Bernanke’s children ignite loan party

March 1, 2011

James Saft is a Reuters columnist. The opinions expressed are his own.

By some measures the bank loan market is partying like it’s 2007, a remarkable turn of events considering three intervening years of recession, crisis and volatility.

This time the market is enjoying a rush of money from small investors, Bernanke’s children if you like, who have decided to take on risk in a world of zero interest rates and quantitative easing.

As a result 25.2 percent of all syndicated bank loans made in the U.S. so far this year have been “covenant-light” credits, according to Standard & Poor’s LCD, more than at the peak of the credit market frenzy year of 2007.

Covenant-light loans are credits in which the lenders have agreed to give up many of the protections that they have traditionally used to safeguard their investment, such as requirements that borrowers maintain a certain amount of earnings compared to debt.

Covenant light loans were widely derided in the aftermath of the credit crisis, and for a time all but disappeared, shrinking to just 4 percent of the market in 2008.

Remember 2007 was an eerie time in loan markets. Supposedly sophisticated hedge funds were not even downloading the documents on the loans they were being offered, essentially taking the arranging bank and the ratings agencies’ word. Really they were reaching for yield, searching for anything that paid enough to allow them to make the return they had promised their investors.

The hedge funds and structured investors of 2007 have been replaced by retail money in 2011; issuance of Prime Funds, mutual funds which buy bank loans, hit $5.9 billion in January, a pace which if maintained would make it not just the biggest year on record for Prime Funds, but five times bigger than the second biggest. Meanwhile huge numbers of borrowers are coming back to market and demanding, and getting, easier and cheaper terms.

While it is impossible to track exactly where the Prime Fund money is coming from, or its motivation, the typical investor is an individual who, seeing good returns last year in the market, is moving money out of lower risk funds,  such as ones which often invest in short-term debt.

In other words, it is a great example of the way in which money has been crow-barred out of safety by monetary policy.

“At this point we are in the Goldilocks period of the cycle. Sans QE II we might still be wearing sweaters,” said Steve Miller of S&P LCD, which tracks loan market activity and trends.

The story is complex, according to Miller, and the market has also gotten a lift from better overall economic conditions, a shortage of supply and low and declining rates of default.

THE DOG THAT DIDN’T BARK

There are two strongly contrasting explanations for the resurgence of covenant-light loans. One argument says that the  loans proved their mettle in the crisis; among loans made in 2007 covenant light issues defaulted far less often. Looking at the market over the past five years covenant-light loans have made a higher return for their investors.

That is really a remarkable performance given the seriousness of the crisis and the downturn, and quite different from most predictions.

The second less reassuring take is that the loan market reflects what happens when monetary and government policy bails out risk takers. On this reading, the cov-light loans of 2007 did well partly because they were the stronger credits which could command easy terms, but largely for the same reason the whole market did well; easy money and extend and pretend.

The heroic measures taken by the Federal Reserve and government in 2008 and 2009, combined with a policy by banks to string borrowers along in hopes they would eventually recover, meant that the weak did not get washed out and go bust in the way they normally would.

That shows not that abandoning old-fashioned banking practices is wise, but rather that if you do it be sure you have a flexible and friendly central bank ready to help out.

This is a great example of how the Federal Reserve’s asymmetric response to crises, bailing out but not pricking bubbles, pollutes the process of asset allocation in the economy. Lenders have learned the lesson of moral hazard from the Fed’s actions and are plunging back into the market, sleeping well at night because their conditioning has deadened them to risk.

This does not mean that today’s loans will go bad; perhaps we are early in a recovery and perhaps investors will be rewarded for riding with the momentum.

Whether this ends in a leveraged buy out boom or a bust, risk has risen and the signals that denote risk are being scrambled.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

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[...] Saft at Reuters has a good piece looking at the resurgence of animal spirits in the U.S. (large) loan market.  With covenant-lite [...]

“The second less reassuring take is that the loan market reflects what happens when monetary and government policy bails out risk takers.”

A mathematically perfect winning strategy for roulette is to leave your chips on red and double your bet at every turn of the wheel. Eventually you will win a turn, canceling out any prior accumulated losses. One more win and you are deep into the black.

The catch, of course, is that you need an unlimited bankroll to make the strategy work. Any real-world player attempting to try this out will eventually go bust.

Certain players in our particular real world have learned that the Federal Reserve will provide the necessary backup. Under that cozy arrangement, such players cannot lose. Woe to the gambling house!

But take a closer look. Those insulated participants are playing, not against some abstract casino, but against the rest of the U.S. (and the world) economy.

The good news about this unusual bargain with fate is an eerie, eye of the hurricane sort of stability — and an increasingly asymmetric society.

The bad news, as usual, is the same as the good news.

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