A U.S. bank regulator is warning about the dangers of banks and alternative asset managers working together to do risky deals and get around rules amid concerns about a possible bubble in junk-rated loans to companies.
The Office of the Comptroller of the Currency has already told banks to avoid some of the riskiest junk loans to companies, but is alarmed that banks may still do such deals by sharing some of the risk with asset managers.
"We do not see any benefit to banks working with alternative asset managers or shadow banks to skirt the regulation and continue to have weak deals flooding markets," said Martin Pfinsgraff, senior deputy comptroller for large bank supervision at the OCC, in a statement in response to questions from Reuters.
Among the investors in alternative asset managers are pension funds that have funding issues of their own, he said.
"Transferring future losses from banks to pension funds does not aid long-term financial stability for the U.S. economy," he added.
The breadth of the statement from the OCC is unusual because it technically oversees banks and not asset managers.
Regulators are eyeing a number of risks to the financial system as they aim to prevent a repeat of the mortgage bubble that spurred the 2008-2009 financial crisis. They are not comfortable with different players sharing risk if the total level of risk in the system is getting dangerously high.
That may be happening with leveraged loan issuance, which hit a record $1.14 trillion in the U.S. in 2013, up 72 percent from the year before, according to Thomson Reuters Loan Pricing Corp (LPC).
A measure of the riskiness of these loans has also been rising - the average size of the debt for companies taking these loans in 2013 was 6.21 times a form of cash flow known as EBITDA or earnings before interest, tax, depreciation and amortization, up from 5.86 times in 2012 and the highest since 2007, LPC said.
The OCC's comments show how emboldened regulators now feel as they seek to curb threats to the financial system. Under the 2010 Dodd-Frank financial reform bill, the OCC, the Federal Reserve and the Federal Deposit Insurance Corporation are among the regulators that belong to the Financial Stability Oversight Council, which is charged with finding and stopping potential sources of financial crashes.
It remains to be seen what tools bank regulators belonging to FSOC can use when dealing with non-banks.
Meredith Coffey, executive vice president of the Loan Syndications and Trading Association (LSTA), which counts alternative asset managers among its members, declined to comment on the role of the alternative asset managers in leveraged finance.
No major asset manager would comment for this story. Some alternative asset managers carrying out private equity deals, including Blackstone Group LP, Apollo Global Management LLC, KKR & Co LP, Ares Management LLC and Carlyle Group LP, have credit investment arms and business development companies that have been financing leveraged buyouts as banks pass on some of the deals.
The OCC, Fed, and the FDIC issued guidelines to banks last year to limit their risk-taking for leveraged loans. But regulators are no more sanguine with asset managers taking on this risk given their investors include underfunded public pension plans. They are also worried about the growth of the so-called shadow banking sector, which includes non-bank lenders such as hedge funds and money market funds.
Officials at the Federal Reserve and the FDIC declined to comment.
THE JUNKIEST JUNK
Regulators are most alarmed about leveraged loans to companies with the poorest credit quality. Many of the loans helped to finance buyouts and to fund payouts to private equity firms in the form of dividends.
The regulators' guidelines to banks last year called for borrowing companies to be able to pay down all of their senior debt in five to seven years, or to be able repay half of their total debt in a similar time frame. These have been followed up by individual letters to some lenders.
Debt levels where total borrowings are more than six times EBITDA, after asset sales, may also be viewed as problematic, regulators said.
As a result, banks appear to be paying some heed to regulators' warnings, and are becoming increasingly selective about which highly-leveraged U.S. company loans they are willing to underwrite.
That's where asset managers believe they have an opportunity. Besides doing deals that banks turn down, alternative asset managers have been exploring ways to team up with banks to share risk on the deals, including ways for the funds to be the first to take losses if the loans head south.
And the vast majority of deals that alternative asset managers help finance are in the so-called middle market, typically involving companies with revenue of less than $1 billion. But many of the credit funds have aspirations to do bigger deals.
Some bigger deals are getting done now. For example, when buyout firm Sycamore Partners agreed to buy apparel retailer Jones Group Inc in November for $1.2 billion, KKR's credit investment arm committed 70 million pounds ($116 million) in debt and $60 million in equity financing for the deal, according to a regulatory filing.
(Reporting by Greg Roumeliotis; Editing by Dan Wilchins, Martin Howell and Eric Walsh)