Cov-lite

Last updated

Cov-lite (or "covenant light") is financial jargon for loan agreements that do not contain the usual protective covenants for the benefit of the lending party. Although traditionally banks have insisted on a wide range of covenants that allow them to intervene if the financial position of the borrower or the value of underlying assets deteriorates, around 2006 the increasing strength of private equity firms and the decreasing opportunities for traditional corporate loans made by banks fueled something of a "race to the bottom", with syndicates of banks competing with each other to offer ever less invasive terms to borrowers in relation to leveraged buy-outs.

Contents

In the wake of the Financial crisis of 2007–08 growth in the use of cov-lite loans stalled, but more recently they have increased in popularity again. [1]

Cov-lite lending is seen as riskier because it removes the early warning signs lenders would otherwise receive through traditional covenants. Against this, it has been countered that cov-lite loans simply reflect changes in bargaining power between borrowers and lenders, following from the increased sophistication in the loans market where risk is quickly dispersed through syndication or credit derivatives.

Covenants

Practices vary, but characteristically cov-lite loans remove the requirement to report and maintain loan to value, gearing, and EBITDA ratios.

More aggressively negotiated cov-lite loans might also remove

Concerns

Many at the time were alarmed by the development. In particular, The Economist thought it was a concerning and short-sighted development. [2] The Financial Times endorsed the view of Anthony Bolton of Fidelity Investments, who warned on his retirement in May 2007 that cov-lite could be "the tinder paper for a serious reversal in the market", [3] and the movement in the market was inexorable. Others argued that the move to cov-lite was a welcome simplification of loan documentation, fully justified as the banks would hedge their risk by transferring exposure to the loan in the CDO market. [4] [5] It was also pointed out at the time that cov-lite loans operated in a very similar way to bonds, but at lower values.

The high-water mark of cov-lite loans came in the 2007 acquisition by Kohlberg Kravis Roberts, a US private equity firm, by way of a record $16bn cov-lite loan for its buy-out of First Data. [3]

2007 credit crunch

The tendency towards cov-lite loans ended abruptly with the 2007 subprime mortgage financial crisis. Some commentators subsequently sought to attribute the credit crunch arising from crisis to cov-lite loans, although the LBO market is almost entirely unconnected with the sub-prime mortgage market in terms of exposure. However, in the credit crunch which ensued, cov-lite loans significantly hampered the ability of banks to step in and both seek to rectify positions which were going bad, and to limit their exposure once matters had gone bad. The suggestion that banks risks were mitigated through the CDO market was difficult to sustain in light of difficulties in that market itself as a result of the credit crunch. In March 2011 the Financial Times reported that, in the three months prior, cov-lite loans to the value of $17bn had been issued. [6]

Post credit-crunch market

As the credit markets recovered after all but shutting down in 2008–09, cov-lite loans returned to the syndicated loan market. Indeed, after seeing an impressive $86.7 billion in volume in 2012, cov-lite loans totaled some $93.5 billion through the first 3-plus months of 2013, just short of the record set in 2007. Unlike before the credit crunch, however, most covenant-lite loans in 2013 back refinancing/repricing of existing loans, as opposed to M&A/LBO deals. [7] Due to borrower-friendly lending conditions in 2018, cov-lite loans as a percentage of outstanding leveraged loans in European markets reached 78%, compared to under 10% in 2013. [8] The ubiquity of cov-lite in leveraged corporate bonds is a characteristic of the corporate debt bubble, which became a topic of increasing worry in the late 2010s. [9]

Related Research Articles

In finance, a high-yield bond is a bond that is rated below investment grade by credit rating agencies. These bonds have a higher risk of default or other adverse credit events, but offer higher yields than investment-grade bonds in order to compensate for the increased risk.

<span class="mw-page-title-main">Leveraged buyout</span> Acquired control over a company by the purchase of its shares with borrowed money

A leveraged buyout (LBO) is one company's acquisition of another company using a significant amount of borrowed money (leverage) to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loans, along with the assets of the acquiring company. The use of debt, which normally has a lower cost of capital than equity, serves to reduce the overall cost of financing the acquisition.

