What are leveraged loans and why should you worry about them?

"You only find out who is swimming naked when the tide goes out."

This is a line Warren Buffett used in his 2001 Berkshire Hathaway chairman's letter. (He was talking about the world of reinsurance, and the risk that in the wake of September 11th one weak link in the chain of reinsurers could mean that, in a worst-case scenario, your policy wouldn't pay out.)

Like many of his pithy phrases, this one has applications well beyond its original usage.

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The basic point is that in the good times, you can get away with a lot, and no one can tell. But when times turn harder and liquidity dries up, you start to see all the mischief and unsustainable practices that people have been getting up to.

So what surprises might the financial seas hold for us when and if the tide of cheap money starts to wash away from the shores?

As usual, it's all about exotic debt.

The rise of leveraged loans

Financial crises often result from people being overly cavalier about the risks they are taking, partly because they think that it's someone else's problem.

The subprime crisis of 2008 was a classic example. Mortgage brokers wrote loans, that they then sold to banks. Banks parcelled up the loans and sold them to yield-starved investors. The investors were happy to buy them because the credit rating agencies said they were AAA-rated.

At no point were the people who stood to lose money (the end-owners of the loan), the same as the people who were analysing the level of credit risk. Banks and brokers just wanted to write as much business as possible to meet the overwhelming demand from investors.

You would think that we might have learned from this. And yet, there's another rapidly-growing area where private investors are putting money into high-risk loans with no real understanding of what risks are involved.

This is the area of lending known as "leveraged loans".

Leveraged loans are loans made to non-investment grade ("junk"-rated) companies. Unlike most corporate bonds, they mostly come with floating interest rates so when interest rates go up in the wider market, they do so on leveraged loans too.

So when everyone is worried about rising interest rates, they look appealing perhaps rather too appealing.

By the end of last year, around $1.36trn in leveraged loans was outstanding. The market is now a little bigger than the high-yield bond market. And the problem is that the quality of these loans is deteriorating all the time.

Why investors have flocked to leveraged loans

There's no mystery as to how this has happened. After 2008, central banks went out of their way to abolish fear of bankruptcy. They also did their best to make credit cheap and plentiful. In that sort of environment, investors feel they can't go wrong.

You get a race to the bottom. Potential borrowers with an even halfway decent business idea are swamped with offers from lenders desperate for any sort of yield.

On top of that, leveraged loans have historically been viewed as "safer" than other debt, because it comes higher up in the pecking order. So if a company does go bust, you'll typically get a higher recovery rate on these loans.

The trouble is, with all that demand, borrowers are practically able to dictate the terms on which they will accept a loan. As Andrew Osterland of CNBC notes, more than 80% of new lending is "covenant lite". What does that mean?

Well, if you were lending money to someone, you'd probably get a bit concerned or irritated if they then promptly went off and borrowed more money from someone else, and also told this other person that they'd repay them first. You'd want some sort of conditions attached to the loan that would prevent them from doing this. That's what the "covenant" dictates.

Put very simply, "covenant lite" means that lenders are so keen to invest their money that they are happily making loans with hardly any strings attached.

As Bloomberg puts it: "To win business, banks compete to offer the most favorable terms including lower interest rates, fewer protections for investors and more debt and wager that they can then sell on those loans". What do the banks get in return? Tasty fees, plus potential future business. A bit like in the run-up to subprime.

Another uncomfortable echo of the subprime crisis is investors' faith in flawed historical data. In the subprime crisis, one reason mortgage debt was seen as safe was the belief that US house prices had never fallen on a nationwide basis before.

It's a similar story in this market. As CNBC reports, typically in the past, "investors in leveraged loans have recovered 70 to 80 cents on the dollar in defaults". By comparison, the typical recovery rate on senior secured high-yield bonds (which stand behind leveraged loans in the queue) is about 60%, while on even riskier unsecured bonds, it's 40%.

However, this time may be different, as credit rating agency Moody's has noted. One problem is that borrowers have used leveraged loans to pay off more expensive debt such as junk bonds. As a result, leveraged loans have simply replaced the junk debt rather than coming above them in the pecking order. So there's no margin of safety left there.

For example, adds CNBC, before the financial crisis, about a third of the average borrower's debt "was below leveraged loans in the financial pecking order". Now it's only 20%.

That in turn means that debt investors might panic when they realise just how ropey their investments are. That in turn could send the market into a downward spiral, as investors try to get out in a hurry, only to find that no one else wants to buy.

When will it happen? No idea. But when interest rates rise to the point where they start to cause real pain, this is probably the market that will reveal it first.