In its special report on the leveraged loan market and post-default recovery, Standard & Poor's describes the macro-market trends in the syndicated loan market, both within the U.S. and globally, and the impact those trends are having on credit quality, as evidenced by the 1,300 loan and recovery ratings we have assigned to date. It is clear that the loan market's evolution from an opaque, relationship-based market to one that is more transparent and open to non-bank, non-relationship-based investors, has led to a huge influx of institutional investor capital. This burgeoning investor appetite for loans has swamped the supply of new loan issuance, despite issuance being at record levels, creating what appears to be a systemic imbalance between the supply of loan investment capital and the supply of loans. From a credit standpoint, this has encouraged what many have called a "race to the bottom" in credit standards since, with such an overhang of loan capital seeking to be employed, few loans go unsold, regardless how risky they may be. This, in turn, has led to a realization that some of these loans--sooner or later--are going to default. Hence, there is a growing interest in credit ratings that not only predict the likelihood of default (i.e., "traditional" ratings), but also that evaluate the likelihood of recovering one's investment after a default.
An article in the special report, titled "The U.S. Leveraged Loan Market: Huge Deals, Few Bargains," describes how volume in the U.S. market has hit record highs ($109 billion in first-quarter 2006), while spreads approach record lows (LIBOR + 168 basis points for loans rated 'BB' or 'BB-' and L+254 for loans rated 'B+' or 'B') and covenant packages weakened across the board. The good news is that default rates in the loan market have remained low, and both anecdotal evidence and the Standard & Poor's Leveraged Commentary & Data default-rate forecasting model suggest that defaults may remain low for the remainder of the year and into 2007. But credit quality is steadily deteriorating, as measured by the proportion of outstanding institutional loans rated 'B+' or lower that has grown to 55% in March 2006, versus 42% 15 months earlier.
Other articles in the special report ("For the U.S. And Europe, Two Loan Markets Become One," "European Loans: Demand Soars Even As Ratings Slide," and "Plain Sailing For European Leveraged Finance Until The Liquidity Tide Turns") explore how similar issues are affecting the European loan market--at an ever-increasing pace--as the European and U.S. markets become less and less separate pieces of a single global loan market. This is evident in spread compression, where the relatively high European loan spreads have been a magnet for U.S. loan investors starved for yield. But some of the same trends evident in the U.S.--especially decreasing credit quality--are appearing in Europe. Although Europe remains a largely unrated loan market, credit quality as measured by leverage and coverage ratios has been on the decline. Credit spreads, while declining slightly, have not dropped as precipitously in the U.S., so we can expect the European loan market to continue attracting U.S. investors in the future.
In this environment, bankers openly admit to gritting their teeth and arranging loans that they would not want to hold in their own portfolios. Investors describe themselves in equally stoical terms, saying they hold their nose and buy the loans, despite reservations about credit risk and adequacy of return. Both groups talk about "when"--not "if"--the bubble will burst and default rates will spike. So it is not surprising that the market has embraced recovery in the event of default as an equally valid credit concern, in addition to the traditional focus on the risk of default itself.
Anticipating the market's interest in loss and recovery, Standard & Poor's introduced its recovery ratings to the secured loan market almost two and a half years ago, and has just assigned its 1,300th recovery rating. The article titled "Recovery Ratings Illustrate The Temptation Of Leverage In A Highly Liquid Loan Market" describes how current market practices in North America have affected recovery ratings. While the distribution of recently assigned ratings shows some deterioration from the historical average recovery, what is even more striking is the increasing dispersion of expected recoveries as suggested by the recovery ratings assigned to new loans. This mirrors the actual experience of recent loan defaults and recoveries, as seen in the recovery data recorded in Standard & Poor's LossStats® Database. In short, while recoveries of defaulted loans are still, on average, relatively high compared to other types of debt, the variability of recovery from one defaulted loan to another has been increasing and, we believe, will continue to do so as traditional credit standards are tested.
In other words, not all so-called "secured" loans are alike. As the market realizes this, the interest in recovery ratings that answer the question "What will I receive if the loan defaults?" is likely to grow. Standard & Poor's assigns loan and recovery ratings to more than 70% of all new leveraged loans. When the market cycle turns--whether next year or the year after--and investors are able to reestablish credit standards, we believe this percentage will increase.
Several trends have helped push the recovery rating average below what historical recovery levels might suggest. One has been the explosion of second-lien loans. While nominally "secured," most second-lien lenders are effectively down the ladder in the bankruptcy queue, and the recovery ratings assigned to them (mostly in the '4' and '5' categories, with recovery expectations of less than 50% and less than 25%, respectively) reflect that. They also pull down the averages for recovery ratings in general. The other main potential drag on recovery values is the aggressive expansion of dividend cash-outs, where loans are used to fund the de-capitalization of the borrowers. This has a dampening effect on recovery prospects in the event of default.
Standard & Poor's is committed to a fundamental, deal-specific analytical approach to rating loans and recovery. It includes a hands-on, forward-looking evaluation of an issuer's likely default scenario, the valuation of its assets within the context of that default scenario, and the ultimate recovery expected at the conclusion of the bankruptcy or workout process. (See "Standard & Poor's Recovery Analysis In Practice" for a comprehensive look at our recovery rating methodology.)
We have chosen not to utilize an actuarial, model-driven approach based on the assumption that future recovery patterns will resemble past ones. We believe models and empirical data are vital to informing the recovery rating process, and we certainly make use of them, but we also believe it is clear that fundamental changes in the structure of the loan market may drive behavioral shifts that may change recovery outcomes in the future from what they have been in the past. Key among these structural changes are (1) the sell-down and secondary market dispersion of loans so there is no true "lead lender" with substantial capital at risk in the event of default, and (2) competing interests within a workout between original par holders and distressed debt holders who bought in at big discounts. As a result, we may expect to see less commonality of interest among lenders in future workouts, with recovery results that reflect that.
Finally, the special report takes a look at how jurisdictional differences in insolvency regimes can affect recovery prospects for secured creditors. "Jurisdiction Matters For Secured Creditors In Insolvency" points out that some regimes are more credit friendly than others, and examines the differences between insolvency regimes in several European countries and the U.S.
The articles in this special report will explore these and other issues in greater detail. We welcome dialogue with the market and look forward to revisiting these topics in the future.
(Leveraged Commentary & Data is a unit of Standard & Poor's, not affiliated with the Ratings Group.)
