Seriously, how dumb does the Wall Street Journal think its readers are? Or does the abject lameness and stenography-taking manifested in its lead story, Wall Street Intensifies Scrutiny of Fraud After Spate of Loan Losses, instead reflect lack of competence on its reporting staff?
Now admittedly this piece is fuzzy on timing, which again may reflect, erm, artful drafting or lack of attentiveness. But it reads as intended to reassure investors about loan standards. Indeed, the industry is going through one of those periodic Come to Jesus1 moments when it gets serious about loan standards after a string of losses and even resulting crises.
But getting religion now does nothing to cure past sins. And they are legion.
The elephant in the room, which this article ignores, is the wide-spread practice of making “cov-lite” loans, as in ones with minimal or even no covenants. Particularly with risky borrowers, sound practice requires imposing covenants, as in post-loan issuance requirements, such as keeping certain minimum net worth, asset and interest coverage levels, and financial disclosures. Mind you, the last time I read covenants was in the 1980s, when they were taken seriously. Then, breaching covenants gave the lenders the right to accelerate the loan, as in demand all future interest and principal payments immediately.2 That would result in bankruptcy in pretty much all cases. But that threat is a potent weapon, allowing lenders to demand more information, force a restructuring if they find real problems, and perhaps also replace key top executives.
Needless to say, cov-lite lending become widespread when memories of past excesses fade and investors are reaching for returns, meaning too much demand for higher-yield paper gives borrowers more power than they ought to have. The protracted post-crisis period of negative real interest rates was destined to drive investors into riskier assets. We’ve been linking to mentions of cov-lite lending for years. There was no point then in inveighing against it since lenders could not be protected from their greed.
A quick search shows how long this sort of thing has been going on. Some examples from a search with a date range of 2010 to 2020:
The reemergence of cov-lite loans Financial Times
‘Cov-lite’ loans soar in dash for yield
Financial Times, 2013Leveraged loans are way past “cov-lite” Financial Times, 2018
Cov-lite loans: the new normal, but at what cost? Hermes [highly regarded UK pension fund manager], 2019
This tweet gives an idea of the extent and implications of this practice.
Cov-lite loans, now 75% of private equity backed rated borrowers, gut essential financial oversight by ditching quarterly tests & meaningful covenants. Caveat Emptor for this obliterates early warning systems, letting PE firms plunder unchecked, prioritizing their profits over… pic.twitter.com/jLWJxjp1Rj
— John E. Montana (@JohnEMontana) September 24, 2025
A sign that risk tolerance has reached dangerous levels was industry publications describing the revival of payment-in-kind loans. These are one that rather than pay all or any of the interest due in cash, that amount is added to the principal balance. The last time these were common was in the very last phase of the leveraged buyout boom, from 1987 to 1989. Asset manager TCW applies porcine maquillage in The Big PIK-ture:
As a form of interest payment where interest is accrued by increasing the loan principal rather than paid in cash, PIK interest represents a nuanced tool within credit markets, particularly in the middle market private credit space…..
Any private credit manager would agree: first lien senior secured lenders1 seldom prefer PIK interest as their primary form of interest payment. Cash interest payments provide immediate income and liquidity that are critical for many investors, particularly those focused on current income. Therefore, an increase in PIK interest – whether at the individual borrower level or across a portfolio – should prompt a thorough review of underlying credit fundamentals.
The primary driver behind the recent growth in PIK interest has been the rapid normalization of interest rates. From 2022 through 2024, SOFR2 (Secured Overnight Financing Rate) rose sharply from near zero to a high of approximately 5.5%. (See Figure 1.) Since most middle market borrowers generally have floating-rate senior secured loans priced as a fixed spread over one- or three-month SOFR, this translated into a significant increase in cash interest expense owed by middle market borrowers. Since the end of the Global Financial Crisis (GFC), many capital structures were constructed under the assumption of a persistently low interest rate environment, often near zero, and most borrowers and lenders didn’t anticipate such a rapid and sustained increase.
