“There’s been an exogenous shock that’s exposing leverage in the system,” said Michelle Russell-Dowe, head of securitized credit at Schroders. “There will be winners and losers, and it will all ultimately come down to leverage.”
Regulators focused on banks when they set out after the 2008 financial crisis to rein in the excessive risk-taking that threatened to upend the financial system. But as the U.S. emerged from that wreckage, the Fed kept lending rates so low that companies across the country binged on borrowings, with U.S. businesses taking on $16.1 trillion, up from $10.2 trillion a decade ago. Investors lined up to lend, in part because U.S. rates were still higher than those in Europe and Japan.
In their enthusiasm, investors let borrowers strip protections, known as covenants, from risky loan contracts. The leveraged lending market expanded to $2.1 trillion. Sales of CLOs, the biggest buyer of leveraged loans, more than doubled to around $670 billion from 2010. A new borrowing complex known as private credit grew, drawing lending even further away from regulated banks to an $812 billion world of non-regulated lenders operating largely out of the authorities’ gaze. Meanwhile, banks rebuilt their derivatives operations.
Read a QuickTake: Clubs, Covenants, Mezzanines -- a Guide to Private Debt
The overall result was a growing pile of risky debt and a variety of options to juice profits.
“You have junkier and junkier debt, and it’s super levered up,” said Stephen Blumenthal, chief investment officer at CMG Management Group Inc. “When you get yields compressed to record lows, it takes more leverage to generate return. It’s classic human and end-of-cycle behavior.”
To be sure, a number of elements of the market are safer now. CLOs sold after the financial crisis don’t have mark-to-market triggers forcing investors to sell when prices fall below certain thresholds, meaning there’s a very high hurdle to breach before liquidation is triggered. Most of the bank warehouse credit lines that CLO managers use also aren’t marked to market.
This time, authorities were quick to roll out measures aimed at putting a bottom under asset prices with corporate bond buying programs. And Congress and the Trump administration are about to hand money directly to people and businesses.
“This unprecedented $2 trillion shock-and-awe fiscal stimulus has been conceived in a relatively thoughtful way,” said Stephen Ketchum of Sound Point Capital Management. Banks were the heart of the problem in 2008 and received much of the money directly, which was relatively simplistic. “Now we’re trying to get money to millions of individuals and thousands of businesses that are being affected by Covid-19. It will be a massive undertaking to get it right.”
The coming weeks will be telling. Unlike a decade ago, when regulatory filings gave the public some insight into the types of risk-taking by banks that contributed to the collapse of Bear Stearns Cos. and Lehman Brothers Holdings Inc., it’s more difficult to see this time how much leverage has accrued, or which investment firms might be most exposed.
The answer will emerge with time, leaving the Fed to face the issues created by its decade of low rates.
“Post-crisis policies drove everyone to places where they shouldn’t have been,” said Larry McDonald, author of the book “A Colossal Failure of Common Sense” about Lehman’s demise. “And then the Black Swan hit.”