Regulators Probing Potential Threats from Leveraged Lending

WASHINGTON — Regulators have been spooked by the possibility of default on large loans to highly leveraged businesses for the past few years, but they are now beginning to worry that such defaults could cause systemic shock waves.

To date, federal agencies have focused mostly on the credit quality of leveraged loans, warning banks that heated competition is weakening underwriting standards. But they are now starting to show interest in how ties between leveraged loans and other links in the systemic chain — including investment funds that buy up loans — could magnify credit losses.

The Financial Stability Oversight Council — charged by the Dodd-Frank Act to identify systemic threats — heard a closed-door presentation last month from Federal Reserve Board staff on "speculative-grade debt markets, including leveraged lending," according to an official summary from the meeting. It was the second time the FSOC had asked regulators for a briefing on the issue.

"There has always been a certain amount of leveraged lending that was outside the banking system. But now that there are vehicles that are publicly traded, that creates liquidity concerns," said Brian Kleinhanzl, an analyst at Keefe, Bruyette & Woods. "That's one of the reasons the FSOC is looking at it."

It is unclear how serious the oversight council is about exploring systemic risks from leveraged loans — usually loans to a company in the millions of dollars shared by multiple banks. Some believe the risk is minor compared with other activities with a bigger footprint and steps institutions have taken to avert catastrophe.

But demand for leveraged loans, though still elevated, actually went down last year, suggesting investors may be cooling to the market. In the Fed's most recent senior loan officer survey, released earlier this month, 22% of respondents, and 27% of those representing large banks, said they expected some deterioration over the next year in syndicated leveraged commercial loans.

Experts say the council's interest in leveraged lending channels is not surprising given regulators' concerns about how quickly loans grew in recent years and similarities with recently maligned distribution models, such as mortgage securitization. (Under Dodd-Frank, the council can recommend stricter standards from member regulators for activities threatening financial stability.)

"I don't know that it means that they're contemplating action as much as that they're doing what they should be doing, which is looking at an issue that a lot of people fear could — particularly in the continued lower interest rate environment — pose potential risk," said Karen Shaw Petrou, managing partner at Federal Financial Analytics. "Money is chasing yield, which means it's chasing risk. In the event that this blows, the question is where does the bouncing ball end?"

Experts say officials are likely interested in leveraged loan mutual funds, which attract ordinary investors in a low-rate environment and promise quick redemptions, and other more complex investment instruments. Another potential concern is whether large banks that sell leveraged loans may still have risk. In the financial crisis, mortgage-related exposures thought to be removed from banks' balance sheets came back to bite them.

"My guess is FSOC would be most concerned about what the banks are exposed to, either directly or by holding the loans on their balance sheet or indirectly by having provided credit to" institutions that purchased them, said Arthur Wilmarth, a George Washington University law professor. "My suspicion is that the banks have direct or indirect exposure."

Overall leveraged loans went down last year by 17% to $940 billion, but that is still very robust following the huge spike in originations starting in 2010. Meanwhile, loan mutual funds — usually made up of leveraged loans — accounted for about 16% of the $850 billion institutional loan market in December, according to the Loan Syndications and Trading Association.

Meredith Coffey, the LSTA's executive vice president for research, said while questions about potential systemic risks could be expected, she doubts regulators will find anything. Coffey noted that the leveraged lending market is less than 2% the size of the capital markets overall, and other sectors pose greater macroeconomic concerns. Whereas the mortgage sector could be dragged down by just one area — housing — Coffey said securities backed by leveraged loans finance numerous sectors and therefore lack the same type of risk.

"Housing was very correlated because it all moved at the same time. But a loan to an automotive company won't tend to be moving in the same direction as a loan to a health care company," she said.

"Am I surprised that the question came up about leveraged loans and systemic risk? No. Do I think that leveraged loans are systemically risky? Not really," Coffey said. "Numbers-wise, it doesn't make sense to us that that is viewed as systemically risky when you have all these other markets that are so much larger."