In finance, a credit derivative refers to any one of "various instruments and techniques designed to separate and then transfer the credit risk" or the risk of an event of default of a corporate or sovereign borrower, transferring it to an entity other than the lender or debtholder.

Credit risk is the possibility of losing a lender holds due to a risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial. In an efficient market, higher levels of credit risk will be associated with higher borrowing costs. Because of this, measures of borrowing costs such as yield spreads can be used to infer credit risk levels based on assessments by market participants.

A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS). Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. Distinctively, CDO credit risk is typically assessed based on a probability of default (PD) derived from ratings on those bonds or assets.

A syndicated loan is one that is provided by a group of lenders and is structured, arranged, and administered by one or several commercial banks or investment banks known as lead arrangers.

An asset-backed security (ABS) is a security whose income payments, and hence value, are derived from and collateralized by a specified pool of underlying assets.

<span class="mw-page-title-main">Hyman Minsky</span> American economist

Hyman Philip Minsky was an American economist, a professor of economics at Washington University in St. Louis, and a distinguished scholar at the Levy Economics Institute of Bard College. His research attempted to provide an understanding and explanation of the characteristics of financial crises, which he attributed to swings in a potentially fragile financial system. Minsky is sometimes described as a post-Keynesian economist because, in the Keynesian tradition, he supported some government intervention in financial markets, opposed some of the financial deregulation of the 1980s, stressed the importance of the Federal Reserve as a lender of last resort and argued against the over-accumulation of private debt in the financial markets.

A structured investment vehicle (SIV) is a non-bank financial institution established to earn a credit spread between the longer-term assets held in its portfolio and the shorter-term liabilities it issues. They are simple credit spread lenders, frequently "lending" by investing in securitizations, but also by investing in corporate bonds and funding by issuing commercial paper and medium term notes, which were usually rated AAA until the onset of the financial crisis. They did not expose themselves to either interest rate or currency risk and typically held asset to maturity. SIVs differ from asset-backed securities and collateralized debt obligations in that they are permanently capitalized and have an active management team.

<span class="mw-page-title-main">Subprime mortgage crisis</span> 2007 mortgage crisis in the United States

The American subprime mortgage crisis was a multinational financial crisis that occurred between 2007 and 2010 that contributed to the 2007–2008 global financial crisis. The crisis led to a severe economic recession, with millions of people losing their jobs and many businesses going bankrupt. The U.S. government intervened with a series of measures to stabilize the financial system, including the Troubled Asset Relief Program (TARP) and the American Recovery and Reinvestment Act (ARRA).

At the micro-economic level, deleveraging refers to the reduction of the leverage ratio, or the percentage of debt in the balance sheet of a single economic entity, such as a household or a firm. It is the opposite of leveraging, which is the practice of borrowing money to acquire assets and multiply gains and losses.

The subprime mortgage crisis impact timeline lists dates relevant to the creation of a United States housing bubble and the 2005 housing bubble burst and the subprime mortgage crisis which developed during 2007 and 2008. It includes United States enactment of government laws and regulations, as well as public and private actions which affected the housing industry and related banking and investment activity. It also notes details of important incidents in the United States, such as bankruptcies and takeovers, and information and statistics about relevant trends. For more information on reverberations of this crisis throughout the global financial system see Financial crisis of 2007–2008.

A credit crunch is a sudden reduction in the general availability of loans or a sudden tightening of the conditions required to obtain a loan from banks. A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates. In such situations, the relationship between credit availability and interest rates, changes. Credit becomes less available at any given official interest rate, or there ceases to be a clear relationship between interest rates and credit availability. Many times, a credit crunch is accompanied by a flight to quality by lenders and investors, as they seek less risky investments.

This article provides background information regarding the subprime mortgage crisis. It discusses subprime lending, foreclosures, risk types, and mechanisms through which various entities involved were affected by the crisis.

