“Be consistently indebted to someone, so that there is always someone to pray for you, [. . .] fearing, if luck turns against you, that it might be his chance to not be paid by you.” — François Rabelais, Gargantua and Pantagruel, Book III
Experts all over the world are discussing what should be done with the enormous public debt that has accumulated since the global financial crisis (GFC) and during the pandemic. Some extreme suggestions include calling for central banks, which are currently engaged in fiscal quantitative easing by monetizing government debt, to cancel their holdings altogether.
The proponents of modern monetary theory argue that increasing national debt has no consequences, while their opponents predict an inevitable US default. Others emphasize the benefits of transforming the existing debt stock into perpetual sovereign bonds. For example, France has created a special-purpose vehicle to hold its “covidette” until it figures out how to achieve this goal.
The Historical Background
If governments that are facing chronic financial pressures choose the “perpetuity” option, they could learn from the private sector’s approach.
In the early 2000s, corporate loans were structured in a rigid manner. They had a specific maturity, a predetermined repayment schedule for amortizable facilities, a set margin for loans based on LIBOR or EURIBOR, or a fixed cash coupon for bonds.
Loans had strict covenants, with a designated buffer known as headroom, established above a coverage ratio to act as an early warning system for covenant breaches.
In the event of a likely breach, the borrower was obligated to inform the lenders, and the terms would be renegotiated only with the lenders’ consent.
Finally, loans were fully repaid upon maturity or in the event of a corporate event, triggering a “change of control” clause.
Evolution of Debt Obligations
As is often the case in financial markets, loan structures evolved gradually, leading to a complete transformation of debt products.
Credit has become the primary source of capital in recent decades, and as financial risks increased, so did the frequency of restructurings. Even during the boom years of the early 2000s, numerous distressed businesses required recapitalizations or amend and extend procedures.
For example, in 2004, Donald Trump, the future US president, managed to save one of his resorts by reducing the debt and extending the repayment period. Similar practices were adopted in the mortgage market, where loans were offered with minimal due diligence, such as the infamous NINJA loans.
Corporate borrowers benefited from looser contractual terms. Standstill agreements, in which lenders agreed not to take action in the event of a covenant breach, became common.
Another significant development was the rise of covenant-light loans, which gained popularity in 2006 and 2007. These loans provided borrowers with more flexibility in managing their operations but limited creditors’ options during loan defaults.
Dealing with Cash Flow Shortfalls
An additional trend in the pre-2008 private markets was the introduction of payment-in-kind (PIK) bonds. These bonds reduced immediate cash demands by converting coupon payments into non-cash items. Interest accrued and was repaid together with the principal upon maturity.
Managing liquidity became crucial during the 2004-2007 credit bubble. Scheduled coupon redemptions hampered dividend distributions.
PIK notes became attractive due to their ability to free up cash, allowing early dividend distribution. These notes also provided fund managers with higher investment returns due to the time value of money.
Another common feature in loan packages was the elimination of amortizable tranches. Leveraged transactions increasingly included non-amortizable “bullet” loans, reducing cash requirements.
Private equity (PE) owners also utilized “equity cures” to address covenant breaches. These involved injecting more equity into troubled portfolio companies. The use of equity cures increased significantly during economic downturns. For example, in 2008, 46% of covenant breaches were cured by fresh equity injections, compared to one-third the previous year and one-fifth in 2006.
Flexible loan agreements became more prevalent, as exemplified by the failure of the EMI buyout. By the time the music publisher went bankrupt in 2011, its PE-backer Terra Firma had spent substantial amounts curing breaches of EMI’s net debt-to-EBITDA ratio. However, these agreements proved ineffective in preventing the ultimate collapse of EMI.
Creative Solutions to Financial Challenges
During the financial crisis, many heavily indebted companies faced significant challenges. However, financial sponsors learned from this experience and sought to remove obstacles to their trade. Over the past decade, they have demonstrated their negotiating power with lenders.
