Cheap money, lax lending standards – I'm getting deja vu here

Last night, I was trying to explain to someone in very simple terms, what caused the 2008 financial crisis.

"Interest rates were pretty low. Investors were desperate to lend their money out at a halfway decent interest rate, and they didn't really think about the risks involved. So when they had the chance to buy up other people's mortgages, they jumped at it.

"Meanwhile, the brokers who actually organised the mortgage loans, got paid for writing the loans. They didn't care if they were repaid or not. So no one bothered to check if the people who were actually borrowing the money could pay it back.

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"It turned out that they couldn't. And that's, in a nutshell, how the financial system blew itself up in 2008."

Hmm. Cheap money, lax lending standards, piles of dodgy debt building up everywhere there's something familiar about this story, I can't quite put my finger on it.

Oh wait. It sounds just like today.

Lenders are getting ever more careless with their money

Covenant quality represents how binding the conditions surrounding a loan are. For example, you might want to make sure that anyone you lend money to cannot take on more debt from someone else. You might also want to make sure that they keep various financial ratios within certain limits, to avoid the risk of going bust.

Covenants matter, because they give you, the lender, more protection by forcing the borrower to be sensible with your money. Borrowers, of course, would prefer covenants to be as relaxed as possible, because that gives them more leeway should problems arise.

Given that monetary policy is incredibly loose and investors are incredibly keen to throw money at anything that offers a semblance of a decent yield, what do you think has happened to covenants in recent years?

That's right they've become progressively less restrictive. In fact, says Moody's, covenant quality hit an all-time low last month (not the first time in the last few years that we've seen that headline).

Put simply, lenders are handing out money to high-risk companies (we're talking high-yield, or "junk", bonds here) with little by way of conditions attached.Meanwhile, despite this lack of protection, the gap between the yield on risky debt and that on "risk-free" government debt, is also near its post-financial crisis low.

That might seem surprising. You'd think that with interest rates apparently set to rise, spreads might be starting to nudge higher. After all, higher interest rates spell tighter money, which could spell trouble for companies at the junkiest end of the quality spectrum.

However, if interest rates are rising because the economy is strong and everything is hunky-dory, it is in fact perfectly logical for spreads to remain slim or even tighten. After all, in a strong economy these companies should be fine and meanwhile they'll give you a better yield than a government bond so why not buy them?

As one analyst points out to Bloomberg: "The primary, direct driver of default rates is not the yield on Treasury bonds but rather the business cycle."

Of course, that's the logic in more "normal" times. Today, things are anything but normal in terms of monetary policy. And spreads are already pretty tight without adding uncertainty about the next central bank move into the equation.

The subprime car loan pile-up

Net losses on these bonds are expected to hit 15% that's higher even than bonds written in 2007. One problem is that lenders have been lending over a longer period of time, which means that by the tail-end of the loan period, there's been a big drop off in the car's "equity" value, potentially leaving the borrower owing a lot of money.

These loans have been parcelled up and sold on to investors, just as with the last subprime crisis (you know, that one with the mortgages that caused a minor kerfuffle in the economy a few years back). And just as with the last subprime crisis, demand from investors for stuff to invest in has seen lending standards plunge across the industry.

Notes Bloomberg: "Wall Street has rewarded lax lending standards that let people get loans without anyone verifying incomes or job histories." And as a result, a lot of those loans are now going bad.

The biggest difference here is that the scale is not considered large enough to disrupt the entire financial system. And I'm sure that's true. On their own, car loans are not going to bring the financial system to its knees.

What concerns me is that there's such a dispersion of bad debt either bubbling up or just waiting to happen. How many dominoes need to tip over before a really important one spills?

As long as investors feel flush and are desperate to chase yield, the dancing can continue. But that'll change. And I expect to see quite a few casualties when it does.