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The Mystery of Low Defaults For Leveraged Loans

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Talk of recession is everywhere. The Fed is cutting like a barber above a pie shop. Consumer confidence is sinking, spending failing to keep up with spending power. You can’t read a Fed statement without coming across worries about the credit crunch. You’d think that we might see an increase in defaults for leveraged loans that fueled the buyout wave that crested last year.
But you’d be wrong. The leverage loan default rate is at the lowest rate in years. We ended 2007 at a 10-year low of 0.1 percent for Moody's-rated issuers, down from 0.6 percent in 2006.
So what’s going on? Are companies saddled with debt are simply especially healthy right now? Not very likely. What’s holding down the default rate is that it’s so hard for a company to breach a covenant these days these days, according to Reuters Jonathan Keehner and Megan Davis. In fact, it may be hard even to find a covenant that can be breached short of total collapse.
“The problem is that the most recent round of dealmaking partly removed a canary in the coal mine traditionally used by lenders to signal when a deal was in trouble,” he writes.

Lending agreements from the buyout boom had such loose conditions that some were dubbed "covenant lite" because they lacked traditional default triggers called maintenance covenants. Those covenants track a borrower's ability to meet financial obligations.
Historically, a company that issued leveraged loans would break a maintenance covenant if it ran into liquidity trouble, said Kenneth Emery, who directs Moody's corporate default research. Lenders would then be alerted to the situation early and could take corrective action, like selling assets, changing management or pushing the company into bankruptcy, according to Emery.
But without such strict covenants, the default rate could react less to liquidity issues at newly private companies -- which may be at higher risk in a recession due to the debt load that often accompanies a buyout.

So companies can run into trouble and keep running without tripping covenants, and lenders may not be able to get them to the table until a lot of value has been destroyed. In short, the lower default rate may also lead to a lower recovery rate for lenders.
LBO companies' health could be worse than it looks [Reuters]