Cov-lite loans are back!

that's patio show marketplace here to talk to you about the latest danger to our economy coven's okay here we are right so what does a cover late loan well it says this word curve is short for covenant alright as everybody knows who's ever read their Bible a covenant is a it's a promise so how does that fit into a loan and then why is that so important to the financial system on why are these cover light loans so dangerous well before I get into that let me just do use a little analogy if you explain how a covenant actually works here's a subway train driver and this subway train if anyone's ever seen that movie the Taking of Pelham one two three they'll remember that part in it where the the train kind of runs out of control it was hurtling down the track a massive rate of knots and the there's a real danger that the train is going to crash it's speeding down there but fortunately it trips something by the side of the track or a signal or something that makes the Train that the brakes engage and it train screeches to a halt okay that's essentially what a covenant is it's something that exists in a loan that can slow a company down whenever things are going wrong if it's running out of control as far as the lenders see things okay so how does that actually work in practice well here let's take a borrower all right his name is his name is Jim and say Jim wants to borrow I don't know a billion dollars so he goes to it goes to a banker friend of his and the banker says yeah I'm happy to lend you a billion dollars but there are going to be some conditions firstly there are preconditions like you're you have to be in good shape as a company but secondly there are ongoing conditions and I'm gonna build into this loan agreement these things called covenants and they're going to insist that every quarter or every you know period that we look at you that you satisfy a certain number of conditions or certain conditions one of these might be you say you have to earn a certain amount of money every month or you have to maintain a certain ratio of debt to earnings okay and if you if your earnings fall below that level your debt your debt level becomes too high then that allows us to come and step in okay and do something about it and there are a couple of things that these covenants usually allow a lend to do ok the lender can sometimes step in and take the loan back because it may look at the company and say you know you've you've you've triggered this covenant and the reason you have is because you guys are hemorrhaging money your debt levels are going to be way too high in comparison to the amount of money you earn this is never going to work we want our money back ok or perhaps they want to step in and say well things aren't too bad so that's just tweak things a little bit so that you go on doing what it is that we really want you to do which is to keep paying interest on a billion dollar loan there's a lot of interest so the banks are really interested in keeping the loan alive rather than calling it back but what they would certainly don't want to do is to lose money and that's why they have these covenants in place all right so the billion dollars goes across to Jim all right but there are a bunch of you know covenants a B and C that that he has to satisfy of course Jim doesn't like this at all right Jim doesn't like this because it allows a Compaq if he's if he if this bank perceives that he's not doing well for whatever reason because of these covenants it allows the man to come in and start futzing with this company all right right now he runs his own company but if things you know don't fall into a certain set of parameters these banks can come in and start get in their hands and they're telling him to earn a certain amount telling him this telling him that I mean you know people who borrow money to buy a house ok they don't have these covenants they're involved in borrowing for a house all you have to do is make your payment at the end of each month ok we don't have these about that kind of an issue but we're not talking about a two hundred thousand dollar loan here I'm talking about billions of dollars which is why these banks are so worried about it because if these covenants were stripped out okay say Jim wanted his revenge on the bankers and said you know I don't want this covenant say he managed to get them stripped out somehow it means that the first warning that the bank would have that there was a problem with Jim was when he failed to pay interest at the end of the month just like a homeowner might okay that's a big problem for a bank because it may mean that the next step for Jim after failing to pay interest at the end of the month may mean bankruptcy and that has happened before in fact it happened quite a lot before the financial crisis kicked in back then there were a lot of covenant low light loans issued because there was so much demand for the loans that the borrower could just come and go yeah I think I'll go with that guy and that guy and and her over there and they'll lend me money without covenants of course it meant that the next thing we knew was guys like him were defaulting okay not able to make interest payments and the banks were suddenly out of the money and when I say the banks I'm not just talking about the big banks I'm talking about the big banks the small banks the regional banks I'm talking about pension funds hedge funds really I'm talking about investors like us who indirectly invest in these loans okay so if the Covenant light thing starts to come back if we start to see borrowers going into the market able to get these covenant light loans it means that we the investors the general investing public okay as well as the banks are not as protected as we were before these government these covenants like our protections and if these covenants are being stripped out of these loans it means our exposure to these heavyweight corporate loans is is where we're being exposed without protection and if things do start to go wrong in the economy as they may well we're not out of this the woods here yet if things do start to go wrong the first thing we're going to hear about it is when they default maybe go bankrupt and let me tell you that'll leave all of us very badly needing a drink

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