While the timing of the next credit downturn is anybody's guess, one thing is certain: The increased prevalence of second-lien debt will inject an unusual degree of contentiousness and confusion in the restructurings and bankruptcies fueled by the inevitable market slump.

The explosion in the second-lien loan market, from issuance of $500 million in 2002 to $12 billion in 2004 and nearly $9 billion through the first six months of 2005, has produced a huge new creditor class with its own idiosyncratic lending practices, players, and intercreditor relationships.

As these loans begin to encounter distress, early indications are that the post-default outcome for second-lien holders is playing out in ways not fully appreciated when the loans were initiated. Moreover, it is becoming apparent that the second-lien loan recovery experience will vary widely, with savvy, proactive holders generally faring better than passive lenders.

Among the elements affecting the recovery experience are the following:

1) Collateral value. Historically, a secured loan was simply a senior bank facility, fully and exclusively secured by a conservative collateral pool. With the advent of the second-lien loan, not only was the concept of a competing claim on a given pool established, but the definition of acceptable collateral was stretched to cover all of a company's residual assets: the more frenzied the issuance of second-lien securities, the more creative the design of their underlying collateral pool and the more abbreviated the lender effort to validate asset quality. Not surprisingly, as defaults begin to arise, the values of many of these marginal assets are proving to be at levels well below those expected at loan origination.

With implications for all parties to a restructuring, the valuation of second-lien loan collateral will undoubtedly spur hotly contested disputes regarding process, methodology and results. "Tranche jumping" alliances between senior and unsecured lenders, mutually interested in depressing the second-lien loan's collateral valuation, may become common. In defense, second-lien holders will have to become early, active participants in the restructuring process, fully prepared to deal with issues such as how to secure a voice in the selection of valuation methodology or whether it makes sense to accept a greater unsecured position if it allows the domination of the unsecured class.

Debtors, meanwhile, will find that second-lien loan asset claims increase the difficulty of the bankruptcy process. Potential impacts range from challenges in obtaining DIP financing because the second- lien has tapped out available collateral, to problems effectuating a plan due to insufficient cash to repay second-lien lenders with super-priority claims covering the post-bankruptcy diminution of their collateral value.

2) Inter-creditor negotiations. The concept of the "silent second", where a second-lien holder dutifully follows the lead of the first when trouble arises, is a linchpin of many inter-creditor agreements. In typical agreements, the first-lien lenders acquire substantial power in the event of borrower distress. Post-default, for example, they can wipe out junior liens by choosing to foreclose on a meager collateral pool; in a bankruptcy situation, they can bring in a DIP lender who reduces, or even wipes out, the second- lien lenders' equity in the collateral pool.

But in the wake of some actual second-lien loan restructurings, the notion of the silent second appears to be evaporating. First, when default becomes a reality, the glaring divergence of first and second-lien interests has driven second-lien holders to fight for their rights, even those they'd previously relinquished. Second, it is becoming abundantly clear that typical inter-creditor agreements inadequately address the highly technical and specialized aspects of bankruptcy.

The interplay of these developments is strongly influencing the ultimate recoveries of second-lien lenders and of other stakeholders as well. For example, second-lien lenders' waiving of bankruptcy rights for the benefit of the first-lien lender, a key tenet of many inter-creditor agreements, has been held by some courts to be unenforceable. That aside, given the scantiness of collateral coverage, second-lien holders are aggressively using the legal system to improve their recovery outcomes post-default, pushing for in or out-of court action to prevent further dissipation of their collateral value or using their ability to hold up a senior lender-proposed asset sale to extract a pound of flesh, even though the value of that collateral didn't support their claim to such proceeds.

Further complicating inter-creditor relations is the rampant claims trading among creditor classes. The concept that you might know who sat above, below, or next to you in a credit, facilitating negotiations in difficult times, will be mere myth in many of these second-lien situations. Even within the second-lien class itself, trading may produce some unpleasant surprises. Second-lien lenders may arrive at a default only to discover their compatriot holders also own big chunks of the senior secured loan and, by the way, their strategy for maximizing recovery just might mean sacrificing a little on their second-lien position for the sake of improving their first-lien recovery.

3) The participants. Hedge funds have dominated the demand side of the second-lien loan market in recent years. Some of them are highly experienced distressed players, likely to take full advantage of their rights vis-a-vis senior and subordinate claims. Others, though, have little experience with troubled credits, let alone the bankruptcy arena. Inevitably, the aggressiveness of the experienced players, and/or the confusion of the novices, in concert with the pure novelty of dealing with second-lien credits, is likely to have a substantial [negative] impact on the pace and conduct of restructurings.

While the story of the second-lien loan recovery experience is yet to be fully written, it is clear that there are complications arising from such loans in distress that justify before-the-fact analysis by the lenders themselves, as well as competing claims holders, borrowers and interested professionals. The smarter of these will work now to develop their post-default strategies, for if anything was learned from the credit meltdowns of the early nineties and 2001-2002, the day of reckoning for second-lien loans may, in fact, be just around the corner.

(Opinions expressed are those of the author or authors, not of Dow Jones Newsletters.)

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