Top-line inflation (including food and energy) hit 2.7 percent in May. The stagflation we have long forecast is now beginning to show.
Most prudent people would expect lenders — expecting interest rates to rise — to become more wary of credit risk. But that's not what's happening!
The Financial Times (June 19) contains an excellent article exposing the rapid growth of both "cov-lite" and "cov-loose" loans in both New York and London.
[Editor's Note:Will the Liquidity Crisis Sink Your Stocks? 12 Ways to Profit.]
As our readers might know, most loan and bond indentures contain a variety of covenants that dictate when the borrower triggers a "technical default". These allow the lenders some rights of effective control.
"If certain financial targets are breached," the covenants allow the lenders rights of effective control of the borrower until remedial action is taken and achieves a restoration of the agreed financial targets. In extreme conditions, immediate repayment of the loan could be triggered.
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Most importantly, the loan covenants allow the lenders to "monitor borrowers on current basis" in addition to the right to corrective action.
These traditional "restrictive covenants" include ratios, such as those setting the amount the borrower's cash flow must exceed of "coverage" the amount of interest payments.
These ratios are widely acknowledged in the debt markets and generally understood and accepted by lenders in the developed financial markets of the world.
Now things are changing in an ever greater drive to create liquidity, even for less than strong borrowers.
Make no mistake about it; the amounts of money involved are large. According to the Financial Times, "In the U.S. more than a third of all loan issuance this year has been cov-lite."
The Financial Times goes on to say that this escalation in the ease at which credit can be obtained is, "in spite of warnings from regulators and financiers that such instruments could produce new dangers for investors if the credit cycle turns."
The article continues, "Regulators and central bankers fear it indicates that credit markets are in a bubble." Well, what sort of amazing understatement is that?
We at MoneyNews.com are frankly astounded that our regulators stand quietly by, while this greed-driven enhancement of debt risk is allowed to run full-bore and relatively unseen by individual investors.
It does not wash with us to say that the institutional lenders know what they are doing their (with other peoples') money.
History is littered with examples of professional managers (as opposed to the owners) of money accepting undue risk in order to boost the return performance that often take their salaries to astronomic levels.
So who are the key culprits forcing such risky deals?
Surprise, surprise, as the Financial Times points out, "Talk is that arrangers (investment bankers) are being told not to bother calling (private equity) sponsors for new mandates unless they are prepared to do "cove-lite," says S&P LCD.
So there you have it. The hedge fund industry is largely unregulated and typically very highly leveraged. It is run by some extremely gifted people. But, unlike its name suggests, it is also highly speculative.
Having accumulated massive amounts of cheap debt, the hedge fund industry is now apparently dictating to institutional lenders, terms that regulators fear could unhinge massive sector of the debt market.
The shareholders of these institutional lenders are ordinary shareholders, who have no idea of the new level of risks their traditionally secure institutions are taking, on their behalf.
And all the time, our regulators and government remain silent!
Last week The Wall Street Journal ran an item with the aptly descriptive headline, "Risky Loans Keeping Near-Bankrupt Companies Afloat." It sums up the situation and should warn us all of the greatly increased financial risks now inherent in just one traditionally conservative sector of our financial markets.
[Editor's Note:Buffett: The best book ever written on investing.]
As if all this was not enough, according to the Financial Times, "Bankers are experimenting with even more complex deals such as those that do not require borrowers to make any repayment until the end of the loan, or "cov-loose" deals that remove [that] part of the [restrictive] covenant[s]."
History appears to indicate that this sort of "greed-driven" financial engineering, permitted by "recession-scared and politicized" regulators, normally presages financial trouble, sometimes of hurricane force.
We note with interest that on June 14 (when your writer was on holiday, deep in the mountains of Maine), U.S. Secretary of Treasury Henry Paulson said that investors should see recent rises in interest rates as a "wake-up call."
Our advice to our more conservative investors is "Please stay awake, listen out for the financial hurricane that we feel looms off-shore and take defensive actions before the storm hits."
Editor's note:
Will the Liquidity Crisis Sink Your Stocks? 12 Ways to Profit.
What Happens When Easy Money Disappears? 12 Ways to Profit.
Buffett: The best book ever written on investing.
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