The financial world was shocked by The Wall Street Journal front page story on the fear that Bear Stearns may have to close two of its hedge funds that are heavily invested in some $20 billion of subprime mortgage market instruments.
As the story of the negotiations between the Bear Stearns hedge funds and their investment bankers unfolded, it emerged that a central issue of contention revolved around what Financial Times of June 18 termed "cov-lite" deals.
Cov-lite stands for dilution, or even exclusion, of certain key restrictive covenants -covenants that have historically been broadly standard in the lending industry.
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On June 19 we wrote on this very issue in an item titled, "Easy Credit Continues to Stoke the Liquidity Boom." In it we referred to the Financial Times article which said, "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 "cov-lite", says S&P LDC."
What appears to be happening is that certain so-called hedge funds are using their high leverage and great financial clout to force lenders to lend on conditions which include subtle changes made to what is termed the "boiler plate," restrictive covenants contained in the loan agreements.
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These restrictive covenants ensure that the borrower meets certain financial criteria on a current basis. Cash flow coverage of interest payments, margin call levels and debt/equity ratios would be examples.
These restrictive covenants serve as a current monitor of financial condition and although sometimes irksome to aggressive borrowers, are most valuable to lenders.
By either lessening or eradicating these restrictive covenants, the risk of a loan can be subtly and covertly increased without even the professional managers of investment banks realizing what has happened.
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Wall Street assumes that the receipt of a loan document equates to the diligent reading of that document.
However, it now appears that some senior investment bankers have either made a competitive, tactical decision to accept the "revision" or even "eradication" of certain, previously standard covenants, or have failed to notice the "slightly changed" lending conditions.
The pace of work is so ultra hot on Wall Street that it is possible to see how such oversights could happen.
One has only to remember how Barings bank was reduced to financial rubble in London, a few years ago. The bank was brought down by a top management oversight in today's super complex and rocket speed world of high finance
Regardless of the oversights at investment banks, the fact is that covert changes to standard restrictive covenants can creep up on the end clients of the investment banks without them being made fully aware of the changes.
Even within major financial institutions themselves, their acceptance of "cov-lite" and "cov-loose" (balloon repayment) loans must surely affect their own credit.
Does anyone currently know how many major loans at our major banks are "cov-lite?" We think it most unlikely.
How can we? The subtle covenant changes are relatively new and remain largely unseen, as credit agencies concentrate on the traditional measures of analysis.
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Cov-lite and cov-loose lending is creeping up on us at an alarming rate.
We therefore term it as, "stealth risk."
It appears that the Bear Stearns hedge funds obtained loans from some very large and prestigious banks, including JP Morgan, Merrill Lynch ($800 million), and Deutsche Bank ($300 million) and that these banks agreed to the dropping or major changes in the conventional "margin call" restrictive covenants.
In the absence of the immediate "margin call" covenants, the lenders were unable to call for a prompt increase in the equity portion of the funds, to offset a fall in the underlying values of their portfolios, to below agreed thresholds.
This example of stealth risk is not an isolated event. Apparently, as the Financial Times headline graphically states, "Cov-lite deal use is snowballing."
As reported in the Financial Times of June 19, Standard & Poor's Leveraged Commentary Data (an industry newsletter) reported, "In the U.S. more than a third of all loans issuance this year has been cov-lite."
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So there you have stealth risk as yet another covert threat to the investor.
In other words, within the gigantic increases in both leverage and liquidity that our financial markets have engineered, even some of the massive loans may be crucially flawed, not openly by a misjudgment of normal risk/ reward ratios, but internally, in a way that many professional market practitioners may have overlooked.
If you add this to the stealth inflation that we have constantly pointed to as stalking our economy, you have the setting for an increase in interest rates and a major correction in both our bond and stock markets.
Editor's note:
Bernanke Reveals `Fiscal Crisis` Ahead
Will the Liquidity Crisis Sink Your Stocks? 12 Ways to Profit.
12 Ways to Recession Proof Your Portfolio
Buffett, Soros, Templeton, Rogers: Learn Their Money-Making Secrets
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