UPDATE 1-Leveraged loan credit risk warrants attention, regulators testify

(Adds regulator answers from Congressional hearing)

NEW YORK, May 15 (LPC) - The US leveraged loan market is a specific credit risk that warrants attention as companies continue to layer on increasing amounts of debt, regulators told lawmakers at a Congressional hearing Wednesday.

Companies are borrowing high levels of debt compared to their earnings, with few lender protections and more liberal repayment terms, which needs to be watched, Comptroller of the Currency Joseph Otting said in written testimony submitted to the Senate Committee on Banking, Housing and Urban Affairs.

But despite more aggressive lending terms, recent supervisory assessments show banks regulated by the Office of the Comptroller of the Currency (OCC) have satisfactory risk management practices for leveraged lending, according to Otting’s written testimony.

The OCC will continue to asses these institutions’ management of lending risks, but he attributed a more balanced risk management approach to leveraged lending guidance issued in 2013.

The OCC, Federal Reserve (Fed) and Federal Deposit Insurance Corp (FDIC) updated lending guidance, worried about weakening underwriting standards. They described loans without a full package of covenants as aggressive and expressed concerns about leverage of more than 6.0 times.

Six years later and debt compared to earnings at companies has soared with leverage for buyouts rising to an average of 6.96 times in the first quarter, up from 5.8 times in the first quarter of 2013 when regulators released the guidance, according to LPC data.

At the same time, almost 75% of broadly syndicated loans arranged in the first three months of the year were covenant-lite compared to 58.9% of loans issued in the same period in 2013, according to the data.

The aggressive terms have drawn the ire of Senator Elizabeth Warren, former Fed Chair Janet Yellen and Governor of the Bank of England Mark Carney who have all criticized the asset class, which has doubled in size to US$1.2trn since the credit crisis as years of low interest rates coupled with increasing demand from investors for floating-rate loans led to frothy market conditions.

“We continue to monitor how this combination of risks is evolving and to assess the adequacy of bank risk management and controls,” Otting said in the prepared testimony.

FDIC Chair Jelena McWilliams also expressed concerns about leveraged lending in her prepared testimony for Wednesday’s hearing on the oversight of financial regulators.

The FDIC is carefully monitoring the market because a significant rise in leveraged loan defaults could have broader economic impacts that affect both bank and non-bank sponsors of leveraged loans, she said in her testimony. It is also tracking growth in lending as well as concentrations of exposure at financial institutions and their underwriting standards.

Regulators will continue to perform semi-annual interagency assessments of loan underwriting standards known as the Shared National Credit (SNC) reviews, Otting said in his testimony. In the most recent review cycle, regulators said in January that leveraged loan risk remained elevated even as risk in the overall portfolio of large syndicated bank loans had improved.

When asked during the hearing by Senator Sherrod Brown about leveraged lending risk, Randal Quarles, vice chair for supervision at the Fed, said the regulator has done a lot of work on the asset class.

“We are concerned, and appropriately so, about what is the right regulatory response to developments in the underwriting of leveraged loans that could affect a business downturn in the future,” Quarles told Brown.

In the last SNC “we looked at leveraged lending underwriting practices and identified a number where we felt there needed to be improvement and we examined the banks and made clear to the banks that those improvements would be appropriate.”

But he noted that Fed analysis shows that a sudden repricing of the leveraged loan asset class would not have an amplifying or destablizing effect on the financial system.

The Financial Stability Board (FSB) is also looking at where Collateralized Loan Obligations (CLOs), the largest buyers of leveraged loans, are held around the globe, Quarles, who serves as FSB chair, said. The FSB plans to release its findings by the end of the year.

Otting’s testimony echos the response he, McWilliams and Fed Chair Jerome Powell wrote in a February 25 letter to Warren, a Democrat running for President, who asked regulators last November about their plans to address risks in the leveraged loan asset class.

The regulatory heads acknowledged her concerns about the growth of the market, and resulting weaker lender protections, and said banks are expected to have prudent underwriting practices in place, according to the letter obtained by LPC. Deficient practices that relate to safety and soundness, they wrote, may result in supervisory action. (Reporting by Kristen Haunss. Editing by Michelle Sierra and Jon Methven)