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Cov-Lite Loan Meltdown May Be Just a Downturn Away

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Just because covenant-lite loans didn't implode during the last credit crisis doesn't mean they're safe: The next downturn in the credit markets may be all it takes to push the risky loans over the cliff face.

That's the conclusion of a Moody's research report—which states that investors were spared the pain of a major collapse "due to the swift revival of credit markets".

First, a bit of cov-light background.

During the credit bubble, cov-lite loans became a popular form of lending—the hallmark of which was an absence of the usual protective covenants, which were designed to restrict the borrower from engaging in risky activities.

Christina Padgett, the report's lead author, explains the risks:"Covenant-lite provisions allow companies to avoid default for a longer time, increasing the risk that value will be lost for creditors at default. In the absence of maintenance covenants measured at regular intervals, which allow lenders to keep a tighter rein on a company"s financial risk-taking, issuers have more means of avoiding default. For investors in covenant-lite capital structures that ultimately default, the extra time can lead to lower recoveries."

Also from the Moody's report: "In a more prolonged credit downturn, companies with lenient covenant terms would be more likely to default, and their lenders would likely recover less than would investors in defaulted companies with more restrictive covenants."

In other words the damage done by cov-lite loans is two-fold: First it makes default more likely —by simply allowing fewer restrictions on the borrower's risky activity. Second—and far more insidious—it masks the underlying warning signs that a loan is about to bust—and causes an even uglier work out for the creditors in the long run.

This time those creditors may have dodged the bullet—due to massive infusions of capital from various bailout programs and the Fed's monetary easing policies in general.

The next time they may not be so lucky.

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