NEW YORK, May 8 (LPC) - US regulators are monitoring how risk in the US$1.2trn leveraged loan market is evolving and its potential impact on the US economy.
Years of low interest rates coupled with increasing demand from investors for floating-rate loans allowed companies to borrow cheaply on looser documents, leading to outcries from Senator Elizabeth Warren, former Federal Reserve (Fed) Chair Janet Yellen and Mark Carney, Governor of the Bank of England.
Warren, a Democrat running for President, wrote to regulators last November asking about their plans to address “growing risks” in the leveraged loan market, comparing the asset class to the pre-2008 subprime mortgage market, which contributed to the financial crisis.
The Fed, the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corp (FDIC) responded to Warren in a February 25 letter that was not issued publicly, acknowledging her concerns about the growth in leveraged lending, which has led to weaker lender protections.
“Agency examiners have observed in some transactions fewer and less stringent protective covenants, more liberal repayment terms, and incremental debt provisions that allow for increased debt that may inhibit deleveraging capacity and dilute repayment to senior secured creditors,” Comptroller of the Currency Joseph Otting, Fed Chair Jerome Powell and FDIC Chair Jelena McWilliams wrote in the letter obtained by LPC.
Banks are expected to have prudent credit underwriting practices and commensurate risk management processes in place, the regulators wrote. Deficient practices that relate to safety and soundness may result in supervisory action.
In 2013, the Fed, OCC and FDIC updated leveraged lending guidance, worried about weakening underwriting standards. They described loans without a full package of lender protections, known as covenants, as aggressive. They also expressed concerns about a company’s leverage, or debt compared to its earnings, of more than 6.0 times. Six years later and terms are even more aggressive.
A record US$923.8bn of US institutional loans was arranged in 2017 followed by US$730.4bn in 2018, according to data compiled by LPC, a unit of Refinitiv. Just US$59bn of institutional loans was arranged in the first three months of 2019, the lowest quarterly volume since the same period in 2016.
Almost 75% of broadly syndicated loans arranged in the first three months of the year were covenant-lite compared to 58.9% of loans arranged in the same period in 2013, according to the data.
Leverage for buyouts rose to 6.96 times in the first quarter, the highest level since the third quarter of 2014, according to LPC data. Leverage was 5.8 times in the first quarter of 2013 when regulators released the guidance.
The Fed said in its latest report on financial stability released May 6 that credit standards for new leveraged loans appear to have deteriorated in the last six months.
Senator Sherrod Brown last month wrote to Steven Mnuchin in his role as Chair of the Financial Stability Oversight Council asking what actions the Council plans to take to “protect the economy from threats in credit and lending markets,” according to the April 11 letter.
While the loan market treated the leveraged lending guidance as a rule, US agencies, including the Fed and the OCC, clarified in September that guidance outlined expectations and agencies will not take enforcement action based on it, opening the market to more aggressive financings.
The regulators stressed in the letter to Warren that because agencies do not take enforcement actions based on supervisory guidance, the banks they oversee cannot violate the guidance.
The OCC assesses leveraged lending activities regularly through the supervisory process and has worked with banks to manage their risks associated with leveraged lending, an OCC spokesperson wrote in an email.
“While bank risk management practices are satisfactory, we continue to see risk accumulate, primarily outside of the regulated banking system where there is much less transparency, making it more difficult to monitor,” the spokesperson wrote. “The OCC has been discussing with bank management and directors the need to consider the potential effect on the financial system from originating and distributing weakly underwritten loans to leveraged borrowers.”
In response to Warren’s November questions, the Securities and Exchange Commission (SEC) responded separately in a January 31 letter noting it has been following the Collateralized Loan Obligation (CLO), loan and high-yield debt markets with “increased attention” since the middle of 2018.
The SEC’s office of credit ratings, which examines nationally recognized statistical rating organizations, has identified CLO ratings as a specific topic for review, SEC Chair Jay Clayton wrote in the letter.
CLOs are the largest buyers of leveraged loans and had a record US$128.1bn of US issuance in 2018. But Clayton stressed that the regulator has limited jurisdiction over the CLO market, and even less authority over the origination of the underlying leveraged loans.
Spokespeople for the Fed, SEC and FDIC either declined to comment or didn’t respond to a request for comment. (Reporting by Kristen Haunss. Editing by Michelle Sierra and Lynn Adler)