Lessons from the credit crisis debacle
- 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.
Covenants 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.
from James Saft:
Save capitalism from the banks – Nassim Taleb
Nassim Nicholas Taleb, the author of "The Black Swan: The Impact of the Highly Improbable", has a simple proposal to as he puts it, "save capitalism and free markets from the banks."
Nationalise the banks, limit the rewards to those who work in what he calls the "utility" part of the system and have a completely uninsured second leg that can take all the risks it wants and lose its shirt, he said in an interview in Davos at the World Economic Forum.
"They rigged the game. We pay them for their profits, there is no clawback so their incentive is to hide the risk they are taking."
"Which is why eventually as someone who loves free markets, a total nationalisation of the part of the business that requires insurance and does clearing and payments needs to happen."
"I am angry with U.S. policy. What we had is exactly the opposite of socialism, they got TARP to pay their bonuses and to take more risk."
He describes his plan as Capitalism 2.0. It would have a barbell structure, with the insured utility-like part on one end and the free market bit with privatized risk on the other.
Absolute right on the nail!! And not only Bob Rubin but each and every one of the bankers who have got us into this mess should be made to pay back all the bonuses they received whilst doing so.
