Play it again Ben - The "dubious" return of Cov-lite financing and other leveraged plays...

While every one is focused on Oil's recent surge linked to the contagion of unrest in the Middle-East, Bahrein, Lybia and co, looks like crazy leverage credit is rearing its ugly face again.

Remember 2006 and the craze for LBOs financed with Cov-lite loans? Well guess what, the boys are back in town!

Albert Einstein Quotes - Insanity: doing the same thing over and over again and expecting different results...

Definition of Credit Market insanity:

"Any statistician will tell you, a good outcome for a bad risk doesn't mean the risk wasn't bad; it just means you happened to get lucky."

Below is a link to what was discussed at the latest Wharton School of Business annual restructuring conference in February:

http://www.gurufocus.com/news.php?id=123115

"The overwhelming consensus among Panelists and Speakers was that we are experiencing a credit bubble and precipitous drop in risk premiums across asset classes, particularly in High Yield Bonds and Leveraged Loans."

"The consensus was that 6.7% was far to low a yield for HY bonds, even thought it is not an all times low on a spread basis, and that it did not portend well for those long HY at these prices."

Get ready for a bumpy ride ahead:

"The longer-term outlook gives cause for apprehension. Some of the concerns evidenced were: the large maturity wall between 2012 and 2015 which is currently comprised of debt trading well below par and unlikely to be refinanced; earnings going up against much tougher 2010 comps in 2011, large fiscal deficits and federal debt in the US combined with state and municipal debt; US bank balance sheets with large amounts of distressed and defaulted debt marked as hold-to-maturity with bid ask spreads so far apart that it is not getting worked off; regional banks sitting on commercial real estate loans that have been amended and extended that are likely to be the next shoe to drop in terms of debt restructurings; and European Sovereign Debt concerns along with skepticism regarding European bank balance sheets."

In respect to the US credit markets:
"With respect to the US credit markets, panel participants shared the view that we are nearing a top and that there will be a second distressed wave in the not so distant future."

Pre-flight "investor" safety briefings:

Keep your seat belt fastened
Before take-off and "hard" market landing ensure that your:
Seat belt is tightly fastened...
In the event of a crash landing, adopt the recommended brace position.
Place your hands on your head with your elbows on the outside of your thighs and your feet flat on the floor.

The panelists went on according to the same article:
"An interesting term was used for current state of bank amendments, “Amend and Pretend”, indicating that there is still an unwillingness on the part of banks to acknowledge certain problem credits."

One of the most important point of the article:

"The Distressed Hedge Fund Panel participants lamented the return of some of the worst practices such as HoldCo PIK dividend recaps and the triumphant return of cov-lite deals so shortly after many had believed the credit markets had learned from its past excesses."

Yes, Cov-Lite deals are back. Lessons learned? Doesn't seem like it.

This is what Bethany McLean, known for her work on the Enron scandal and the 2008 financial crisis, had to say in her article - Corporate Subprime
The default crisis that never happened:

"When most of us think about the credit bubble that burst in 2008, we think about the lax terms of mortgage loans. But many corporations, particularly those that were bought out by private equity firms, also got debt on lax terms. This debt was known as "covenant-lite," because the normal terms of corporate credit—such as a requirement that a company, say, maintain a certain level of profits—were waived by deal-hungry lenders.

After it all went pop, banks regretted the cov-lite loans almost as much as mortgage originators regretted their "no documentation" loans to home buyers. Cov-lite loans plunged in price. At his retirement dinner in May 2007, Anthony Bolton, Fidelity's investment guru, said, "Covenant-lite borrowing … will come back at some stage to haunt the banks." Indeed, Goldman Sachs and other big firms took massive losses when they sold or marked down the price of the bonds they were stuck holding. One person involved in negotiating these deals says his banking clients swore, "Never again."

But less than three years later, cov-lite loans are back. "With a vengeance," my friend David Pesikoff, a Texas-based hedge-fund manager, assures me. Has the world of finance gone insane? Not necessarily. The return of cov-lite loans makes a certain sense in the current financial environment. But I find myself wondering what that says about the current financial environment."

Well, Bethany me too, I am also asking myself if they have gone insane again.

Looks like the street smart (Hedge Fund community...) attended the Wharton conference...

