Are we facing another subprime crisis?

Fears are growing that leveraged loans – a high-risk section of the corporate debt market – could cause a subprime mortgage-style meltdown. Marina Gerner reports.

931-TRU-634

Fears are growing that leveraged loans a high-risk section of the corporate debt market, worth more than $1.2trn could cause a "subprime mortgage-style meltdown", say Anna Isaac and Tom Rees in The Daily Telegraph. This time, the borrowers are not US homeowners taking out mortgages, but "US companies with weaker credit ratings", notesJim Puzzanghera in the Los Angeles Times.

Companies taking out such loans are often already heavily indebted. Last year, for example, toy shop chain Toys R Us and US department-store giant Sears collapsed under the strain of such debt. Investors have flocked to leveraged loans because typically the interest rates charged are not fixed but floating, so they rise along with central bank rates. But in their haste to invest, lenders have been willing to accept far more forgiving terms (known as "covenant-lite") than in the past.

Subscribe to MoneyWeek

Become a smarter, better informed investor with MoneyWeek.

In 2007, "cov-lite" loans accounted for about 25% of leveraged loans now it's a record 80%, reports credit ratings agency Moody's. So when hard times hit and default rates rise from their current lows, says Moody's, recovery rates for lenders could average 61 cents on the dollar, well below the historical average of 77 cents.

Central banks are starting to worry

The Bank for International Settlements (often known as the central banks' central bank) warns the Financial Times that a slide in the value of such loans "could spur fund redemptions, induce fire sales and further depress prices".

Advertisement
Advertisement - Article continues below

In turn, this could hurt "the broader economy by blocking the flow of funds to the leveraged credit market". Demand for CLOs may now be cooling. In December, investors rattled about the overall economic outlook pulled $1bn from the asset class, notes the FT. But the debt pile remains significant.

A slow-motion meltdown

As a result, a shock credit-market collapse seems a lot less likely than a"slow-motion meltdown". Yet while we may not be facing a repeat of 2008, a slump would still hurt. As former Federal Reserve chair Janet Yellen told the FT last autumn, when the next recession hits, "there are a lot of firms that will go bankrupt because of this debt. It would probably worsen a downturn."

Advertisement

Recommended

Visit/519858/how-long-can-the-good-times-roll
Economy

How long can the good times roll?

Despite all the doom and gloom that has dominated our headlines for most of 2019, Britain and most of the rest of the developing world is currently en…
19 Dec 2019
Visit/516944/why-wall-street-has-got-it-wrong-again
Economy

Why Wall Street has got the US economy wrong again

The hiring slowdown does not signal recession for the US economy. Growth is just moving down a gear, says Brian Pellegrini.
25 Oct 2019
Visit/economy/uk-economy/601098/coronavirus-big-brother-widens-his-embrace
UK Economy

Coronavirus: Big Brother widens his embrace

The coronavirus crisis has led to a massive expansion of the state into all areas of daily life. Should we be worried?
4 Apr 2020
Visit/economy/global-economy/601113/the-charts-that-matter-recession-is-here-how-deep-it-will-get
Global Economy

The charts that matter: recession is here – how deep it will get?

After a week in which US unemployment claims topped six million, John Stepek looks at how the charts that matter most to the global economy are lookin…
4 Apr 2020

Most Popular

Visit/investments/property/601081/three-things-matter-for-the-uk-housing-market-now-and
Property

Three things matter for the UK housing market now – and “location” isn’t one of them

The UK housing market is frozen. And when it does eventually thaw out, the traditional factors that drive prices will no longer apply. The day of reck…
1 Apr 2020
Visit/investments/property/601065/what-does-the-coronavirus-crisis-mean-for-uk-house-prices
Property

What does the coronavirus crisis mean for UK house prices?

With the whole country in lockdown, the UK property market is closed for business. John Stepek looks at what that means for UK house prices, housebuil…
27 Mar 2020
Visit/investments/commodities/energy/oil/601107/oil-shoots-higher-have-we-seen-the-bottom-for-the-big-oil
Oil

Oil shoots higher – have we seen the bottom for the big oil companies?

Just a few days ago everyone was worried about negative oil prices. Now, the market has turned upwards. John Stepek explains what’s behind the rise an…
3 Apr 2020
Visit/economy/uk-economy/601079/how-the-coronavirus-pandemic-is-killing-cash
UK Economy

How the coronavirus pandemic is killing cash

Covid-19 is making a huge difference to the way we live, work and do business. One of its less obvious effects, says Merryn Somerset Webb, is to accel…
31 Mar 2020