May 8, 2019 - Last Wednesday, LSTA executive director Lee Shaiman moderated a panel at the 7th Annual LPC Middle Market Conference on whether leveraged loans and CLOs pose systemic risk to the economy, an issue that has received a lot of attention in the financial press in recent months. Here are our takeaways:
- Market Size. The panelists agreed that the size and recent growth of the loan market do not imply that the market has become systemically important. They noted that the market is still relatively small compared to other capital markets and that the market’s growth, once compared to that of other markets, is not extraordinary or peculiar.
- Regulators. One of the panelists said that the right way to look at the systemic risk debate is the way the regulators look at it—which is to ask what will happen in the market when the next downturn occurs, not whether the loan market will trigger the next downturn. The panelist agreed with the regulators that the macroeconomic factors that would normally lead to fragility in the system—such as high leverage in the banking system—are simply not there this time around.
- Covenants. Panelists agreed that the risk appetite of investors is driving the evolution in covenants. One panelist expressed his view that a lot of investors who historically had preference for bonds are exchanging that preference for one for loans, and that that is why loans have begun to take on bond-like qualities. Another panelist thinks the cov-lite distinction is meaningless in itself. He said you have to dig into the details on the specific covenants to know their worth, and that some cov-lite deals today actually may offer more protection than did cov-heavy deals in the past because of the comparative quality of the covenants. He added that recovery rates might be higher in the next downturn because the lack of covenants may keep fundamentally sound businesses in operation through abnormal rough periods.
- CLOs v. CDOs. One panelist said that except for superficial characteristics, CLOs and CDOs have very little in common. He said there are two critical differences between them, having to do with: (1) the asset quality of the underlying credit instruments, and (2) the ability of managers to actively manage portfolios. He pointed to highly transparent nature of CLOs and ability of CLO managers to adjust portfolios as new information arises. He said CDOs, in contrast, contained mortgages about which investors could know very little and that once the mortgages were in a portfolio there was nothing that could be done to get rid of them when their toxic nature became apparent. There was general agreement from rest of panel that CLOs are CDOs are not comparable.
Overall, the panelists agreed that the leveraged loan market and CLOs do not pose systemic risk at this time and most popular analyses are superficial and misleading. This was welcome news to us and, presumably, to the rest of the loan market as well.