But it was not so long ago that the leveraged lending sphere experienced a market tremor. In 2007, the building unease in the debt markets from heightening mortgage losses flowed to financing for leveraged buyouts. At that time, Citigroup Chief Executive Charles Prince was famously bullish about the availability of liquidity. When he said that "as long as the music is playing, you've got to get up and dance" and "we're still dancing," he was referring specifically to leveraged financing. But the leveraged buyout market ultimately froze up.

Coffey said banks have taken steps to avoid a repeat. While lenders previously were exposed to "pipeline risk," meaning they were committed to provide financing to a borrower even after an investor decided to walk away from the deal, "pipeline management is something banks take very seriously now," she said.

"The [investor] demand has gone down, but the pipelines are nowhere near where they were in 2007."

The bank regulators' current focus on leveraged lending has been driven largely by underwriting weaknesses. Echoing fears officials have expressed since at least 2012, the agencies' 2014 Shared National Credit report, which tracks loans of $20 million or more shared by at least three institutions, found that leveraged loans made up nearly 75% of "criticized" SNC assets. The report was accompanied by a supplement focused on deficiencies in leveraged loans, in which the agencies suggested they could lead to macroeconomic risk.

"A poorly underwritten or low-quality leveraged loan that is pooled with other loans or is participated with other institutions can generate excessive risk to the financial system," the supplement said.

In 2013, the regulators issued guidance instructing banks to improve risk management procedures for leveraged lending.

Yet policymakers have also given signals to the market that any macroprudential concerns about leveraged lending are still mild.

"To date, we do not see a systemic threat from leveraged lending, since broad measures of credit outstanding do not suggest that nonfinancial borrowers, in the aggregate, are taking on excessive debt and the improved capital and liquidity positions at lending institutions should ensure resilience against potential losses due to their exposures," Fed Chair Janet Yellen said in a July speech. "But we are mindful of the possibility that credit provision could accelerate, borrower losses could rise unexpectedly sharply, and that leverage and liquidity in the financial system could deteriorate."

Observers said regulators may simply see the growth of leveraged loan investments in the secondary market — especially as fixed-income investors yearn higher returns amid historically low interest rates — and are reminded of other securitization models that threatened the system.

"You can imagine someone saying that leveraged lending has all of the same potential for problems as private-label securitization," said Phillip Swagel, a professor at the University of Maryland and a former assistant Treasury secretary.

But Swagel said any broader risk stemming from leveraged loans is likely contained. Leading up to the crisis, the market had the impression banks had absolved themselves of mortgage risk by distributing loans to investors, but that belief overlooked the off-balance-sheet risk that institutions still had through structured vehicles.

"I understand why the FSOC would investigate this, because I could see, in principle, how [leveraged lending] would be a problem … in the same way that private-label securitization was a problem in the last crisis," Swagel said. "I don't think it is, in reality, because the institutions involved learned the lessons of the crisis. When institutions do a securitization, they truly have to transfer the risk. They can't hide it back on these off-balance-sheet entities."

But others note aspects of the leveraged lending market that they say could amplify the risk. While more sophisticated investors can invest in leveraged loans through channels such as collateralized loan obligations, there are also mutual funds and exchange-traded funds backed by the loans.

"Anytime you have this chain of securitization you have this problem of different actors having different incentives. The final risk of the product may be greater than what the investors think it is," said Elisabeth de Fontenay, a Duke University law professor.

She noted that mutual funds' interest in leveraged loans is relatively recent, and unlike with other types of vehicles, mutual funds "have to be able to redeem investors on a dime." That process is complicated by the fact that leveraged loan borrowers typically have to grant permission before a security is reassigned.

"That's really easy to do when you're talking about stocks and publicly traded bonds. It's much harder to do when you're talking about leveraged loans," she said. "It's kind of an onerous process . ... The fear is that if the market really went south, and mutual fund investors were asking to be redeemed, they might not be able to be redeemed in time. That could cause big issues for these funds."

But de Fontenay also sees reason to be optimistic. She said the risk of not knowing what type of credit quality underlies a security — which was a huge issue during the mortgage meltdown — would likely be less of a problem for leveraged loan funds.

"It's really hard to go down to the individual level of each home mortgage that is packaged," she said. "With the leveraged loans, it's not that difficult to figure out what loans are in a particular vehicle and to kick the tires at least a little bit."