Make Mine a Lite, Please

Cov-lite lending is back, and setting records, according to Reuters:

Huge demand for leveraged loans from billions of dollars flowing into U.S. loan funds pushed covenant-lite loan volume to a record $188.7 billion, far surpassing the record of 2007, and still going strong.

Demand for yield by investors is so high now that cov-lite loans are close to becoming the standard, according to the report; covenants in a debt deal are now viewed as a sign that the borrower is risky. Also, credit quality is going down:

As lending to lower-rated companies has increased generally, more of them are also opting for covenant-lite financings.That trend is evident particularly in the B3 ratings category. Around 18 percent of covenant-lite loans are for B3 rated companies so far this year, versus 8 percent in 2012 and 3.7 percent in 2011.

Amazing.

Quote of the Day

As one analyst observed, it is curious when investors are forced to purchase shares for yield and bonds for capital gains.

This gem of a quote is courtesy of the brilliant Satyajit Das, in the FT (registration required). I still think sometimes of an interview he gave in September, 2007, the first four paragraphs of which are about as prescient as a pre-Lehman, pre-Bear-Stearns interview could have been.

More Wisdom from Tett

Gillian Tett has written yet another great column for the Financial Times, summarizing what should have changed, but has not, since the darkest days of the 2008 crisis. Her main points are:

1. The big banks got bigger
2. Shadow banking grew
3. Investors believe in central banks more, not less
4. The rich got richer
5. There have been few relevant criminal convictions
6. Fannie and Freddie Mac are still in business

I recommend the whole thing (registration may be required).

Tett's depth and prescience are a marvel. In January of 2007, too, she wrote a great piece (registration, again). She compared the financial system at that time to "candy floss":

...what worries some policy-makers is that structured finance is often so opaque that dangerous concentrations of credit risk could develop in the system - unseen until a shock. Banks, for example, now seem to be buying each others' securitised bonds through their investment arms, which could mean they are acquiring risk through the back door even as they appear to be shedding it in their published accounts. 

That makes it harder to assess overall leverage in the economy. But it could also make it difficult for central banks to control credit conditions with old-fashioned monetary tools.

 I am a huge fan of hers.

News Flash: Bubbles Exist

It is news when a central banker admits that bubbles exist.

But it happened earlier this week, when John Williams, who heads the the San Francisco branch of the Federal Reserve System, gave a very good speech. An excerpt:

The lesson from history is clear: asset price bubbles and crashes are here to stay. They appear to be a consequence of human nature. And the events of the past decade demonstrate the enormous human costs of asset price bubbles and crashes. 

To understand the past and avoid a recurrence of the devastating events we lived through so recently, we need to acknowledge that investors and financial markets do not behave the way rational asset price theory implies. We need to incorporate these channels into the models we use for forecasting, risk analysis, and policy evaluation. This opens up a world where actions, including regulatory and monetary policy measures, may have unintended consequences—such as excessive optimism, risk taking, and the formation of bubbles—that are assumed away in standard rational models.

If everyone acted rationally, independently, and with perfect information, then, yes, bubbles would be impossible. But guess what? They don't.

Cautionary Words from Leon Black

Leon Black, of Apollo Asset Management, quoted in Barron's last month (registration or subscription may be required):

"It's almost biblical. There is a time to reap and there's a time to sow," Leon Black, chairman and chief executive of Apollo Global Management declared to the Milken Institute's global conference in Los Angeles, alluding to that same Scriptural passage. "We are harvesting," he added pointedly.

That is, the private-equity giant is a net seller because things simply can't get much better. "We think it's a fabulous environment to be selling," he says, noting Apollo has sold about $13 billion in assets in the past 15 months. "We're selling everything that's not nailed down. And if we're not selling, we're refinancing."

That's because there has never been such a good time to borrow -- which is raising warning flags for Black. "The financing market is as good as we have ever seen it. It's back to 2007 levels. There is no institutional memory," he observed, referring to the peak of the last credit bubble.

Black worked for Drexel Burnham Lambert, back in the bad ol' days. Black is bright and has a privileged view of the market for bank loans, especially for buyouts.

I don't think that everything literally should be sold, and he doesn't seem to be saying exactly that, but it's more of a seller's market than a buyer's market, and that it is a good time to tidy up a portfolio. Of course, for as long as the Fed chooses, cash will not be keeping up with inflation.

Nice to be Getting Back to Normal (Not)

From the WSJ today:

Investors are once again clamoring for a risky investment blamed for helping unleash the financial crisis: the synthetic CDO.

In a sign of how hard Wall Street is trying to satisfy voracious demand for higher returns amid rock-bottom interest rates, J.P. Morgan Chase & Co. and Morgan Stanley bankers in London are moving to assemble so-called synthetic collateralized debt obligations.

Again! Full story here (registration required). Article is titled "One of Wall Street's Riskiest Bets Returns."

This reminds me of a passage in Charles Kindleberger's excellent book, Manias, Panics, and Crashes: A History of Financial Crises, which first came out in 1978. (Just another light summer read.) He writes,

The paradox is equivalent to the prisoner's dilemma. Central banks should act one way (lending freely) to halt the panic, but another (leaving the market to its own devices) to improve the chances of preventing future panics. Actuality inevitably dominates contingency. Today wins over tomorrow. (Fourth edition, p. 164)

Unfortunately, all medicine, even necessary medicine, has side effects. I do not envy the decisions that the Federal Reserve is faced with making, but with junk bond yields near record lows and CDOs returning, the sooner we can end q.e. and ultra-low interest rates, the better.

Worth Reading

Both of these are good:

1. William Dudley, CEO of the New York branch of the Fed, reflecting on what the Fed got right, and wrong, since the crisis of 2008. Calculated Risk did a good job highlighting key passages here. Dudley is thoughtful, and the whole thing is worthwhile. Dudley delivered this talk at the Japan Society (appropriately enough) yesterday.

2. Speaking of bubbles and their consequences, Washington Irving wrote an amazingly accurate description of bubbles almost two centuries ago, in 1820. Forget the Financial Times; this passage from Irving's The Crayon Papers may be the timeliest thing I have read this year. Just read pages 41-43. A friend just sent it. New to me, but I see that it gets quoted on the web from time to time.