Gwen Robinson posted on the 5th of June 2007 the following article on Cov-lite loans:

Cov-lite loans: bubble-time or a sign of maturity?

Secondary spread of covenant-lite loans has narrowed dramatically:

The answer was bubble Gwen...

Bethany goes on in her article:

"This calculus shifted in 2006, because the financial world was awash in credit. Yields on debt were so low that investors were searching for something, anything, that paid just a little bit more. Subprime mortgages were one answer, but so were cov-lite loans made to highly indebted takeover targets, which paid just a wee bit more in interest (and at the peak of the mania, it really was just a wee bit) than super-safe debt. A big market for these loans existed in so-called "collateralized loan obligations," or CLOs, which were a sister of the "collateralized debt obligations," or CDOs, that snapped up subprime mortgages. Investors such as insurance companies bought slices of the CLOs, which were assigned varying levels of risk by the rating agencies, just as they bought slices of the CDOs.

Another reason for the rise in cov-lite loans was the relationship of mutual convenience between private equity firms and Wall Street banks. Private equity firms wanted cheap money on easy terms to finance all those big buyouts. Because private equity firms made such great clients—all those fees generated by buyouts!—Wall Street banks vied to give them what they wanted. Cov-lite loans were used to finance some of the biggest, best-known deals of the era, like KKR's buyout of Alliance Boots and Thomas H. Lee and Bain Capital's buyout of Clear Channel. According to the credit rating agency Standard & Poor's, $32 billion in cov-lite loans were issued between 1997 and 2006. Most of that came in 2006. In the first six months of 2007, cov-lite volume hit a stunning $97 billion, according to an S & P piece called "The Leveraging of America: Covenant-Lite Loan Structures Diminish Recovery Prospects."

Bethany adds:

"There are other similarities between the credit bubble and the current credit market. Banks still want to please their biggest clients, the private equity firms. And CLOs are once again a brisk market for whatever higher-yielding debt that can be found. That's because CLO managers aren't paid to have cash on hand, and all that refinancing of risky debt has resulted in an inflow of cash. They have to invest the money somewhere—and in order to justify the existence of the CLO in the first place, it has to be somewhere that offers a decent yield."

Some facts as per Bethany's great article:

"According to S&P, more than 25 percent of first-lien loans (those that have the first call on a company's assets) issued in 2011 have cov-lite structures. The $8.8 billion in such issuance so far this year already tops the total for all of last year, and it isn't even March. Among the private equity deals that used cov-lite loans are the buyouts of Del Monte and J. Crew, according to market participants."

And Bethany concludes:

"The fact that the Fed rode to the rescue doesn't necessarily mean that cov-lite loans were a good risk to begin with. You also might see in the desperate hunt for yield some uncomfortable parallels to the bubble years. Weren't we all supposed to have learned that too much debt is bad for us? Whether the cov-lite deals getting done right now will face a day of reckoning is anyone's guess. But at the very least, these deals strike me as a sign that some kind of reckoning is in store. I hope I'm wrong about that."

I hope too.
From the Standard & Poors website:

Full Index analysis: Loans return 10.13% in no-drama 2010

"If, on the other hand, the economic recovery fizzles for whatever reason – the known worries have been recounted in this space many times – loans would likely slip as risk-margins widen and the asset class loses its luster with retail investors, which poured a record $16.2 billion into prime funds in 2010, according to Lipper FMI, pumping up demand."

At the Wharton Restructuring conference, the panelists commented:

"One panelist noted the CityCenter refinancing at over 8x leveraged through the first liens and 12x through the seconds as one of the “worst deals ever done”, and a strong indication of an over-heated credit market. Another instrument highlighted as being fundamentally unsound are the surplus notes being issued by mono-lines, these are deeply subordinated securities that have little security and function more like preferred stock. They are being marketed to aggressive credit investors reaching for yield, a strategy that most agreed would end badly for those investors. Distressed investors were cautioned against style drift into chasing large-cap HY."