Amend and extend procedures became commonplace, with the main goal of extending the debt maturity wall. Lenders tried to gain control of distressed assets through deeply discounted loan-to-own transactions, but overall, long-term relationships between private equity owners and lenders enabled loans to be rescheduled.
Loan renegotiations were time-consuming and affected returns due to the time value of money. Cov-lite loans, which had disappeared during the Great Recession, were reinstated as soon as possible. In 2013, they represented over half of leveraged loan issuance, and by 2019, they accounted for more than 80% of global originations.
Another significant development after the GFC was the widespread manipulation of earnings metrics. Private equity firms began making fanciful adjustments to earnings before interest, taxes, depreciation, and amortization (EBITDA) to avoid covenant breaches without injecting fresh equity. This practice became popular after 2014.
Transferable Debt
All these tools, such as amend and extend procedures, loose covenants, equity cures, bullet and PIK loans, and earnings adjustments, have shifted costs and risks from borrowers to lenders during the credit crunch and its aftermath. However, they have not completely eliminated the risks associated with permanent leverage.
The ultimate goal for borrowers would be to have the option never to repay their loans or to make debt redemption solely at their discretion, without relying on lenders’ approval. In recent years, this possibility has gradually become a reality. Debt repayment has become increasingly voluntary, with PIK toggle notes dubbed as “pay if you want” loans.
Debt portability, which allows for optional balloon repayments upon maturity, has also gained attention. Companies can be transferred between private equity owners without triggering a “change of control” clause, a critical consideration in the prevalence of secondary buyouts.
Private capital firms, due to their significant role in M&A transactions and credit provision, have managed to impose portability on dividend recapitalizations, even without any change in ownership.
The Role of Central Banks
If borrowers are unable to negotiate portability with lenders to avoid default risk, they can rely on another significant factor in a debt-driven economy.
In August 2002, as the dot-com bubble continued to burst, then-US Federal Reserve chair Alan Greenspan stated that while central bankers cannot identify and prevent asset bubbles, they can intervene to mitigate the aftermath and ease the transition to the next economic expansion. This approach came to be known as the “Greenspan put,” as it implicitly limits the downside risk for investors.
The Federal Reserve demonstrated this doctrine during the global financial crisis, providing significant support to US mortgage holders. The Fed purchased $1.3 trillion worth of mortgage-backed securities issued by Fannie Mae and Freddie Mac between November 2008 and March 2010.
The implicit guarantee that borrowers will be relieved of their debt obligations in times of trouble has created a significant moral hazard across the financial system. If personal default or bankruptcy is no longer a possibility, individuals and corporations are encouraged to accumulate debt without restraint in this “buy now, pay later” world.
Thus, the concept of the Greenspan put has been passed down to subsequent Federal Reserve chairs, including Ben Bernanke and Jerome Powell. Central bankers are actively supporting asset prices and acting as a backstop for the financial system.
Sustainable Debt or Perpetual Debt?
Herbert Stein, former chairperson of the Council of Economic Advisors, once said, “If something cannot go on forever, it will stop,” referring to the nation’s balance of payments deficit. However, when it comes to government debt, we may have reached the point of no return.
Even before the pandemic, the total unfunded government liabilities in the United States, including pension entitlements, social benefits, and Medicare, had exceeded $200 trillion. Without a significant debt cancellation through a modern Jubilee law, extreme leverage is here to stay.
Non-perishable loans with never-ending commitments are already prevalent in the corporate world. Borrowers can usually find a creditor willing to amend the terms for a fee. Non-covenanted, portable loans with perpetual commitments are essentially perpetual in all but name.
If governments desire the perpetual right never to redeem their sovereign debt, they could follow the private sector’s example. By converting their long-term liabilities into perpetuities, they could issue 100-year bonds with low or negative yields. However, it is essential to note that these bonds would lack a binding repayment obligation, challenging the traditional definition of a bond.
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All opinions expressed in this article are solely those of the author and should not be interpretated as investment advice. The views and opinions expressed do not necessarily reflect the official policy or position of CFA Institute or the author’s employer.
Image credit: ©Getty Images / Yamgata Sohjiroh / EyeEm
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