NEW YORK, March 15 (LPC) - The US leveraged loan market is unlikely to see a renewed regulatory crackdown despite mounting criticism of the asset class, as political gridlock in a divided Congress would hold up reform attempts.
Federal Reserve (Fed) Chair Jerome Powell said in late February that the US$1.2trn leveraged loan market does not pose a risk to the broader economy, but is an important supervisory focus. His comments contrast with other regulators who compared loans to subprime mortgages, which were responsible for the 2008 economic crisis.
His predecessor, former Fed Chair Janet Yellen, took a tougher line in late February, when she warned about the potential economic perils of excess corporate debt in leveraged loans for the second time.
“If the economy encounters a downturn, we could see a good deal of corporate distress,” Yellen said at an industry conference in Las Vegas. “If corporations are in distress, they fire workers and cut back on investment spending. And I think that’s something that could make the next recession a deeper recession.”
Yellen’s comments follow earlier warnings by Senator Elizabeth Warren and Bank of England Governor Mark Carney, who both warned of a potentially negative economic impact.
US regulators in 2013 updated Leveraged Lending Guidance (LLG), which said leverage of more than six times “raises concerns.” The Republican administration promised deregulation, however, and President Donald Trump vowed to dismantle the sweeping 2010 Dodd-Frank regulatory reform package after his election in 2016.
Market participants thought that the LLG could be relaxed in 2017 when it was deemed a rule under the Congressional Review Act. Government agencies clarified in September 2018 that guidance does not carry the weight of law and they will not take enforcement action based on it.
Leverage levels are touching new highs as a result, and are averaging 6.9 times in 2019 so far, after dropping to 6.09 times in a volatile fourth quarter, according to LPC data. Leverage ratios hit a record 6.97 times in the third quarter.
“One would say (the leveraged lending guidance) has had an insufficient effect,” said J. Paul Forrester, a partner at law firm Mayer Brown.
“There has been a sharp uptick in leverage, which is odd when loan funds had money exiting and there has been concerns expressed about a slowdown and possible recession,” he said. “None of it has seemed to curb (aggressive) lending. I find that striking in the absence of more bullish economic news.”
Although regulators have the authority to propose a rule on leveraged lending, they are unlikely to do so, according to Lee Reiners, executive director of the Global Financial Markets Center at Duke Law School and a former examiner at the Federal Reserve Bank of New York.
“Do they have the political will or desire?,” he asked. “It seems unlikely (in the) broader deregulatory environment and (a) slowdown in economic growth.”
The Office of the Comptroller of the Currency (OCC) has been working with the Fed and the Federal Deposit Insurance Corp, and has the power to take steps if it has concerns about loan underwriting quality, if necessary.
“We do compare notes in terms of what we see in the leveraged lending space in the regulated institutions, and then we also certainly talk about and work with each other on examinations of leveraged lending activities,” said Morris Morgan, chief operating officer at the OCC.
When the agency sees a weakness, either in the way Ebitda is calculated or covenants that it deems “problematic,” it addresses them with each institution, and will continue to address issues that way going forward, he said.
“The only way really to be more restrictive than looking at the facts and circumstances of every institution would be to write a rule, and I don’t see writing a rule to be in the near term future,” Morgan said.
A Fed spokesperson declined to comment.
The rapid growth of non-bank lenders and their potential contribution to systemic risk is also worrying regulators as they have less reach in the ‘shadow banking’ market, which has grown at breakneck speed after banks pulled back during the credit crisis.
Morgan said the question that has arisen is how do banks’ determine whether the appetite for credit risk is more than the market can bear at this late point in the credit cycle, due to reduced transparency in the shadow banking sector.
“That is what would ultimately be the real systemic risk is that you exceed the capacity of the market,” he said. “In my opinion that is the US$64,000 question and it’s one that is difficult to answer but we keep probing on that.”
The US leveraged loan market almost doubled in size in the last five years to US$1.2trn as investors bought floating-rate loans to hedge against rising interest rates, buttressed by the issuance of Collateralized Loan Obligation (CLO) funds, the biggest buyers of loans, which hit a record US$128.1bn of volume in 2018.
Low default rates – 1.75% at the end of 2018, according to Fitch Ratings – and a strong performance by CLOs have historically supported the asset class, but the massive influx of cash has allowed borrowers to strip away lender protection and produce aggressive terms that have caught regulators’ and legislators’ attention.
US secondary loan prices fell 4% in a volatile fourth quarter and investors pulled US$20.1bn from loan mutual and exchange-traded funds during that period, in the largest quarterly outflow ever, according to Lipper.
Critics point to the increasing number of ‘covenant-lite’ loans that continue to be issued without full lender protections and higher leverage levels in 2019 as signs of a disturbingly hot market after the recent outflow of liquidity, but the Loan Syndications and Trading Association (LSTA) is trying to rebut conclusions about the asset class that it sees as “erroneous.”
“From our vantage point – we’re trying to engage constructively on both sides of aisle to talk about and differentiate between credit risk and systemic risk,” said Meredith Coffey, executive vice president of research and regulation at the LSTA.
“Leverage has increased and credit risk is higher than 2010, but we see loan systemic risk as substantially lower than in 2007 and moreover don’t see loans as a systemic risk,” she added.