They went on:

"The Distressed Hedge Fund panelists identified the low quality refinancing being done over the last year as a strong source for potential distressed names over the next 18-24 months. Steve Moyer noted that between 2012 and 2016 there are $650bn dollars in maturities coming due, $150bn of which is Ca1 or below. Many of these issues are trading well below par and are unrefinanceable which will present opportunities for distressed investors. Moreover, Shawn Foley of Avenue Capital cited a JP Morgan report indicating that the majority of CCC rated paper has less than 1 turn of equity beneath it, a proposition he considered unsustainable."

Want a perfect storm?

"The primary concern among all conference participants for both credit instruments and the economy is the anticipation of a substantial increase in inflation. With PPI up almost 9% and CPI up only 3%, companies are suffering margin compression. Companies will be forced to raise prices which will eventually lead to wage increases to compensate for that higher price level. Commodity prices for cotton, wheat and corn are all near record highs while industrial commodities and oil have also moved higher signaling inflation in the pipeline. In addition, food price rises in non-producer countries in the third world are a major source of global instability and are large factor in the civil unrest in the Middle East. Mid-caps are particularly vulnerable due to a lack of pricing power and international diversification."

What about banks balance sheets?

"It was estimated that banks are still sitting on $2 trillion of mostly middle market loans that they have yet to take a write-down on. And while the Fed has pressured financial institutions to deal with their books with respect to residential housing, construction and building products, they have been far more lenient with respect to other sectors. That is particularly the case with commercial real estate, most of which is on the balance sheets of regional banks. When commercial real estate will start restructuring en masse was also a prime topic for discussion. The 2005-2007 vintage LBOs were considered to be the best class of candidates for restructuring opportunities now and in the future."

And finally the icing on the cake:

"The key take away from a distressed investor’s point of view, is that while there are currently some opportunities in less liquid middle market names, the overall HY and leverage loan markets are experiencing a 2005-2007 type bubble."

Good night and good luck:

The writing is on the wall...

Sovereign CDS for Spain is now trading at 257 bps for 5 year, and Portugal has now joined the highest default probabilities list from CMA DataVision. Portugal 5 year CDS trades at 312 bps. The cumulated probability of default for Portugal now equates 22.91%.

Greece Sovereign CDS is trading at 835 bps for 5 year, with a CPD (Cumulated Probability of Default) of 49.72%, just behind Argentina, which trades at 1073.17 bps and has a CPD of 50.06%.

Greece is not like Argentina, it is in a worse shape.

In this post, we will look at some solutions coming from the man who was at the helm of Argentina's finances in 2001, Domingo Cavallo as well as leverage still in the system and the ongoing discussions around banking reforms.

Domingo Cavallo, the fomer minister of finance of Argentina gives a good analysis of what should be followed by Greece, Spain and Portugal to restructure their economy:

http://www.voxeu.org/index.php?q=node/5018

"Greek debt woes could spark contagion within and beyond Europe. Argentina’s former finance minister and co-author draw four lessons from Argentina’s crisis: devaluation/exit is not the answer; orderly debt restructuring involving a ‘Brady Plan’ now is better than a disorderly one later; fiscal consolidation that improves external competitiveness is a must; all these must be done simultaneously."

Domingo Cavallo gives in this article make some good points on what should be done:

Three Lessons
"The main lessons for Greece stemming from Argentina are, in our opinion, as follows. First, devaluation (exiting the eurozone) is not the answer, particularly since the post-crisis world outlook is unlikely to be as benign with Greece as it was with Argentina. Re-adopting the drachma and letting it fall in value relative to the euro would cause a sharp deterioration in the balance sheets of both the government and the private sector. On the other hand, a forcible conversion of euro-denominated financial assets and liabilities into drachmas (a replication of what Argentina did in 2002) would, in all likelihood, set in motion a perverse devaluation-inflation spiral, as people would want to substitute away from drachmas into euros to avoid losing purchasing power if they stay in drachmas.

Second, any sovereign debt restructuring must be planned and executed in an orderly manner, with bilateral discussions between creditors and debtors, and with an active support from the international financial organizations, both in Europe and Washington DC (i.e., the IMF). These organizations can get more bang for their bucks if instead of trying to bailout Greece’s creditors over the next two years, they use their limited financial resources to enhance, a la Brady plan, new bonds that are swapped for the old ones in exchange for haircuts in principal, interest or both. A default followed by unilateral and incomplete debt restructuring several years later, as done by Argentina in the previous decade, would be the wrong model to follow.

