November 21, 2014 / 6:31 PM / 3 years ago

Confusion over leveraged loans despite regulators' insight

NEW YORK (Reuters) - Regulators’ attempts to clarify U.S. leveraged lending guidelines have answered some questions raised by banks, but also added fresh layers of complexity into loan underwriting decisions, banking sources said.

A Wall St. sign is seen in New York's financial district September 16, 2008. REUTERS/Lucas Jackson

Banks have been trying to stick to U.S. leveraged lending guidelines since March 2013, using a process of trial and error that erred on the side of lenience and attracted regulators’ ire and closer scrutiny.

The guidelines, which aim to curb risky loans to lower rated companies, categorize loans as ‘criticized’ or ‘special mention’ if companies cannot amortize or repay all senior debt from free cashflow, or half of its total debt, in five to seven years.

Leverage over six times debt to Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA) is also seen as problematic.

Three U.S. regulators - The Federal Reserve, Office of the Comptroller of the Currency and Federal Deposit Insurance Corp - issued 26 Frequently Asked Questions (FAQs) on Nov. 7 in an effort to answer banks’ questions.

The FAQs were released alongside the Shared National Credit review, which showed that leveraged loans accounted for about three-quarters of criticized assets. Fifty-four percent of new loans with leverage of more than six times debt to EBITDA were criticized.

While the FAQs provided some clarity around refinancing and safety and soundness expectations for banks, they leave some key areas open to interpretation for underwriters of the high-risk debt and warn of more frequent reviews, industry experts said.

“The overall tone is still pretty clearly critical, and the regulators remain unhappy with ongoing origination excesses,” said Paul Forrester, partner at Mayer Brown.

A drop in new leveraged loan issuance at the end of the year, attributed to October’s global markets volatility and a recent focus on high-grade acquisition deals, is making it hard to gauge how banks are interpreting regulators’ latest responses.

It is difficult to see whether banks are altering their underwriting practices or passing riskier deals to unregulated non-bank lenders as the cost of compliance soars. Bankers are not commenting on whether the FAQ’s have provided the clarity they need.

While the regulators clarified that refinancings can comply with the guidance - a major source of uncertainty before the FAQs were issued - the conditions are more restrictive than many expected, which still leaves it unclear whether banks are able to underwrite these loans.

Refinancing or modifying special mention or criticized loans must improve the underlying credit, using measures other than just cutting interest margins and extending maturities, according to the FAQs.

Regulators still clearly do not want banks originating special mention loans, said Meredith Coffey, Loan Syndications and Trading Association executive vice president.

“Banks we have spoken with said they have heard this message loud and clear,” Coffey said.

The hot spot appears to be special mention deals that are structured as covenant-lite loans for private equity-owned companies, she said.

Although many of these companies and loans are performing well, banks may not be allowed to refinance unless they tighten up loan terms, such as adding collateral or covenants.

“Sponsors may not submit to this happily, particularly if the loan is performing perfectly well, so folks aren’t sure exactly what happens when it’s time to refinance,” Coffey said.

“Do the companies all go to non-bank originators? Do the companies just choose to do bonds? Do the companies accept tighter terms even though the loans are performing? It’s really not clear how this will play out.”

PLENTY OF DETERMINATION

Other areas where regulators have offered some clarity but have left wiggle room include leverage ratios and repayment parameters.

Leverage of more than six times companies’ annual Ebitda will still raise concerns and may get added scrutiny, the regulators said. But it is not a “bright line.”

Companies that are unable to amortize or repay all senior debt or half of total debt in five to seven years will not automatically get a “non-pass” rating.

“The agencies seem to indicate that they understand some of these nuances. Even so, it’s clear that there are other companies for which an arranger will not be able to meet the guidelines and we need to come up with a special way to think about them,” Forrester said.

Strong demand from borrowers and investors is driving lenders to find ways to issue highly leveraged loans, which have remained plentiful even as banks have become more judicious about how many and which deals to take on.

Banks may have to rein lending in further to avoid holding more capital against risky loans and other penalties, as regulators have offered broad catch-all definitions.

“When the question was about how broadly they should define leveraged loans, in every instance they took the more expansive view,” Brett Barragate, co-head of the Jones Day banking and finance practice, said of the new FAQs.

Editing by Tessa Walsh

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