The Office of the Comptroller of the Currency has issued a new report that says banks are taking bigger risks when they lend. They’re doing that in two ways: lending more in auto loans to individuals, and lending more in leveraged loans to companies. And, increasingly, they’re making those corprate loans “covenant-lite.” Stopped you in your tracks, huh? Let me explain:
Q. First, what’s a leveraged loan?
A “leveraged loan,” also often known as a high-yield loan (if you’re talking dirty, a junk loan), is a risky loan, borrowed by a company that’s heavily in debt. Because of the risk, leveraged loans come with high interest rates. They also usually come chock-full of covenants.
Q. Which raises the question: What’s a covenant?
A covenant is a requirement that the borrower has to meet every month. Perhaps is a certain debt-to-earnings ratio, or a minimum amount of gross income. It can be anything the lender decides on. Covenants act like canaries in the coal mine for lenders, giving them early warnings that a company might run into trouble and possibly default on the loan.
Q. Got it… so what’s a covenant-lite loan?
A covenant-lite (cov-lite, in the jargon) loan is like a coal mine with few or no canaries. So there will be little or no advance warning of problems in these loans: the first the lender hears about any issues is when the loan is on the brink of default.
Q. So why would anyone want a covenant-lite loan?
Well, borrowers love cov-lite loans, because they’re easier to live with. There are fewer pesky rules and regulations to follow, and in some cases the loans are just pure money, with no strings. Lenders don’t really like them, for obvious reasons, but right now they’re over a barrel. They’re stuffed full of cash that they have to put to work in a very low-interest rate environment. There are precious few investment opportunities out there that will make the much money. And that allows the borrowers to force the lenders’ hands. If you want a real estate analogy, it’s a buyer’s market. The buyers are the borrowers, and they’re getting pretty much anything they want in these loans.
Q. Finally, then, why should I care?
Because all this means that risk is being baked into the system again. Leveraged loans are already risky.
When they’re structured with few covenants, they’re even riskier.
And when banks are loaded down with risky investments, well, we all remember how dangerous unfettered risk can be… don’t we?