Third, there must be fiscal consolidation. But, this cannot be limited to cutting spending and raising taxes. It must also include fiscal measures designed to improve external competitiveness so as to ease the fiscal adjustment.

Last but not least, the three ingredients of the recovery plan (fiscal consolidation, debt restructuring, and the enhancement of competitiveness) must take place simultaneously."

Furthermore, Domingo Cavallo raise a very interesting point in relation to VAT versus Payroll Tax:

"In a previous article, we suggested that Greece could achieve the same effect on competitiveness that could be achieved under a 20% real exchange rate devaluation by raising the collection of the value added tax (VAT) while simultaneously reducing payroll taxes. We think that this is an idea that merits consideration not only in Greece, but also in Portugal and Spain. Given the importance we give to this subject, we devote the rest of this note to explain our proposal in more detail.

One characteristic of taxation in many countries—typically in Continental Europe, but also in Latin America and other regions—is that payroll taxes, which finance social security, are extremely high (see Table 1). Of course, this is due to the fact that social transfers are also very high. However, there is no reason why these transfers have to be financed by payroll taxes, especially if there is room to increase other, more neutral, taxes.

Take the VAT, for example. Unlike payroll taxes, which are levied on labour income, the VAT is levied on final consumption. This has two main advantages: it promotes formal job creation and it stimulates private saving. In countries like Greece, Portugal and Spain, this can kill three birds with one stone by helping to reduce unemployment, informality in the labour market, and the current account deficit. Furthermore, the fact that the VAT is levied on final consumption and not on investment or exports (capital goods purchases are deductible as VAT “credits” and exports are tax exempt) makes the substitution of VAT for payroll taxes a competitiveness-enhancing tool. As such, it is like devaluing the local currency, but without the inflationary pass-through to domestic prices or the disrupting balance sheet effects."

In addition to these proposed measure, one could also argue that Spain need to drastically reform its labour market which is critically hindered by its very rigid system.

Many economists blame the high jobless rate in Spain on the high cost of firing workers. This makes employers quite reluctant to hire staff and encourages the use of temporary contracts that have few benefits and rights. 24.3 % of Spanish employees are currently on temporary contracts.

In Spain, workers on full contracts are entitled to severance pay of as much as 45 days per year worked, one of the highest levels in Europe. Under the Spanish government reform it would be reduced to 33 days for some contracts.

Although the Spanish government is pushing ahead with the labor reform plan, it has so far failed to calm markets as reflected in the continuous widening in Sovereign CDS spreads.

Spanish 10 year bonds yielded an all time high against the German 10 year Bund today at 4.87%. This is 2.23% more than German 10 year Bund.

Three-month dollar libor rates rose to an 11-month high of 0.53894% , while euro rates edged up to 0.65563%, exceeding levels reached last week to set a six-month high.

The situation for European banks is getting difficult as highlighted by Georges Soros comments in this article from Reuters:

http://www.reuters.com/article/idUKTRE65E5JT20100615

"European banks had bought large amounts of the sovereign bonds of weaker euro zone countries for a tiny interest rate differential, Soros said.

"That's one of the reasons why the banks are so over-leveraged and why the German and the French banks own Spanish bonds," he said.

"Now ... they have a loss on their balance sheets which is not recognised and it reduces the credibility of those banks so the banking system is in serious trouble," he said.

"The commercial paper market, for instance, in America is now refusing to lend to European banks so there is even a funding crisis and the ECB (European Central Bank) has to step in and the banks are unwilling to lend to each other," he said."

European banks are getting punished for their greed in trying thier quest to capture more yields on riskier government bonds.

Too much greed can be dangerous because it clouds good judgement and good risk management. We have already witnessed the devastating results in the US where the hunt for yield (due largely to Alan Greenspan's low rates environment) led to the financial debacle. Investors in supposedly AAA securitized products (CDOs, etc.) showing promising yields, were wiped out.

