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.

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Toys R Us collapsed under the weight of its debts

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.

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".

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."

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