LONDON, Oct 30 (LPC) - Leveraged loans are coming under increasing fire from international regulators who are warning that loosening lender protections mark a huge deterioration in corporate lending that could pose a systemic risk to the banking sector.
Janet Yellen, the former chair of the US Federal Reserve, has joined a growing chorus of regulators who are highlighting leveraged loans as a possible source of a wave of bankruptcies as the next downturn draws closer.
Regulators updated US leveraged lending guidance in 2013 to curb systemic risk by monitoring and potentially penalising loose underwriting standards.
Those efforts have been relaxed as the US Republican administration focuses on deregulation and as cash continues to pour into the market and loan terms grow ever more aggressive.
“The recent statements are carefully framed and appear consistent with prior regulatory statements ... that leveraged lending must be subject to appropriate risk management and supported by capital,” said J Paul Forrester, a partner at law firm Mayer Brown.
The warnings come amid increased market volatility. The Dow Jones Industrial Average fell last week and the outlook for global growth in 2019 dimmed, according to a Reuters poll of economists. The economists are worried that tightening financial conditions and a US-China trade war may trigger a downturn.
Yellen said that she was worried about the systemic risks associated with leveraged loans, adding that there had been a huge deterioration in standards and also cited looser covenants as a concern in a Financial Times interview.
The Fed’s Todd Vermilyea also told a US loan conference that regulators are concerned about loosening terms including covenants, the ability to raise additional debt and aggressive adjustments to earnings before interest, tax, depreciation and amortisation.
“The presence of these practices, especially without the appropriate controls, may lead to safety and soundness concerns,” he said.
The Bank of England also issued a strong warning over the global leveraged loan market in October, drawing a comparison with the US sub-prime mortgage market that triggered the 2008 financial crisis.
The BoE’s Financial Policy Committee said that lending standards were falling and that it would monitor the risks to the UK and its banking sector more closely.
The publication of notes from the Fed’s September policy meeting also showed that officials raised the issue of loosening terms and standards in the US leveraged loan market, following remarks from Fed Chairman Jerome Powell in September.
The volume of cash pouring into the US$1.1trn US leveraged loan market shows no signs of abating as investors seek floating-rate debt to hedge against further interest rate rises. The Fed has hiked rates eight times in the last three years.
Investors have ploughed more than US$16bn into loan mutual funds and exchange-traded funds in 2018. More than US$106bn of US Collateralised Loan Obligation (CLO) funds and €22.4bn of European CLOs have been issued this year, according to LPC data and data provider Lipper.
As more regulators call for caution, President Donald Trump continues to push for deregulation. Although the leveraged lending guidelines remain in place, federal agencies including the Fed said in September that guidance does not have the force and effect of law and agencies will not enforce.
The sheer weight of liquidity targeted at the leveraged loan market combined with looser regulation is encouraging some arranging banks to bring more aggressive deals to the market.
Debt compared with Ebitda, which measures leverage on buyouts, increased to 6.94 times in the third quarter, the highest level since the same period in 2014, according to LPC data.
Leverage for Blackstone Group’s US$20bn purchase of a 55% stake in Thomson Reuters’ Financial & Risk business, which was renamed Refinitiv and includes IFR and LPC, was 7.6 times as of June 30, according to Moody’s. The private equity firm says total leverage is just 5.3 times after adjustments.
Such deals far exceed the parameters of the original guidance, which limited leverage to six times and also evaluated companies’ ability to repay debt.
The rise of covenant-lite lending is also expected to drive “worse than average” recoveries in the next default cycle, Moody’s said.
“Investors should be worried and mindful of the risks presented in the current vintage of leveraged loans,” said Enam Hoque, a vice president at the ratings firm. “Cov-lite is only the tip of the iceberg. There are serious deficiencies throughout the credit agreements.”
About 73% of the US leveraged institutional market was covenant-lite in the first three quarters of the year compared with 30% in March 2013 when the guidance was updated, according to LPC data. In Europe, where such loans were rare before the financial crisis, the number is 80%.
“At some point, investors should ask themselves if a senior secured term loan is just senior secured in name only,” Hoque said. “The flexibility provided in these documents is a real risk to investors accustomed to leverage loans with more traditional protections.” (Editing by Tessa Walsh)