US banking regulators warn of leveraged loan market risks

Risks associated with the leveraged loan market are still “elevated” despite marginal improvements in corporate creditworthiness in 2021, top U.S. banking regulators have warned.

In a report released on Monday, the Federal Reserve Board, Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency pointed to growing vulnerabilities in a number of sectors hardest hit by the coronavirus pandemic, including real estate. commercial. Many of the riskiest loans, they warn, are held by non-bank financial entities.

Businesses across the credit spectrum have rushed to borrow money in recent years, first to build a reserve to survive the pandemic, then to refinance their borrowings at lower interest rates.

This has led to swelling piles of corporate debt, with credit extended even to lower-rated companies, fueled by investor demand for higher-yielding assets and buoyed by the Fed’s historic intervention in the markets. financial.

But regulators have warned that a large number of borrowers remain constrained in their ability to repay their debts.

“While some leveraged borrowers have adjusted to the economic impact of Covid-19 and are showing signs of recovery, other high leverage borrowers remain particularly vulnerable,” according to the Shared National Credit Review. report.

The total number of loans that failed regulators has increased during the pandemic.

They include so-called special mention loans, which have “potential weaknesses that warrant management’s attention”, and classified commitments, defined as “substandard, impaired and [uncollectible]”.

The total number of special mention loans and classified commitments fell by about $80 billion in 2021 from the previous year to $550 billion, but still represents north of 10% of all commitments. loans assessed by the SNC.

The report also warned of the number of loans with “weak structures”, including high leverage, aggressive repayment schedules and terms that allow borrowers to increase their debt.

“The volume of leveraged transactions with these overlapping risks has increased significantly in recent years and continues to grow as strong investor demand for loans has enabled borrowers to obtain less restrictive terms,” ​​the report said. .

Non-bank financial groups are exposed to more than $300 billion of the total $550 billion in special mention lending and classified commitment, with around a quarter of the total committed by institutions, meaning they are responsible for it. By comparison, just over 12% is committed by US banks and foreign banks.

The trajectory of the pandemic will determine the “direction of risk” this year, regulators have said, with inflation, supply chain imbalances and labor issues putting additional pressure on indebted companies.

They also pointed to vulnerabilities associated with rising interest rates, which they said could “negatively impact” both “the financial performance and repayment capacity of borrowers across a wide variety of industries.” “.

Priscilla C. Carnegie