As a result, borrowers with highly leveraged balance sheets faced increased debt service burdens that the underlying businesses were unable to sustain with free cash flow generation alone. In some cases, this led to liquidity crises, where cash flow generation from business operations was insufficient to meet scheduled principal and cash interest payments. Converting some, or all, cash interest to PIK allows borrowers to defer cash outflows, preserving liquidity to maintain operations, invest in growth, or execute turnaround plans. For lenders, PIK accrual increases the principal balance, preserving lenders’ contractual economics and potentially enhancing lenders’ recovery. PIK clearly isn’t the first choice for lenders and can be potentially value destroying for equity investors as well.
Translation: even though the Fed has signaled since before the 2014 Taper Tantrum that it wanted to normalize interest rates, investors acted as it that was na ga happen on their watch. So lenders chose to allow stressed borrowers to pretend to stay current by allowing payment in kind.
An alert reader might have said earlier, if these bad practices are so long standing, why have there not been more blow-ups? The PIK example shows that investors (as in actual fund investors not the fund manager) are being sold out to preserve the fiction that borrowers would not have defaulted. Other factors:
One is that even though loan terms became more permissive, that does not necessarily mean all caution was thrown to the winds in terms of who got loans. There presumably was generally not-bad borrower due diligence before credit was extended.
Second is that in a low interest rate environment with too much competition among lenders, some (many? most?) stressed borrowers could likely have refinanced before they got in real trouble.
Third is that there has been a ton of stimulus, benefitting corporations more than individuals, which also would generally keep bad outcomes at bay. In the US, Covid relief was particularly business-friendly. Biden and Trump post Covid have kept up large fiscal deficits.
So with this background, it’s easier to see the Journal parroting fund manager sleight-of-hand. The first part of this con is to depict the recent blow ups as the result of fraud, as opposed to long-standing lax lending standards resulting in a predictable crunch as the economy weakens and interest rates rise. Second is the pretense that lenders can do anything about outstanding loans. They can’t suddenly demand that borrowers make more disclosures than their credit agreements stipulated. These debtors are nearly all private companies, so transparency is limited. Even if they hire the business analogue to private investigators, such as so-called channel checkers like Gerson Lerhman to get a better grip on company performance, what do they do if they find something amiss? Absent an actual covenant breach, they can’t deploy the big hammer of payment acceleration.
A string of alleged frauds by corporate borrowers is spurring a reckoning across Wall Street, sending bankers and investors scrambling to prevent future blowups.
Lenders are increasing due diligence and demanding a longer history of financial data from companies. Some are inserting conditions that permit them to do more frequent checkups before agreeing to make loans. A group of the biggest names in banking, investment management and accounting have formed a task force that will take a deeper look at the nature of the problem and how to protect investors.
The frauds that have emerged so far, which involve small to midsize companies in sectors such as autos and telecommunications, haven’t sparked widespread trouble in the market or economy. But they have generated fallout for both regional banks and Wall Street giants such as JPMorgan Chase and BlackRock, and the string of revelations has made it harder to dismiss any one case as an isolated event.
Consistent with the headline, and the notably frequent use of the “f” word, lenders are supposed victims, as opposed to perps who handed out money on overly generous terms. Even though the first line does make the “alleged fraud” concession, the entire piece is framed around the idea that the only hazard is fraud, as opposed to marginal-at-best borrowers hitting the wall as the economy deteriorates.
One does not have to look hard to find more balanced reporting. Bloomberg does focus on the fraud aspect in Credit Fraud Fears Loom After BlackRock’s HPS Zeros Out Bad Loan, if nothing else because BlackRock stuffed up so badly.
But a few days ago, Bloomberg also warned of how more and more borrowers can’t service their debt in The Ranks of Corporate Zombies Are Growing. Key sections:
The tally of “zombie companies” in the US that aren’t earning enough to cover their interest expenses stands at the highest since early 2022, with almost 100 gaining the designation in October. The main reason: Companies that gorged on debt at near-zero interest rates in the pandemic era have since been hurt by tariffs and higher funding costs.
The odds of getting much relief on either front aren’t improving, with the US signing trade deals that lock in some of the higher tariffs and the Federal Reserve signaling that it might not continue to cut rates at its December meeting. Zombies will have to take steps to fix their balance sheets, such as boosting earnings or arranging costly new financing, or potentially face default.
