As investors continue to unload loans to risky companies, pushing prices into distressed territory, those still holding these investments are increasingly looking the other way. They continue to value the loans on their books at par, even when the loans change hands in the secondary market at prices far below face value.
Typically, loans that trade below 80 cents on the dollar are considered to be distressed. At this point, market participants come to an agreement about the level of risk involved in holding the loan, and potential buyers demand representations and warranties from the seller before purchasing it.
And once a loan is classified as distressed, it’s hard to justify holding it at par, so investors typically start marking it to market.
Recently, however, the number of loans trading below 80 has increased dramatically, which could compel investors to market large swaths of their loan portfolios to market.
As a result, investors have been waiting until the price of a loan falls much lower, say to 60 cents on the dollar, before seeking reps and warranties and marking it to market.
Sound like a scene from movie version of The Big Short?
The last time investors lowered their collective standards and waited longer to mark loans to shaky companies to market was in 2008 and 2009.
“Following the financial crisis, the entire market went through changes and loans went down to 70-60 on the dollar” before being considered distressed, said Elliot Ganz, general counsel and executive VP with the Loan Syndications and Trading Association (LSTA).
“The market had a decision to make at that point to decide if they go par or distressed,” Ganz said. “The market decided overwhelmingly that they were not distressed.”
The LSTA is not charged with determining whether a loan is trading at distressed levels; this is negotiated between the buyers and sellers. But the trade group is responsible for completing the necessary paperwork to documenting when this occurs, explained Ted Basta, senior VP of market data analysis.
“We collect trade data from large broker dealers in the U.S. and analyze the trade date to see what at which point the market viewing it as is distressed,” Basta said. “Once I see that distressed documents are used, we then have a shift date.”
When this shift date is identified, the market now has distressed documents that provide additional warranties by the seller.
Trade data isn’t the only thing used to determine whether a loan is distressed. An issuer default or Chapter 11 filing can also result in investors pushing for the distressed designation.
An example of this was Texas electricity provider TXU Energy, now known as Energy Future Holdings. In the early 2000s, the company’s debt was trading in the 60s. Despite this, investors kept it on their books at par until the company ultimately sought bankruptcy protection. The debt was then classified as distressed.
Why give loans trading in the 80s and 70s a pass? Investors may feel that the particular credit has been unfairly tarnished by concerns about other issuers, or that the entire loan market is oversold.
But there’s an obvious downside to waiting too long to demand reps and warranties from sellers: buyers are putting themselves at risk .
“As an attorney representing investors, it does trouble me when I see these kinds of prices and I will try to get clients to push back,” said Steven Golub, a managing partner at New York law firm Golub & Golub LLP.
Golub has been involved in over $40 billion in distressed debt transactions. His clients include multi-strategy and distressed hedge funds and private equity firms.
Golub said that banks, in their role as brokers and intermediaries, have an incentive to discourage the buyside from obtaining distressed documents as long as possible.
However, the LSTA’s Ganz said what is accepted as distressed or as on par is decided by all parties involved.
“What is happening is market participants are deciding that they can either get representation or stay on par and not get that extra protection, but do it with eyes wide open,” Ganz said. “This is not a bank issue, but a counterparty issue.”