U.S. leveraged loans take five-year regulatory round trip

NEW YORK (LPC) - The US leveraged loan market has nearly doubled in size in the last five years to a US$1trn asset class from a small private market despite feeling the full weight of regulatory pressure in the aftermath of the credit crisis, and is poised to set new records as regulation is rolled back.

Agencies have dictated everything from the way financings should be structured to the type of investments portfolio managers can buy in the five years since revised Leveraged Lending Guidance was introduced in 2013, but a softer regulatory touch could take the asset class to new highs.

President Donald Trump has promised to dismantle the massive 2010 Dodd-Frank bill, which was introduced under President Barack Obama and banned banks from speculating with their own money as well as creating the Consumer Financial Protection Bureau.

With new heads at the regulatory agencies, a Republican majority in Congress and some help from a US Appeals Court, aiding Trump’s plans, an unfettered market could turbocharge US leveraged lending.

“Many of the regulations put in place back in the wake of Dodd-Frank, all of those things were largely reactions to much larger issues than just the loan market – loans got swept up while not being the primary target,” said Elliot Ganz, general counsel at the Loan Syndications and Trading Association (LSTA).

Companies including American Airlines and Four Seasons Hotels rely on the leveraged loan market to back acquisitions and finance their operations. Investors are drawn to the floating debt in a rising-rate environment as they are paid a set coupon over Libor, and yields rise as rates rise. The Federal Reserve (Fed) has increased rates six times since December 2015.

The market has nearly doubled in size, buoyed by breakneck buyside growth including US$117bn of Collateralized Loan Obligation (CLO) fund issuance and US$12.5bn of loan mutual fund inflows in 2017, which comfortably absorbed a record US$923.8bn of US institutional loan issuance, despite the tougher regulatory environment.

The Fed, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp updated leveraged lending guidance in 2013 to say debt compared to earnings before interest, taxes, depreciation and amortization, known as leverage, that exceeds six times “raises concerns,” and that at least 50% of total debt should be able to be repaid within five to seven years.

The result was a pullback in lending by some of the largest banks, which pushed some of the more aggressive financings to institutions that were not subject to the guidance. As regulators cracked down on aggressive lending, they also sought to ensure the soundness of the funds buying the debt.

Dodd-Frank risk-retention rules that aimed to ensure that manager and investor interests were aligned forced CLO managers to hold ‘skin in the game’ by retaining 5% of their fund, a potential non-starter for smaller firms that lacked the required capital.

The Volcker Rule, better known for its ban on prop trading, prohibited banks from investing in CLOs that own bonds, which led the funds to purchase loans only or lose important investors.

Oversight of mutual funds, a retirement account mainstay, also increased. Regulators singled out loans in liquidity risk management rules that were designed to ensure that funds could meet redemption requests during volatility.

Spokespeople for the regulators either declined to comment or could not comment.

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The tide is turning on regulation after years of increasing restrictions and red tape. The Treasury Department said that it has eliminated, reduced or proposed to eliminate more than 300 regulations since Trump took office.

Comptroller of the Currency Joseph Otting said banks have the “right” to do the leveraged lending they want if it does not impair their “safety and soundness,” and Fed Chairman Jerome Powell said that his agency may seek market comment on the guidance. The US Government Accountability Office ruled that it is subject to Congressional review.

Leverage has climbed to 6.39 times for buyouts in the first quarter from 5.85 times in the same period of 2017, according to Thomson Reuters LPC data, as a result, despite warnings from the LSTA that the guidance is still in place.

As regulation disappears or is not enforced as strictly, more competition for aggressive deals will emerge as banks shut out by the guidance get back in the game, said John Fraser, head of Investcorp Credit Management US.

A February legal victory also paved the way for a risk retention-free CLO market after a US court ruled in favor of the LSTA, which sued the Fed and SEC saying the regulation was “arbitrary, capricious” and “an abuse of discretion.”

CLOs may also benefit from the “fresh look” Powell said the Fed is giving the Volcker Rule.

At US$1trn, the US leveraged loan market is among the closest in volume terms that it has ever been to the US$1.1trn US high-yield bond market, according to Bank of America Merrill Lynch. Reducing oversight is opening the door for further growth as banks and investment firms boxed out by regulations return.

But one regulatory legacy remains – the rise of so-called shadow banking, which sits outside of regulators’ reach. The US had a massive US$14.1trn of such assets in 2016, according to the Financial Stability Board.

The critical question of whether markets are safer is hard to answer, according to J. Paul Forrester, a partner at law firm Mayer Brown

“It should be [safer] in that the financial services industry is better capitalized, generally, and there has been a better job of dispersing risk so major systemic problems at banks have probably been reduced,” he said. “But it also pushed a lot of financial activity out of banking and into shadow banking” away from regulators.

(Additional reporting by Lynn Adler.)