US leveraged buyouts

There's a storm brewing on the horizon. The chances of another financial crisis are gaining intensity. 

On one front, we have lenders practically showering companies with billions of dollars in loans. On the other hand, companies are more than eager to take on those loans, especially now that they are dirt cheap and basically free of covenants. 

Let's back up a bit. After the Great Financial Crisis of 2008, the Fed lowered rates to 0.25% and kept them there until December 2015, when it raised them to 0.5%. Right now they are at 1.25%, still very low. The Fed rate controls short-term interest rates such as banks' prime rate, and many types of loans and credit card rates. The reason for keeping rates so low is to encourage banks to lend to each other, and consequentially, to companies and consumers.  

And so they have. Thanks to low Fed rates, lenders - the regulated banks that take deposits, and the alternative lenders, which aren't as strictly regulated - have been busy showering companies with loans. While the regulated banks have been relatively cautious, the alternative lenders have gone out in full force, backing practically everything in sight. 

Not only have they been on a lending spree, the loans they've offered, known as "covenant-lite," come with almost no strings attached. So, for example, if your company took out a loan with strong covenants (think of covenants as rules), which determined that if your company's debt levels exceeded, say, 6 times your EBITDA amount, you will have "tripped" the covenant, and thus would see the interest rate on your loan rise, possibly leading the lender to call a default if you can't keep up with the payments. (EBITDA stands for "earnings before interest, taxes, depreciation and amortization" and is considered an important metric of a company's financial performance).

Defaulting on debt is not good for any company - it will ruin their credit rating and drastically increase the cost of taking on leverage (leverage is another word for debt). But covenant-lite loans also add more risk to the lender, who will have almost no way to recoup its money if a borrower defaults. Now imagine if a lender only did covenant-lite loans in an attempt to compete with the other lenders in the market. What happens if a high portion of that lender's clients went into default? The answer is pretty obvious. 

So far, defaults have been pretty low in the U.S. But the race to lend, already at high-speed, is about to jump into overdrive. 

Back in 2013, in an attempt to reduce market risk, the Securities and Exchange Commission enacted guidance that discouraged regulated banks from providing loans valued at more than 6 times a company's EBITDA. While many market observers think that the 6 time EBITDA threshold is arbitrary, credit ratings agencies like Moody's and Standard & Poor's see leverage at that level as a sign of danger ahead, so it's definitely worth taking seriously. 

In October, the Government Accountability Office noted that the above "guidance" is actually a rule, which means it can be repealed via Congressional review. So far, it hasn't been officially repealed, but ask any banker and they'll tell you everyone is proceeding as if it had been. Just the other day the head of the Office of the Comptroller of the Currency said bankers shouldn't consider themselves bound by the lending guidelines. He even said he does expect leverage levels to increase in the near future. This basically gives regulated banks permission to join the alternative lenders in the debt party, providing riskier loans that they wouldn't have provided before.

Another thing that could encourage regulated banks to be less cautious when lending is the incoming hike in Fed rates. So far, three rate hikes are expected this year. A hike in Fed rates essentially puts more money in banks' hands, as the interest rate they charge for loans will increase. At the same time, the rate hikes could add more danger to lenders. When companies holding vast amounts of covenant-lite loans see the cost of the interest on their debt rise, payments will be harder to make. And the lenders will be caught with no way to get their money back.

Also keep in mind that a good portion of fund managers were not old enough to be working in finance when the 2008 financial crisis erupted, and have never faced a major financial meltdown. More than half of them don't even have a decade of experience. Think about it. 

Untested fund managers

T. Rosa

T. Rosa

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