A report published by the BIS reviews the role leverage played in the crisis:

http://www.bis.org/publ/cgfs34.pdf?noframes=1

"Leverage in structured products and the US housing market downturn
Structured credit products referencing US subprime mortgages exposed investors to much higher leverage and losses than the stress scenario modelling they performed had implied. First, an investment in a subordinated tranche of a subprime residential mortgage-backed security had a leveraged exposure to the underlying subprime mortgage loans (embedded leverage).
Second, re-securitisation compounded the multiplier effect of embedded leverage. For example, mezzanine tranches of mortgage securitisations (which themselves have embedded leverage) were often purchased by CDOs, which in turn issued senior and subordinated tranches, creating additional leverage on top of that embedded leverage in subordinate tranches.
The magnitude of this embedded leverage was estimated by investors with models using assumptions about the likely future path of house prices. Hence, investors could not always be certain about the degree to which their exposure to the mortgage market was leveraged at the time of investment. When delinquency assumptions associated with subprime mortgage securitisations of 2005–07 proved to be far too low, the leverage and losses experienced by investors were much greater than anticipated."

Now European Banks are sitting on hefty losses on their balance sheets, because of their exposure to the weaker parts of Government bonds in Europe. So much for good risk management...

In addition to this behavior, leverage in some European Banks is still higher than their American counterparts which went through the painful process of deleveraging and had to raise massively capital to shore up their impaired balance sheets.

“In the early days of banking, liability was not just unlimited; it was often as much personal as financial. In 1360, a Barcelona banker was executed in front of his failed bank, presumably as a way of discouraging generations of future bankers from excessive risk-taking."

Bank of England Financial Stability executive director Andrew Haldane

http://www.bankofengland.co.uk/publications/speeches/2009/speech409.pdf

"From the earliest times, the relationship between banks and the state was often rocky.
Sovereign default on loans was an everyday hazard for the banks, especially among states vanquished in war. Indeed, through the ages sovereign default has been the single biggest cause of banking collapse. It led to the downfall of many of the founding Italian banks, including the Medici of Florence."

Andrew Haldane describes as well the current issue with State Support:

State support stokes future risk-taking incentives, as owners of banks adapt their strategies to maximise expected profits. So it was in the run-up to the present crisis. In particular, five such strategies were clearly in evidence:

• Higher leverage: The simplest way of exploiting the asymmetry of payoffs arising from limited liability is to increase leverage. For example, if the capital ratio of the hypothetical bank were to halve from 10% to 5%, the beta of the bank’s equity would double (Figure 2). In that event, the imbalance between privatised gains (above the zero axis) and socialised losses (below the zero axis) would increase. Private investors would harvest more of the upside and export more of the downside.
There is clear evidence of this strategy being pursued over long sweeps of history.
UK banks migrated North-West over the past ten years, with balance sheet expansion financed by higher leverage. Because UK and European banks were not subject to any regulatory restriction on simple leverage, there was no effective brake on this leverage-fuelled expansion.Higher leverage fully accounts for the rise in UK banks’ returns on equity up until 2007. It also fully accounts for the subsequent collapse in these returns.

The high-leverage strategy pursued by UK and European banks rather effectively privatised gains and socialised losses.
• Higher trading assets: An alternative means of replicating the effects of higher leverage is to increase the proportion of assets held in banks’ trading books. Trading assets are marked to market prices, thereby increasing their sensitivity to aggregate market fluctuations (beta). To illustrate, assume that a bank holds 90% of its assets in the banking book (with a beta of zero) and the remainder in the trading book (with a beta of one). That gives an asset beta of 0.1 and an equity beta of unity (Figure 1). But if the size of the trading book is doubled to 20% of assets, this doubles the equity beta of the bank."

Andrew Haldane also indicates how to reduce the risk taking habits for banks in his paper

What options best tackle excessive risk-taking incentives? A number suggest themselves, some modest, others more radical.
• Introducing leverage limits: One simple means of altering the rules of the asymmetric game between banks and the state is to place heavier restrictions on leverage. European banks were not subject to a regulatory leverage ratio in the run-up to crisis. They exploited that loophole. Closing it would bring about a clockwise rotation in banks’ payoff schedule, lowering the beta of banks’ equity returns and reducing risk-taking incentives.This is an easy win. Simple leverage ratios already operate in countries such as the US and Canada. They appear to have helped slow debt-fuelled balance sheet inflation. The Basel Committee is now seeking to introduce leverage ratios internationally. To be effective, it is important that leverage rules bite. They need to be robust to the seductive, but ultimately siren, voices claiming this time is different. That suggests they should operate as a regulatory rule(Pillar I), rather than being left to supervisory discretion (Pillar II)."