The Financial Crisis Inquiry Commission (FCIC) was a ten-member commission appointed by the leaders of the United States Congress with the goal of investigating the causes of the financial crisis of 2007–2008. The Commission has been nicknamed the Angelides Commission after the chairman, Phil Angelides. The commission has been compared to the Pecora Commission, which investigated the causes of the Great Depression in the 1930s, and has been nicknamed the New Pecora Commission. Analogies have also been made to the 9/11 Commission, which examined the September 11 attacks. The commission had the ability to subpoena documents and witnesses for testimony, a power that the Pecora Commission had but the 9/11 Commission did not. The first public hearing of the commission was held on January 13, 2010, with the presentation of testimony from various banking officials. Hearings continued during 2010 with "hundreds" of other persons in business, academia, and government testifying.

<span class="mw-page-title-main">Causes of the Great Recession</span>

Many factors directly and indirectly serve as the causes of the Great Recession that started in 2008 with the US subprime mortgage crisis. The major causes of the initial subprime mortgage crisis and the following recession include lax lending standards contributing to the real-estate bubbles that have since burst; U.S. government housing policies; and limited regulation of non-depository financial institutions. Once the recession began, various responses were attempted with different degrees of success. These included fiscal policies of governments; monetary policies of central banks; measures designed to help indebted consumers refinance their mortgage debt; and inconsistent approaches used by nations to bail out troubled banking industries and private bondholders, assuming private debt burdens or socializing losses.

Leverage is defined as the ratio of the asset value to the cash needed to purchase it. The leverage cycle can be defined as the procyclical expansion and contraction of leverage over the course of the business cycle. The existence of procyclical leverage amplifies the effect on asset prices over the business cycle.

<span class="mw-page-title-main">2007–2008 financial crisis</span> Worldwide economic crisis

The 2007–2008 financial crisis, or Global Financial Crisis (GFC), was the most severe worldwide economic crisis since the Great Depression. Predatory lending in the form of subprime mortgages targeting low-income homebuyers, excessive greed and risk-taking by global financial institutions, a continuous buildup of toxic assets within banks, and the bursting of the United States housing bubble culminated in a "perfect storm", which led to the Great Recession.

Private credit is an asset defined by non-bank lending where the debt is not issued or traded on the public markets. Private credit can also be referred to as "direct lending" or "private lending". It is a subset of "alternative credit".

The corporate debt bubble is the large increase in corporate bonds, excluding that of financial institutions, following the financial crisis of 2007–08. Global corporate debt rose from 84% of gross world product in 2009 to 92% in 2019, or about $72 trillion. In the world's eight largest economies—the United States, China, Japan, the United Kingdom, France, Spain, Italy, and Germany—total corporate debt was about $51 trillion in 2019, compared to $34 trillion in 2009. Excluding debt held by financial institutions—which trade debt as mortgages, student loans, and other instruments—the debt owed by non-financial companies in early March 2020 was $13 trillion worldwide, of which about $9.6 trillion was in the U.S.

References

  1. ↑ "Covenant-light loans are on the rise". 4 November 2013.
  2. ↑ "You only give me your funny paper - Debt markets turn grouchy as creditors ask for more". The Economist . June 28, 2007.
  3. 1 2 "Bolton warns of bubble fuelled by “cov-lite” loans". Financial Times . May 18, 2007. (subscription required)
  4. ↑ Salmon, Felix (June 12, 2007). "A Closer Look at Cov-Lite Loans". Market Movers. Portfolio.com. BizJournals.
  5. ↑ Comment, Deal (March 29, 2007). "Through the looking glass with leveraged finance". Legal Week blogs. Archived from the original Archived June 30, 2007, at the Wayback Machine on June 30, 2007.
  6. ↑ Tett, Gillian (March 4, 2011). "The return of cov-lites hints at more caution not madness". (Financial Times) Fidelity Worldwide Investment. Archived from the original on March 4, 2011.
  7. ↑ "Covenant-Lite Loan Volume Nears All-Time Record". Forbes.
  8. ↑ PricewaterhouseCoopers. "Restructuring Trends". PwC. Retrieved 2018-06-27.
  9. ↑ Cohan, William D. (9 August 2018). "The Big, Dangerous Bubble in Corporate Debt". The New York Times. Retrieved 10 March 2020.
This page is based on this Wikipedia article
Text is available under the CC BY-SA 4.0 license; additional terms may apply.
Images, videos and audio are available under their respective licenses.