It won’t be easy. “Even if the Fed were continuing with cuts, the borrowing costs for small companies, zombie companies, are still multiples higher than historic averages,” said Liz Ann Sonders, chief investment strategist at Charles Schwab. “A lot of these companies were barely scraping by at zero rates.”
Read that last sentence again. It is a terse indictment of the lending practices that are producing the current crunch.
The UK’s This Is Money makes clear that the idea of taking comfort from the ideas that the distressed companies are mainly small and midsized. Remember the banks in the US savings and loan crisis individually were way below too big to fail status, yet collectively presented a systemic risk. From Lenders urged to come clean over loans to so-called ‘shadow banks’ on November 2:
Some of Britain’s biggest lenders have been accused of failing to come clean about the full extent of loans to so-called ‘shadow banks’ as fears grow that a recent spate of corporate collapses in the US could trigger another global financial crisis.
HSBC and Barclays were among big European banks accused of ‘very poor disclosure’ over how much money they have lent to this opaque part of the financial system, also known as the ‘non-bank’ lending market.
Bank of England Governor Andrew Bailey has warned that ‘alarm bells’ are ringing after the collapse of sub-prime vehicle finance provider Tricolor and another US firm, car parts maker First Brands, earlier this year….
Shadow banks have become a vital source of funding for consumers and firms as big name lenders have retreated from riskier funding deals since the 2008 financial crisis.
They promise higher returns for investors than the big banks, but lack transparency and are unregulated, meaning they don’t have to disclose financial details.
Mainstream banks are exposed to this risk too as they lend direct to the shadow banks.
A risky form of this lending, known as ‘private debt’, has expanded rapidly in recent years and is set to account for £2.1 trillion of all lending in 2029, up from £1.2 trillion last year….
…it [Barclays] declined to say how much it had lent to non-depository financial institutions (NDFIs) – a broader group of non-banks that include insurers, pension providers, private equity groups and hedge funds.
NDFIs provide services similar to those of traditional banks but crucially do not take deposits from the general public and are not regulated as lenders.
In a recent note, credit ratings agency Fitch warned that lending by these non-banks, while still niche, was becoming increasingly complex, meaning ‘a financial shock event could reveal unexpected transmission channels’ to the wider system.
It risks creating a domino effect similar to the 2008 crash when a collapse in the US mortgage market spread to other parts of the banking sector through a web of interlocking deals and financial products.
Mind you, this picture does not contain much evidence of the leverage on leverage which enabled the 2008 credit crunch to threaten to destroy the financial system. In January 2007, we cited Gillian Tett at the Financial Times describing the astonishing gearing driving the so-called “wall of liquidity.”
But the flip side is the unwind of the massive Japanese real estate/stock market bubbles didn’t feature big blowups until 1997, years into its protracted zombification, due to the authorities loosening up a bit on the assumption recovery was starting to take hold just before the Asian crisis hit. So a gut-wrenching market upheaval is not necessary to have seriously bad debt overhang outcomes.
Nevertheless, things are set to get worse before they get better. So take precautions if you can.
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1 I heard this expression often from a terrific Jewish lawyer.
2 Obviously there is A Process. I do not recall what percentage of lenders is required to notify a bond trustee (and I assume these lenders have a similar party in the mix) to trigger the process, or mere documentation of a breach by any lender suffices. I assume there is a notice process, and that the borrower is also given a limited amount of time in which to cure the breach.
Another great post. Yes, the ‘f’ word is being bandied about by the increasing number of lenders being caught up in the Big Credit Squeezola. And now we have the ‘z’ word surfacing in a number of places. This ( Private capital zombie firms will pile up in next decade, says EQT chief ) from the FT two days ago. The mainstream financial press is nothing if not derivative. The zombie talk is entirely too charitable.
Here we have private equity, or private credit if you will, engaging in a dictionary of extend and pretend…secondaries, PIK, cove-lite and the latest genius move…tertiaries. As you might expect tertiary investors are intended to, (indeed required) to pay off the secondary investors clamoring for their payday. Perhaps we need a new word to define this Mulligan stew of bad investment. How about the ‘p’ word. Nah! Ponzi would never appear on the paragon pages of Bloomberg or the Financial Times.