Finally to conclude this post, relating to Bank reform, Andrew Haldane in his excellent paper says the following:

"Events of the past two years have tested even the deep pockets of many states. In so doing, they have added momentum to the century-long pendulum swing. Reversing direction will not be easy. It is likely to require a financial sector reform effort every bit as radical as followed the Great Depression. It is an open question whether reform efforts to date, while slowing the swing, can bring about that change of direction."

Dubious Dubai and the issue of perception...

From Wikipedia definition of a "mirage"

"A mirage is a naturally occurring optical phenomenon in which light rays are bent to produce a displaced image of distant objects or the sky. The word comes to English via the French mirage, from the Latin mirare, meaning "to look at, to wonder at". This is the same root as for "mirror" and "to admire"."

Suddenly last week, Markets reacted strongly on news relating to the difficulties arising in Dubai. Sovereign CDS protection on Dubai significantly widen on the news and Credit indices such as Itraxx Main and Banks CDS also took a hit. It took them a while to realised how inflated their perception of Dubai real estate companies creditworthiness was.

It was all about false perception. Similarities can be made on this story that made headlines recently. Perception of the credit worthiness on Dubai World was all about implicit guarantees from the Dubai Government. Investors invested believing in implicit support. Probably the same investors who believed in the sacro-saint AAA rating issued on dodgy CDOs and CLOs as a gauge of credit quality of the underlying pool of assets in the structure. Probably the same investors who believed that a callable LT2 bond will be called on the call date by the issuer, because it has been market practice in the past. How suprised they were when Deutsche Bank, nearly a year ago in December 2008, decided not to redeem some sub debt on the date of the call! Investors trade sub debt based on the date of the call to calculate the price of the bond.

This shows you how short memory is on the market and how perception can affect sound judgement.

I travelled to Dubai in October 2008 and I went to Cityscape 2008 (as per the picture above, all rights reserved). For me it was an eye opener on the real estate bubble in Dubai. As equities market were getting crushed following Hank Paulson's fateful decision of letting Lehman go under with catastrophic consequences (when an orderly wind down could have been managed under FDIC's supervision), 60,000 "Real" Estate professionals were meeting in Dubai to have a look at the pharaonic new projects which were presented in this event. It was history in the making, the top of the bubble.

What's next for Dubai?

From the 1973 movie My Name is Nobody, here is a reminder of a little story told in the movie...
In “My Name is Nobody,” the protagonist, Nobody (played by Terence Hill), tells a famous fable:
"There was this little baby bird that fell from it’s tree in the cold of snow. It starts peeping, “Pa peep! Pa peep!” as it was damn near freezing.
Along comes this cow. She looks down at the little bird and feels sorry for it. She raises her tail and… “splah!”
…She drops a steaming hot cow pie right on top of it.
The little bird starts again… “Pa peep! Pa peep!” Because it’s hungry.
Along comes a mean ole Coyote… It reachs down easy into the cow pie and picks the little bird up. He raises the little bird higher and brushes the dirt off him real nice.
And then… “Gulp!” Swallows the little bird down all in one bite!
My grandfather says there is a moral to the story, but you have to figure it out for yourself…
At the movie’s end, the aging gunfighter, legend Jack Beauregard (played by Henry Fonda) figures out the moral to the story:
Folks that throw dirt on you aren’t always trying to hurt you, and folks that pull you out of a jam aren’t always trying to help you. But the main point is: when you’re up to your nose in shit, keep your mouth shut."

Although Sheikh Mohammed bin Rashid al-Maktoum tried to reassure the market, there was a continued sell-off in the Gulf stock markets today.

It looks like perception has changed, like perception changed for AAA ratings for structured CDOs/CLOs notes previously, and for callable LT2 bonds.

The price for the bail out of Dubai will be costly and prized assets such as Emirates airlines could possibly change ownership and end up in the hands of their powerful saviours Abu Dhabi.