- 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.