Regulatory crackdown unlikely in US leveraged loan market

NEW YORK, March 15 (LPC) — The U.S. leveraged loan market is unlikely to see another regulatory crackdown despite growing criticism of the asset class, as the political stalemate in a Divided Congress would delay attempts at reform.

Federal Reserve (Fed) Chairman Jerome Powell said in late February that the $1.2 billion leveraged loan market did not pose a risk to the broader economy, but was a goal. important oversight. His comments contrast with those of other regulators who compared lending 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 for the second time about the potential economic dangers of excess corporate debt in lending. leverage.

“If the economy encounters a downturn, we could see a lot of corporate distress,” Yellen told an industry conference in Las Vegas. “If companies are in trouble, they lay off workers and cut capital expenditure. And I think that’s something that could make the next recession a deeper recession.

Yellen’s comments follow earlier warnings from Senator Elizabeth Warren and Bank of England Governor Mark Carney, who both warned of a potentially negative economic impact.

In 2013, US regulators updated the Leveraged Lending Guidance (LLG), which said that leverage more than six times “raises concerns”. The Republican administration has promised deregulation, however, and President Donald Trump has pledged to dismantle the sweeping 2010 Dodd-Frank regulatory reform package after his election in 2016.

Market participants thought the LLG might be relaxed in 2017 when it was deemed a rule under the Congressional Review Act. Government agencies clarified in September 2018 that the guidelines did not have the weight of law and that they would not take enforcement action based on them.

As a result, debt levels are hitting new highs and are averaging 6.9x in 2019 so far, after dropping to 6.09x in a volatile fourth quarter, the data shows. of the LPC. Leverage ratios hit a record 6.97x in the third quarter.

“It looks like (the leveraged loan guidelines) had insufficient effect,” said J. Paul Forrester, a partner at law firm Mayer Brown.

“There was a big increase in leverage, which is strange when loan funds had money coming out and there were concerns about a slowdown and a possible recession,” he said. -he declares. “None of that seemed to dampen (aggressive) lending. I find that striking in the absence of more upbeat economic news.

RELEASE LIKELY

Although regulators have the power to propose a rule on leveraged loans, 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 will or the political desire? he asked. “That seems unlikely (in) the broader deregulation environment and (a) slowing economic growth.”

The Office of the Comptroller of the Currency (OCC) works with the Fed and the Federal Deposit Insurance Corp, and has the authority to take action if it has concerns about the quality of loan underwriting, if necessary.

“We compare notes in terms of what we see in the leveraged lending space in regulated institutions, and then we certainly discuss and work with each other on reviews of leveraged lending activities” , said Morris Morgan, chief operating officer at OCC.

When the agency finds a weakness, either in the way Ebitda is calculated or in the commitments it deems “problematic”, it raises them with each institution and will continue to solve the problems in this way at the future, he said.

“The only way to be really more restrictive than looking at the facts and circumstances of each institution would be to write a rule, and I don’t see a rule being written in the near future,” Morgan said. .

A Fed spokesman 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 grew at breakneck speed after banks withdrew during the credit crunch.

Morgan said the question that has arisen is how banks determine whether credit risk appetite is greater than the market can bear at this late stage in the credit cycle, due to transparency reduced in the shadow banking sector.

“That’s what ultimately would be the real systemic risk is that you go over the market’s capacity,” he said. “In my opinion, that’s the $64,000 question and it’s a difficult question to answer, but we’re continuing to probe into it.”

INSUFFICIENT EFFECT

The U.S. leveraged loan market has nearly doubled in size in the past five years to US$1.2 billion as investors bought floating-rate loans to hedge against rising interest rates , backed by the issuance of Collateralized Loan Obligation (CLO) funds, the largest buyers of loans. , which reached a record volume of US$128.1 billion in 2018.

Low default rates – 1.75% at the end of 2018, according to Fitch Ratings – and a strong performance of CLOs have historically supported the asset class, but the massive influx of liquidity has allowed borrowers to remove lender protection and to produce aggressive conditions that have caught the attention of regulators and legislators.

U.S. secondary loan prices fell 4% in a volatile fourth quarter and investors withdrew $20.1 billion from loan mutual funds and exchange-traded funds during the period, in the largest quarterly release on record, according to Lipper.

Critics point to the growing number of ‘covenant-lite’ loans that continue to be issued without full lender protection and higher debt levels in 2019 as signs of a worrying market after the recent outflow of liquidity , but the Loan Syndications and Trading Association (LSTA) is trying to refute the findings on the asset class which it considers “erroneous”.

“From our perspective, we’re trying to engage constructively on both sides of the aisle to talk about and differentiate credit risk from systemic risk,” said Meredith Coffey, executive vice president of research and regulations at the LSTA.

“Leverage has increased and credit risk is higher than in 2010, but we consider the systemic risk of lending to be significantly lower than in 2007 and, furthermore, we do not consider lending to be a systemic risk,” she added.

Priscilla C. Carnegie