I spent more than 35 years on Wall Street, in the trenches. I built a fortune helping my clients make billions before stepping away to run high-profit trading research services for my subscribers and expose the Street’s dirty little secrets.
So believe me when I tell you I’ve seen a harebrained Wall Street scheme or two: the savings and loan crisis… the “crash-proof” portfolio insurance craze that led directly to the Black Monday market crash in 1987… subprime loans and toxic, mortgage-backed securities in 2008.
Those are just the biggies; there were dozens of other, smaller schemes that didn’t crash the entire market – but wiped out plenty of investors.
Dumb, dangerous ideas… On Wall Street, they’re more contagious than a cold.
All it takes is one firm to try out an idea. If it works, even in the short term, it catches like a virus, and then everyone’s doing it… to the tune of tens, even hundreds of billions of our dollars at risk.
I’m going to take you inside the latest “I can’t believe they thought this was a good idea” craze sweeping Wall Street. Be warned: If you have even a shred of common sense, you’ll be outraged.
Now, I’m not doing this to shock you – although you’re better off knowing what’s going on here.
I’m telling you this because there’s a dead simple way for any investor to cash in big time when this scheme inevitably backfires on the greedy bankers pulling it…
Meet the New Scheme, Same as the Old Scheme
I’m sure we’re all familiar with the risky, subprime loans that led directly to the global financial crisis of 2008. They were outrageously popular right up until the very end because they were so profitable, of course – so profitable that no one thought to look the gift horse in the mouth and ask hard questions.
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So surely Wall Street learned its lesson and wants nothing more to do with risky loans, right? Don’t answer that…
The latest thing going is leveraged loans – credit for companies with big debt loads on their balance sheets, with ratings running anywhere from below investment grade to junk. The borrowed money is used to finance private-equity transactions, deals, leveraged buyouts, debt refinancing, and oftentimes just plain-old lifeblood for these cashless, witless wonders.
Now, there’s nothing inherently wrong with considering your investments carefully and taking on some risk to make a speculative move.
The problem comes when you don’t think it through. And it’s clear from the sheer size of the leveraged loan market that Wall Street hasn’t thought this through.
Big surprise there.
Leveraged loans dried up during the financial crisis, but they started making a comeback in 2011.
By 2013, issuance jumped to $607 billion. And loans, in the last two years, surged beyond levels seen in the 2007 to 2008 financial crisis.
The numbers are staggering, actually.
The market hit a record of $1.66 trillion in 2017 and stood at $1.46 trillion in 2018, according to data from Dealogic. That’s bigger than the high-yield bond market.
Demand is high, and the money is flowing easy.
In an echo of the “anyone can get a mortgage” attitude of the early 2000s, there’s no problem getting leveraged, high-interest loans for the companies lined up at the easy-money trough, thanks to investor demand for huge chunks of packages of loans.
Because interest rates have been artificially tamped down for years, investors who want yield have to go further out on the risk spectrum to get any. Leveraged loans are plentiful on the “way out there” end of the risk spectrum.
Banks and non-bank lenders make leveraged loans and package them into collateralized debt obligations (or CDOs, an old “friend” from the financial crisis), which investors have been gobbling up.
Big investors, like pension funds, insurance companies, and asset managers.
When investors buy packaged leveraged loan CDOs, the money they spend goes back to the originators of the loans, to make more fees lending to more borrowers and more money packaging and selling more CDOs.
It gets even riskier.
There Are Fewer Default Protections Every Day
With all the money being thrown at leveraged companies, they’ve been pushing back on the debt covenants typically demanded by lenders.
Covenants in bond and loan indentures are the paperwork that defines the lender-borrower relationship. They offer protection to lenders by making borrowers abide by things like interest rate coverage ratios, leverage ratios, and what position a lender has in the company’s capital structure.
But with so much money being thrown at borrowers, they’ve pushed back on what covenants they’ll offer. Sometimes, they’ll say no to even the most basic protections.
Issues that don’t offer typical protections are called “covenant-lite.” And they’re everywhere, to say nothing of the more insidious leveraged loan derivatives like credit default swaps.
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In fact, because demand for leveraged loan investments is so high and borrowers are in control of what protections they’ll offer, 80% of all leveraged loans made in 2018 were covenant-lite.
So, all the ingredients for a big, ticking time bomb are here. It’s just a question of time now. Warnings are beginning to appear, not least of which is the slow, inexorable climbing of interest rates. The U.S. Federal Reserve, International Monetary Fund, Bank for International Settlements, and legislators from both parties have sounded alarm bells.
When stocks dropped at the end of 2018, prices of leveraged loans on the secondary market started to back up, and issuance to already-leveraged companies froze up.
Banks like Barclays and Wells Fargo & Co. (NYSE: WFC) and others found themselves stuck with hundreds of billions in risky loans on their balance sheets. Outflows from leveraged loan mutual funds and exchange-traded funds (ETFs) hit records.
It was all frighteningly reminiscent of 2007-2008, and the only thing that stopped the leveraged loan market from blowing up was that the Fed blinked and held off on its planned rate hikes.
The market made it by the skin of its teeth. It could’ve been otherwise.
That’s the bad news. The great news is you can not only protect yourself from this, but turn a tidy profit as well when all this speculation goes bad for the Street.
Punish Wall Street: Make Money While They Lose It
There are two easy ways to make money – repeatedly – on the decline of the leveraged loan market. What’s more, if history is anything to go on, there could be massive sums made on this play if we get an outright crash.
I’ve got two ETFs in mind.
The Invesco Senior Loan ETF (NYSE Arca: BKLN) and SPDR Blackstone GSO Senior Loan ETF (NYSEArca: SRLN). Both of these are up slightly for the year, but at just 4% and 5%, they’re badly lagging the market.
I’ve seen it before. That underperformance is a sign of things to come. When leveraged loans tip over, these two will be the “short side” moneymakers to have, cashing in with shorts and potentially explosive put options.
Stick with me, and I’ll let you know when the time comes to move.
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