Thursday, August 10, 2006

This I promise you...

In yesterday's Market Beat Serena Ng commented about the decline of covenants in bank loan deals. These are certain restrictions placed on the borrower for protection of the lender. Common covenants include maintenance of certain minimum debt or interest coverage ratios, restrictions on new issuance of debt, requirements to pay down debt early or pay a higher coupon if certain adverse events occur, etc.

Here are the dirty little secrets about covenants.

1. Ratings agencies don't assign higher ratings to pieces of debt with covenants. I'm sure if I write "Rating agencies don't care about covenants," someone will e-mail me and claim otherwise. But in my experience dealing with public finance covenants, it is quite rare that the covenants are a major factor in a rating. A rating is all about financial strength of the operation, not about whatever promises management makes.
2. Banks commonly allow borrowers to break the covenant. They just charge a fee for renegotiating terms of the loan. So the bank is more interested in getting a fee than enforcing the covenant.
3. Hedge funds and banks and CLOs (not mentioned in the WSJ article, but a big part of the issue) are obviously more interested in getting the loan done than negotiating a bunch of covenants. Otherwise they'd still be asking for the covenants.

So why should we be so worried about the decline of covenants? It seems like very few market participants care.

I think we are right to be worried, but not because of the lack covenants per se. A covenant is just a promise by management to remain relatively conservative in their capital allocation. But covenants didn't stop Enron from fiddling with their accounting. I'm sure they passed all their covenants with flying colors in 2000. The real problem is what the decline of covenants signals.

Most recessions are caused by a misallocation of capital. Capital takes time to be reallocated, and during that time economic growth suffers. When credit conditions are too loose, there is a good chance that capital is being allocated poorly. So it isn't the covenants themselves that are the problem. The fact that borrowers have the negotiating power in this market, as evidenced by the decline of covenants, suggests credit conditions are very loose indeed.

Recession anyone?


Accrued Interest said...

First of all, give me an example of a covenant that ISN'T a promise by management.

Second, I grant that you are right when you say that covenants are used by some vulture funds. But this isn't why the covenants were originally put into place by lenders.

Accrued Interest said...

Maybe we are arguing semantics, but if the covenant is to maintain cash flow ratio of X, then management is promising to maintain cash flow ratio of X. That's all I'm saying.

Now, I don't traffic in bank loans, so you may know about that area better than me. Within bond covenants, its common that bond holders will not try to force a ch. 11 filing because they figure the recovery is better if they renegotiate the covenant and/or allow for a cure.

The people I know in banking tell me that the bank often figures that they will make more money by charging a fee to renegotiate the covenant as opposed to forcing a ch. 11. I'm sure it depends on the type of loan. Like a real estate-backed loan, the recovery doesn't get worse and worse as the company's operations deteriorate. So the bank can try the renegotiation route knowing they can later force bankruptcy and get the same recovery.

Also, in the case of a bank loan you have a single lender, whereas a bond has many lenders who may not be as organized.