Are Leveraged Loans Really 'The Next Lehman'?

A lot of things have happened since Lehman Brothers went bankrupt 10 years ago Saturday. The stock market and economy have recovered, and then some. America has had two new presidents. The Fed and Treasury have profited on all the toxic assets they took over from Bear Stearns and AIG. Your friendly senior MarketMinder editors have noticed more grey hairs and crows’ feet. But one thing has held fairly constant: Investors still search around every corner for “The Next Lehman.” First it was Dubai. Then Greece, Ireland and Portugal. Spain and Italy each took their turn, then Greece again (and again). More recently, we have seen eurozone banks, US subprime auto loans, student debt and Chinese shadow banks get “The Next Lehman” treatment. This summer, another joined the ranks: leveraged loans, which are bank loans to companies, backed by illiquid assets, usually with floating interest rates. Like subprime loans in the 2000s, many leveraged loans have been repackaged into securities called collateralized loan obligations (CLOs), creating fears that we are in for a near-perfect repeat. However, we think this thesis misunderstands securitization and—crucially—ignores how mark-to-market accounting transformed a couple hundred billion dollars’ worth of eventual loan losses into a few trillion in immediate paper losses for banks.

Leveraged loans are in the spotlight today largely due to a recent Moody’s report, which projected high default rates if rising interest rates and an economic downturn coincide. Ordinarily, it wouldn’t be huge news that loan defaults would rise under such conditions, but leveraged loans get special treatment. For one, investors supposedly see them as safer than typical junk bonds, as they are higher in the creditor pecking order in the event of bankruptcy since they are backed by collateral. Plus, because many have floating rates tied to the three-month Libor rate, returns have improved alongside rising rates this year, presumably creating a false sense of security. And then there is the securitization angle, combined with the fact many of these loans are now owned by mutual funds or ETFs that market them as high-yield alternatives for investors.

At face value, this is a very large market. Bloomberg tallies total issuance from 2009 – 2018 at $8.7 trillion, while The Wall Street Journal estimates about $1.4 trillion of this is below investment-grade. According to Moody’s analysis, the average recovery for investors in firms that go bankrupt would fall from 77% in past downturns to just 61% in a hypothetical next downturn, thanks to the weakening of covenants (aka legal protections in the loan contract) in recent years. Recovery rates in the market’s riskier segment would drop from 43% to just 14%. As the Journal sums up: “That means that in the next default cycle there will be more loanholders making claims on companies with fewer assets to recover than the historical norm. There will also be less left over for unsecured bondholders, who stand to recover about 32% in the next default cycle compared with a historical average of about 40%, according to Moody’s.”

But the actual hit investors would take in a hypothetical crisis isn’t quite as huge as these numbers might suggest. For argument’s sake, let us pretend their recovery projections turn out to be 100% correct and that the leveraged loan default rate matches the last recession’s peak: 10.5%, in 2009, according to Fitch. If a recession started tomorrow and 10.5% of the outstanding dollar amount of leveraged loans defaulted, that gives us $913.5 billion in defaulted loans. A 61% recovery rate translates to $356.3 billion in actual losses to investors. That is not a small number. But it is also not big enough to cause a crisis of 2008 proportions. Using a conservative estimate, it is only about 20% of total US writedowns during the financial crisis.

We will concede $356.3 billion in realized losses on leveraged loans is in the neighborhood of banks’ actual loan losses during the last crisis. But there is a difference between then and now, which also neuters the securitization issue: There is no longer a transmission mechanism to turn those actual losses into exaggerated paper losses. The bugaboo in 2008 wasn’t the existence of securitized debt in the form of CLOs, collateralized debt obligations (CDOs) or mortgage-backed securities (MBS). Rather, it was an accounting rule that forced all banks to take a paper loss, or writedown, any time another bank or hedge fund sold one of these securities at a firesale price. The trouble started when hedge funds facing margin calls had to sell these assets to raise capital in 2007, and it spiraled from there as writedowns begat more firesales, which begat more writedowns. These writedowns, not the eventual loan losses, are what we (and numerous others, including former FDIC chief William Isaac and former Dallas Fed President Bob McTeer) believe catalyzed the dark days of autumn 2008, when an illiquid Lehman Brothers couldn’t meet its short-term obligations and had to declare bankruptcy.

The trouble in 2008 is that FAS 157, the mark-to-market accounting rule, forced banks to treat assets equally for accounting purposes whether or not they planned to sell them. Even illiquid (rarely traded) assets that weren’t designated as “for sale” required the mark-to-market treatment. That includes all those securitized loans, for which there was no market. Since then, however, regulators have adjusted the rule, enabling banks to list the market value of illiquid and hard-to-value held-to-maturity assets in footnotes instead of on their main balance sheet. So, if leveraged loan CLOs encounter market volatility in the future, and some firms sell them at a discount, it shouldn’t ripple across every bank’s balance sheet.

Some argue the real trouble lurks in the retail segment of the leveraged loan market, namely, the nearly 300 mutual funds and ETFs enabling individual investors to get in on the leveraged loan party. These have reportedly attracted $84 billion from investors since 2010, creating fears that, when the market encounters trouble, investors will flee faster than the fund managers can sell, creating a vicious cycle of falling fund prices, redemptions and asset fire sales. While there indeed is a liquidity mismatch between these funds, which trade freely, and their illiquid assets, this seems mostly like a rehash of long-running bond market liquidity fears. We heard the same rumblings about high-yield corporate bond ETFs in 2015 and 2016, but when that market actually tumbled and trading spiked, everything went smoothly. The vicious cycle didn’t happen. Nor was there much fallout in UK commercial real estate funds in the wake of Brexit. Some funds did have to erect redemption gates, but that mostly speaks to the need for investors to understand what they are buying and the potential for illiquidity during a crisis. Neither was a systemic event, which is what investors broadly seem most concerned about now.

To us, the continued hunt for “The Next Lehman” speaks mostly to sentiment and investors’ overwhelming tendency to fight the last war. But bear markets rarely start the same way twice. The 2007 – 2009 bear market and financial panic unfolded differently from 2000 – 2002, starting in a different corner of the market. The next bear could very well look more like 2000 – 2002, the Tech Bubble and its aftermath, beginning in the stock market amid widespread investor euphoria. Or it could be a less flashy version, with euphoric investors ignoring mounting evidence of economic problems, without a sector-specific bubble like Tech then. That doesn’t mean investors shouldn’t keep watch for problems in the banking sector and illiquid investments, but it highlights the wisdom of a) putting alleged risks in context and b) looking beyond the setting of the last crisis.