropped has 30 percent or more in 5 calendar years, according to data from Yale Professor Robert Schiller’s webpage (http://www.econ.yale.edu/~shiller/data.htm), while advancing 30 percent or more in 10. Not for nothing did many of the best years closely follow the biggest sell-offs, and in the case of 1931 and 1937, visa versa:

Year    Change
30%+ Declines

1907    -33.23%
1917    -30.61%
1931    -45.58%
1937    -35.40%
2008    -40.67%

30%+ Advances
1908    37.44%
1928    32.59%
1933    46.19%
1935    40.82%
1936    30.83%
1945    32.29%
1954    40.84%
1958    32.63%
1975    32.25%
1995    35.01%

These data are not perfect, of course. The stock market doesn’t hue to calendar years any more than it follows the forecasts of experts. That, for instance, is why 2009 doesn’t make the list. Despite a 66 percent run between March and December, the full-year return was weighted down to 27 percent by a terrible first quarter.

Still, the point holds: the market maybe an efficient processor of all available information, but as investors we all consistently misjudge the economy’s outlook and are unable to foresee exogenous shocks. The loan market over the past two years is an object lesson in this point. After plunging 29 percent in 2008, the S&P/LSTA index bounced back 52 percent last year.

As this suggests, the market underestimated 2008’s default risk and then compounded the mistake by overestimating 2009’s.

  Average spread to maturity Imputed default rate Actual default rate over the next 12 months Return of the S&P/LSTA Index over the next 12 months
12/31/2002 LIBOR+372 1.40% 3.75% -29.10%
12/31/2008 LIBOR+1641 26.80% 9.61% 51.60%

Acting on history can change the future
In 1976, Nobel-prize winning economist Robert Lucas published his famous critique of financial policy (http://en.wikipedia.org/wiki/Lucas_critique) that proposed, in effect, that historical insights become obsolete when policy makers try to exploit them. Though his work focused on the relationship between unemployment and inflation, the key observation is applicable to the credit markets broadly, and the loan market specifically, over the past five years. The key insight of the first decade of leveraged-loan market history was that loans as an asset class were inherently stable. Between the start date of the S&P/LSTA Index of leveraged loans in January 1997 and June 2007, the standard deviation of monthly returns was a mere 0.53 percent, creating a Sharpe ratio that, at 0.94, towered over virtually every other asset class.

  Standard deviation of     Sharpe  
  returns     ratio  
  1/97-6/07 7/07- 1/97 – 12/09 1/97- 1/97-
    9-Dec   7-Jun 9-Dec
S&P/LSTA Index 0.53% 4.46% 1.99% 0.94 0.27
ML HIGH 2.04 5.38 2.96 0.44 0.36
YIELD (H0A0)          
S&P 500 4.36 6.21 4.78 0.41 0.17
ML HIGRADE 1.31 2.77 1.68 0.6 0.55
CORP (C0A0)          

Once financial engineers began to exploit this insight by applying massive leverage to the market –- and in particular, leverage through such mark-to-market vehicles as Total Return Swaps (TRS), market-value Collateralized Loan Obligations (CLOs) and Loan Credit Default Swaps (LCDS) -– the game changed. This was less about covenant-lite structures and second liens and more about the volatility caused by two technical factors. The first was the massive build up in the underwriting calendar, which, at its peak, reached $247 billion.

When the CLO market cooled in mid-2007, all of this paper weighed on the market pushing down prices even though default rates remained low. The second, of course, was the terrible aftershocks of Lehman’s bankruptcy, which pushed prices far below anything before seen and set off a punishing round of TRS and market-value CLO unwinds; though it’s fair to point out that cash-flow arbitrage CLO’s held up well because they required mark-to-market only at the margin.

Absent the massive calendar and the deleveraging, this cycle might have looked a lot like the past two – painful but hardly earth-shaking. Instead, it brought unimaginable volatility to the market, what with 2008’s 29 percent loss in the S&P/LSTA index, a previously unimaginable move off the historical average.

This perhaps is what Lucas was talking about when he suggested that rather than looking at broad trends, policy-makers need to drill down to analyze the “deep parameters” of a given policy change. By that he meant anticipating how the policy would change individual behavior. For example, foreseeing that the securitization of no-documentation mortgages might push house prices to untenable levels ultimately causing the market to over-heat, then burst. This type of prescience, however, is as rare in the financial markets as it is in the fortune telling business.

Black swans

Few prognosticators were more on point about the dangers that lurked in the bull run of the mid-2000s than Nassim Taleb. His 2007 book, “The Black Swan” (http://en.wikipedia.org/wiki/Black_swan_theory), which we summarized here https://www.lcdcomps.com/lcd/n/article.html?aid=9177581&rid=20, was a prescient warning that just because something hasn’t happened in the past doesn’t mean it won’t happen in the future.

The lessons of the past may well prevent investors from making the same mistake twice. Investors learn from the past in a micro sense. The default cycle of the early 2000s ended the blue-print loan just as the cycle of the early 1990s ended the highly leveraged retailer trade. In the mid-2000s, clearly, it was leverage that proved the loan market’s undoing. It’s logical, then, that CLO’s leveraged at 10-11 times equity and TRS lines at 15-20 times will not be coming back anytime soon. But something will.  Every cycle creates a new excess that is obvious only in retrospect.

Never say never
At the 2002 LSTA Annual Conference in the midst of the last credit crunch there was a panel on which phrases like “we won’t do a deal without prepayment fees or a spread inside L+250” were bandied about.
We all know what happened next. Markets bounced back as they always do. It’s not that memories are short. In fact, investors can recount their battle scars in exquisite detail. But the genius – or downfall – of the credit markets is that defaults are rarely at a stable average.  They are either below trend, spiking or coming down. As a result, credit appears to be easy money during periods when the economy is strong and default rates low.

Back in the days before mark-to-market accounting and the shadow-banking system, banks would try to smooth the cycle by reserving for losses. These days, the market is free to rise and fall, making the system more efficient but also more volatile.

And while predictions are a dangerous game, investors hope that with less leverage, the market will settle down in the years ahead. Certainly, few expected to see the 81-point swing in S&P/LSTA Index returns that we saw in 2008 (-29 percent) and 2009 (+52 percent). On the other side of the ledger, few expect the market to go back to sleepy pre-2008, when the loan market envelope was limited to a return of just 8 points: +2 percent in 2002 to 10 percent in 2003.

Post Your Comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/