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Marketplace Scratch Pad

Less filling, bad taste

Scott Jagow Mar 26, 2010

This may be a bit in the weeds, but it’s probably worth taking a run at. Investors seem to be warming back up to a certain type of loan known as covenant-lite. The lite part isn’t a good thing.

The Wall Street Journal reports that banks removed the covenants from a $3.25 billion loan package for bankrupt chemical company Lyondell. Our Whiteboard guru Paddy Hirsch explains covenants this way:

Covenants are like early warning signals. Or maybe like a set of automatic brakes, the kind you have on a subway train. If you’ve seen the movie The Taking of Pelham 123, you’ll remember that scene where the out-of-control train trips an automatic brake, and the train screeches to a halt just before it blasts through the wall and, presumably, into the Hudson River. Well, loan covenants are like those trips, they give the lenders a chance to tweak a loan before it all goes horribly wrong.

For example, a covenant might require the borrower to prove that its earning a certain amount of money each quarter — something akin to proving your income for a home loan. If the covenant isn’t met, the bank can either tweak the loan or demand its money back. When the covenants are removed, it’s known as a covenant-lite loan. More from Paddy:

In a truly cov-lite loan, the lenders have no warning that the borrowing company could default. The first thing they’ll hear is the company saying, sorry, we can’t make the interest payment. In other words, the lenders have no control over a company’s ability to keep paying interest.

Covenants give the lenders control, so it’s not surprising companies don’t like them.

But they protect the loan investors. Not only did the banks remove the covenants from Lyondell’s loan, but it lowered the yield, and investors still came flocking. More from the Journal:

Some investors turned away from the loan portion of the packaged after the lead banks changed the terms, removing financial requirements in an arrangement known as covenant-lite. The loan market has been skittish about covenant-lite loans since the economic crisis drove prices to all-time lows in March 2009.

But the investors who were turned away by the last-minute changes in the deal were quickly replaced, people with knowledge of the deal said. That affirms signs that the market may be warming to cov-lite loans again.

Possibly signaling confidence? Wrong-headed confidence? Or possibly just that the market is slinking back into its old ways of recklessness?

Covenants are, of course, unpopular with borrowers. Anything that makes it more difficult to get the money is unpopular with borrowers. But let’s think for a second what kind of shredded safety net was in place for many home loans. Paddy sums it up this way:

… would you like it if your lenders made it a requirement of your home loan that you have to prove every quarter that you’re earnings enough to make your mortgage payments? None of your damn’ business, I hear you say.

But we’re not talking about 250K home loans here, we’re talking about billions of dollars of loans, much of which is lent, directly or indirectly, by pension funds. And if loans like those start going bad without any warning, the lenders could end up losing a lot of money. And that would leave us all very badly needing a drink.

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